SOLUTIONS MANUAL For Economics 12th Global Edition By Michael Parkin by welldoneassistant

Solutions Manual For th Economics 12 Global Edition By Michael Parkin (All Chapters, 100% Original Verified, A+ Grade) Part 1: Answers to the Review Quiz: Page 2-417 Part 2: Lecture Notes: Page 418-734

Part 1: Answers to the Review Quiz

C h a p t e r

WHAT IS ECONOMICS?

Answers to the Review Quiz Page 40 1.

List some examples of the scarcity that you face. Examples of scarcity common to students include not enough income to afford both tuition and a nice car, not enough learning capacity to study for both an economics exam and a chemistry exam in one night, and not enough time to allow extensive studying and extensive socializing.

Find examples of scarcity in today’s headlines. A headline in The Sacramento Bee on May 6, 2014 was “Sleep Train Kicks Off Annual ‘Clothing Drive for Foster Kids’.” The story points out that these children face scarcity because “foster children typically arrive in a foster home with just the clothes on their back.” Accordingly, the charity group Sleep Train is looking for donations to provide foster children with more clothing, which means that the foster family will need to provide less clothing.

Find an example of the distinction between microeconomics and macroeconomics in today’s headlines. Microeconomics: On May 6, 2014 a headline in The New York Times was “Bayer Buys Merck’s Consumer Business for $14.2 Billion.” This story covers a microeconomic topic because it discusses how two pharmaceutical firms have decided to transfer ownership of the unit producing over-the-counter consumer products for Merck. Macroeconomics: On May 6, 2014, a headline in The Wall Street Journal was “U.S. Trade Gap Narrows as Demand Grows Here and Abroad.” This story covers a macroeconomic topic because it concerns the total amount of international trade in the entire economy.

Page 45 1.

Describe the broad facts about what, how, and for whom goods and services are produced. What gets produced is significantly different today than in the past. Today the U.S. economy produces more services, such as medical operations, teaching, and hair styling, than goods, such as pizza, automobiles, and computers. How goods and services are produced is by businesses determining how the factors of production, land, labor, capital and entrepreneurship, are combined to make the goods and services we consume. Land includes all natural resources, both renewable natural resources such as wood, and nonrenewable natural resources such as natural gas. Labor’s quality depends on people’s human capital. In the U.S. economy, human capital obtained through schooling has increased over the years with far more people completing high school and attending college than in past years. Finally, for whom are goods and services to be produced depends on the way income is distributed to U.S. citizens. This distribution is not equal; the 20 percent of people with the lowest income earn about 5 percent of the nation’s total income while the 20 percent of people with the highest incomes earn about 50 percent of total income. On the average, men earn more than women, whites more than nonwhites, and college graduates more than high school graduates.

CHAPTER 1

Use headlines from the recent news to illustrate the potential for conflict between self-interest and the social interest. One example of an issue concerns the income necessary to live in an apartment building in San Francisco. A May 5, 2014 headline from The San Francisco Chronicle was “S.F. Landlord: Make $100K or Get Out.” This story discusses an owner’s attempt to make the tenants prove that their annual income is at least $100,000. The owner is following his self-interest because he wants to have only high-income residents who, presumably, create less damage and might be willing to pay more rent. The head of San Francisco’s Housing Rights Committee, Sara Shortt, believes that the requirement is not in the social interest. She asserts that the effort “definitely reads like a harassment tactic” and that the effort to force tenants to move is illegal. She believes that the social interest is served by having a variety of tenants in the apartments.

Page 48 1.

Explain the idea of a tradeoff and think of three tradeoffs that you have made today. A tradeoff reflects the point that when someone gets one thing, something else must be given up. What is given up is the opportunity cost of whatever is obtained. Three examples of tradeoffs that are common to students include: a) When a student sleeps in rather than going to his or her early morning economics class, the student trades off additional sleep for study time. The opportunity cost of the decision is a lower grade on the exam. b) When a student running late for class parks his or her car illegally, the student trades off saving time for the risk of a ticket. The potential opportunity cost of the decision is the goods and services that cannot be purchased if the student receives an expensive parking ticket. c) A student trades off higher income by spending time during the day working at a part-time job for less time spent at leisure time and study. The opportunity cost for the higher income is less leisure and lower grades in classes.

Explain what economists mean by rational choice and think of three choices that you’ve made today that are rational. A rational choice is one that compares the costs and benefits of the different actions and then chooses the action that has the greatest benefit over cost for the person making the choice. Three rational choices made by students include: a) The choice to skip breakfast to go to class. In this case the benefit is the higher grade in the class and the cost is the breakfast forgone. b) The choice to stop talking with a friend on the phone and start studying for an impending exam. In this case the benefit is the resulting higher grade in the class and the cost is the conversation forgone. c) The choice to do laundry today rather than watch television. In this case the benefit is the fact the student will have clean clothes to wear and the cost is the loss of the entertainment the television show would have provided.

Explain why opportunity cost is the best forgone alternative and provide examples of some opportunity costs that you have faced today. When a decision to undertake one activity is made, often many alternative activities are no longer possible. Often these activities are mutually exclusive so only the highest valued alternative is actually forgone. For instance, the decision to go to a student’s 8:30 AM class eliminates the possibility of sleeping in during the hour and of jogging during the hour. But in this case, it is impossible to both sleep in and to jog during the hour, so the opportunity cost cannot be both activities. What is lost is only the activity that otherwise would have been chosen—either sleeping in or jogging—which is whatever activity would have been chosen, that is, the most highly valued of the forgone alternatives. For students, attending class, doing homework, studying for a test are all activities with opportunity costs.

WHAT IS ECONOMICS?

Explain what it means to choose at the margin and illustrate with three choices at the margin that you have made today. Choosing at the margin means choosing to do a little more or a little less of some activity. Three common examples students encounter are: a) When a student faces a chemistry and an economics final exam in one day, the student must determine whether spending the last hour studying a little more chemistry or a little more economics will yield a better contribution (marginal benefit) to his or her overall GPA. b) A college student buying a computer must decide whether the marginal benefit of adding 1 GB of additional memory is worth the marginal cost of the additional memory. c) A student football fan with a choice of a cheap seat in the student bleachers located at the far end of the playing field or a more expensive seat located on the 30 yard line must determine whether the marginal benefit of watching the game from a better seat is worth the marginal cost of the higher ticket price.

Explain why choices respond to incentives and think of three incentives to which you have responded today. People making rational decisions compare the marginal benefits of different actions to their marginal costs. Therefore people’s choices change when their incentives, that is the marginal benefit and/or marginal cost, of the choice changes. Just as everyone else, students respond to incentives; a) A student studies because of the incentives offered by grades. b) A student is more likely to attend a class if attendance is factored into the grade. c) A student might attend a meeting of a club if the student’s significant other is eager to attend the meeting.

Page 49 1.

Distinguish between a positive statement and a normative statement and provide examples. A positive statement is a description of how the world is. It is testable. A normative statement is a description of how the world ought to be. It is, by its very nature, not testable because there is no universally approved criterion by which the statement can be judged. “I will receive an A for this course,” is a positive statement made by an economics student—it might not be true, but it is testable. “I will receive a good grade for this course,” is a normative statement. Whether someone agrees with it depends on his or her interpretation of what makes for a “good” grade.

What is a model? Can you think of a model that you might use in your everyday life? A model is a description of some aspect of the economic world. It includes only those features that are necessary to understand the issue under study. An economic model is designed to reflect those aspects of the world that are relevant to the user of the model and ignore the aspects that are irrelevant. A typical model is a GPS map. It reflects only those aspects of the real world that are relevant in assisting the user in reaching his or her destination and avoids using information irrelevant to travel.

How do economists try to disentangle cause and effect? Economists use models to understand some aspect of the economic world. Testing the predictions of models makes it necessary to disentangle cause and effect. To overcome this problem, economists have three methods of testing their models: Using a natural experiment, using a statistical investigation, and using economic experiments. A natural experiment is a situation that arises in the ordinary course of life in which one factor being studied varies and the other factors are the same. This method allows the economist to focus on the effect from the factor that differs between the two situations. A statistical investigation looks for correlations between variables but then determining whether the correlation actually reflects causation can be difficult. An economic experiment puts people into decision making situations and then varies the relevant factors one at a time to determine each factor’s effect.

How is economics used as a policy tool? Individuals, businesses, and governments use economics as a policy tool. Individuals use the economic ideas of marginal benefit and marginal cost when making decisions for such topics as attending college, paying cash or credit for a purchase, and working. Businesses also use the concepts of marginal benefit and marginal cost when making decisions about what to produce, how to produce, and even how many hours to stay open. Finally governments also use marginal benefit and marginal cost when deciding issues such as the level of property taxes, the amount to fund higher education, or the level of a tariff on Brazilian ethanol.

CHAPTER 1

Answers to the Study Plan Problems and Applications 1.

Apple Inc. decides to make iTunes freely available in unlimited quantities. a. Does Apple’s decision change the incentives that people face? Apple’s decision changes people’s incentives. For example, it increases people’s incentives to buy an iPod to take advantage of the newly “free” music available on iTunes.

b. Is Apple’s decision an example of a microeconomic or a macroeconomic issue? Apple’s decision is a microeconomic decision because it affects a single company and a single market.

Which of the following pairs does not match? a. Labor and wages Labor earns wages, so this pair matches.

b. Land and rent Land earns rent, so this pair matches.

c. Entrepreneurship and profit Entrepreneurship earns profit, so this pair matches.

d. Capital and profit Capital earns interest, so this pair does not match.

Explain how the following news headlines concern self-interest and the social interest. a. Starbucks Expands in China Starbucks’ expansion is a decision made by Starbucks to further Starbucks’ interest. Thus the decision is directly in Srarbucks’ self interest. The social interest is affected because Starbucks’ expansion will have an effect in China. For instance, more Chinese citizens might drink coffee rather than tea and fewer coffee shops run by Chinese firms might open.

b. McDonald’s Moves into Gourmet Coffee McDonald’s decision to serve gourmet coffee is a decision made by McDonald’s to further McDonald’s interest. Thus the decision is directly in McDonald’s self interest. The social interest is affected because more people will drink coffee rather than other drinks such as sodas.

c. Food Must Be Labeled with Nutrition Data The decision to require that food must be labeled with nutrition information is made in the social interest. This decision is not made by any one single firm and so does not (necessarily) reflect anyone’s self interest.

The night before an economics test, you decide to go to the movies instead of staying home and working your MyEconLab Study Plan. You get 50 percent on your test compared with the 70 percent that you normally score. a. Did you face a tradeoff? Yes, you faced a tradeoff. The tradeoff was between a higher test score and an evening with your friends at the movies.

b. What was the opportunity cost of your evening at the movies? The opportunity cost of going to the movies is the fall in your grade. That is the 20 points forgone from choosing to see the movie rather than study.

WHAT IS ECONOMICS?

Cost of Sochi Winter Olympics The Russian government spent $6.7 billion on Olympic facilities and $16.7 billion upgrading Sochi area infrastructure. Sponsors spent $27.6 billion on hotels and facilities hoping to turn Sochi into a year-round tourist magnet. Source: The Washington Post, February 11, 2014 Was the opportunity cost of the Sochi Olympics $6.7, $23.4, or $51 billion? Explain your answer. The $6.7 billion spent on Olympic facilities is definitely an opportunity cost of the Sochi Olympics. The $16.7 billion spent upgrading the Sochi area infrastructure and the $27.6 billion spent on hotels and facilities are an opportunity cost of the Sochi Olympics if the funds would not have spent otherwise. However, if there were already plans underway to upgrade the Sochi area infrastructure then the cost is not an opportunity cost of the Sochi Olympics because the cost would have been paid even if Sochi did not host the Olympics. Similarly, if there were already plans underway to build hotels and facilities in Sochi then the cost is not an opportunity cost of the Sochi Olympics because the cost would have been paid even if Sochi did not host the Olympics.

Which of the following statements is positive, which is normative, and which can be tested? a. The United States should cut its imports. The statement is normative and cannot be tested.

b. China is the largest trading partner of the United States. The statement is positive and can be tested.

c. If the price of antiretroviral drugs increases, HIV/AIDS sufferers will decrease their consumption of the drugs. The statement is positive and can be tested.

CHAPTER 1

Answers to Additional Problems and Applications 7.

Rapper Offers Free Tickets for Concert Eminem will hit the road with Rihanna offering an awesome deal—buy one and get one free! Source: Mstars News, February 24, 2014 When Eminem gave away tickets, what was free and what was scarce? Explain your answer. The seats in the arenas are scarce—there are only a limited number. Also scarce is the time the enthusiastic fans spend in line to acquire the tickets. In addition, if the fans who with the “free” ticket attended the concert rather than sell their free tickets, they incurred the opportunity cost of the foregone ticket price. So the concert was far from “free” for the concert-goers. The publicity that Eminem receives is free to him but the publicity used reporters’ scarce time to report on the lines for the tickets rather than reporting on other news worthy events.

How does the creation of a successful movie influence what, how, and for whom goods and services are produced? The “what” question is affected in two ways. First, one good or service that is produced is the successful movie. Second, spinoffs (Iron Man II) and/or similar films likely will be created in the future. The “how” question is affected to the extent that movies use different production methods. Some movies, for instance, have a lot of special effects while other movies have few or none. The “for whom” question is influenced because those people who, as the result of the blockbuster movie, have higher incomes so that more goods and services are produced for them.

How does a successful movie illustrate self-interested choices that are also in the social interest? The a successful movie increases the income of the people involved with the movie. Hence these people’s choices are driven largely by self interest. However the creation of a successful movie also increases the quantity of widely enjoyed entertainment. The amount of entertainment available in the economy increases which benefits society. So the choices the people made in their self interest also reflected choices made in the social interest.

10.

The rising star of Brazilian football, Neymar Jr., signed his first professional contract at the age of 17 with Santos Football Club for $1.2 million a year. Six years later, he signed with FC Barcelona a 5-year contract, making his average annual salary $15.4 million. a. How do you expect the professional success of Neymar Jr. to influence the opportunity cost of signing a contract with him? Neymar Jr.’s success had encouraged numerous football clubs, including Barcelona, to bid competitively to secure a contract with him. If his success continues, the opportunity cost to football clubs of hiring Neymar Jr. will keep increasing.

b. How does Neymar Jr.’s success change the incentives for football clubs to hire him? There are two effects on the incentives of football clubs to hire Neymar Jr. First, because the opportunity cost of hiring Neymar Jr. increased, the incentive to hire him decreased. However because of Neymar Jr.’s great success, there is a stronger incentive for football clubs to sign contracts with him as they believe that he could help them win.

11.

What might be an incentive for you to take a class in summer school? List some of the benefits and costs involved in your decision. Would your choice be rational? Early graduation, smaller class sizes, and/or retaining eligibility for a scholarship are examples of incentives that encourage taking summer classes. The benefits of taking summer classes might include early graduation, more personal attention from the instructor, retained eligibility for a scholarship, and increased knowledge about some aspect of the world. Costs potentially include forgone summer jobs or internships, less time to spend with friends, and additional tuition and other class-related expenses if the class I not one that would be taken otherwise. The choice is rational as long as the student determines that taking summer classes offers the highest benefit over cost for the use of his or time and efforts.

12.

Look at today’s BBC News. What is the leading economic news story? With which of the big

WHAT IS ECONOMICS?

economic questions does it deal and what tradeoffs does it discuss or imply? On March 9, 2015, the top economic news story discussed cutting the defense spending in the United Kingdom by cutting thousands of jobs held by the army, navy and the royal air force. This comes about as a result of the overall need to practice austerity measures in public spending. This news story addresses the “what” question because the government has decided to cut back on security spending, specifically the employment of personnel as opposed to the cost of military equipment. It also touches upon the “how” question as it specifies that this saving will be done by cutting up to 30,000 jobs. The story implicitly illustrates a tradeoff: For the government to decrease its spending and save more, the security of the country will be affected.

Source: BBC News; http://www.bbc.com/news/uk-31798029

13.

Provide two microeconomic statements and two macroeconomic statements. Classify your statements as positive or normative, and explain your classifications. Microeconomic statements are: Fewer deep water oil wells should be drilled in the Gulf of Mexico. If less oil is produced, the price of oil will rise. The first statement is normative because it relies on what the person thinks “should” be done. The second statement is positive because it is possible to test the effect of less oil being produced. Macroeconomic statements are: The currently unemployment rate is too high. The current unemployment rate is higher for blacks than for whites. The first statement is normative because it depends on what is deemed “too high.” The second statement is positive because it can be checked to determine its validity.

Appendix

GRAPHS IN ECONOMICS

Answers to the Review Quiz Page 66 1.

Explain how we “read” the three graphs in Figs. A1.1 and A1.2. The points in the graphs relate the quantity of the variable measured on the one axis to the quantity of the variable measured on the other axis. The quantity of the variable measured on the horizontal axis (the x-axis) is measured by the horizontal distance from the origin to the point. Similarly, the quantity of the variable measured on the vertical axis (the y-axis) is measured by the vertical distance from the origin to the point. The point relates these two quantities. For instance, in Figure A1.2a, point A shows that at a price of $1.37 per song, 3.8 million songs are downloaded.

Explain what scatter diagrams show and why we use them. Scatter diagrams plot the value of one economic variable against the value of another variable for a number of different values of each variable. We use scatter diagrams because they quickly reveal if a relationship exists between the two variables. Moreover, if a relationship exists, scatter diagrams show whether increases in one variable are associated with increases or decreases in the other variable.

Explain how we “read” the three scatter diagrams in Figs. A1.3 and A1.4. The scatter diagram in Figure A1.3 shows the relationship between box office ticket sales and DVDs sold for 9 popular movies. The figure shows that higher box office sales are associated with a higher number of DVDs sold. But the figure shows that the relationship is weak. The scatter diagram in Figure A1.4a shows the relationship between income, in thousands of dollars per year, and expenditure, also in thousands of dollars per year, for the years 2001 to 2011. The scatter diagram shows that higher income leads to higher expenditure. The figure also shows that the relationship is relatively strong. The scatter diagram in Figure A1.4b shows the relationship between the inflation rate and the unemployment rate for the years 2001 to 2011. The figure shows that for most of the years, there was a weak relationship between these variables, with perhaps higher inflation being associated with lower unemployment.

APPENDIX 1

Draw a graph to show the relationship between two variables that move in the same direction. A graph that shows the relationship between two variables that move in the same direction is shown by a line that slopes upward. Figure A1.1 illustrates such a relationship.

Draw a graph to show the relationship between two variables that move in opposite directions. A graph that shows the relationship between two variables that move in the opposite directions is shown by a line that slopes downward. Figure A1.2 illustrates such a relationship.

GRAPHS IN ECONOMICS

Draw a graph of two variables whose relationship shows (i) a maximum and (ii) a minimum. A graph that shows the relationship between two variables that have a maximum is shown by a line that starts out sloping upward, reaches a maximum, and then slopes downward. Figure A1.3 illustrates such a relationship with curve B. A graph that shows the relationship between two variables that have a minimum is shown by a line that starts out sloping downward, reaches a minimum, and then slopes upward. Figure A1.3 illustrates such a relationship with curve A.

Which of the relationships in Questions 4 and 5 is a positive relationship and which is a negative relationship? The relationship in Question 4 between the two variables that move in the same direction is a positive relationship. The relationship in Question 5 between the two variables that move in the opposite directions is a negative relationship.

What are the two ways of calculating the slope of a curved line? To calculate the slope of a curved line we can calculate the slope at a point or across an arc. The slope of a curved line at a point on the line is defined as the slope of the straight line tangent to the curved line at that point. The slope of a curved line across an arc—between two points on the curved line—equals the slope of the straight line between the two points.

How do we graph a relationship among more than two variables? To graph a relationship among more than two variables, hold constant the values of all the variables except two. Then plot the value of one of the variables against the other variable.

10.

Explain what change will bring a movement along a curve. A movement along a curve occurs when the value of a variable on one of the axes changes while all of the other relevant variables not graphed on the axes do not change. The movement along the curve shows the effect of the variable that changes, ceteris paribus (holding all of the other non-graphed variables constant).

11.

Explain what change will bring a shift of a curve. A curve shifts when there is a change in the value of a relevant variable that is not graphed on the axes. In this case the entire curve shifts.

APPENDIX 1

Answers to the Study Plan Problems and Applications Use the spreadsheet to work Problems 1 to 3. The spreadsheet provides data on the U.S. economy: Column A is the year, column B is the inflation rate, column C is the interest rate, column D is the growth rate, and column E is the unemployment rate.

1 2 3 4 5 6 7 8 9 10 11

A 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

B 1.6 2.3 2.7 3.4 3.2 2.9 3.8 −0.3 1.6 3,1 2.1

C 1.0 1.4 3.2 4.9 4.5 1.4 0.2 0.1 0.1 0.1 0.1

D 2.8 3.8 3.4 2.7 1.8 −0.3 −2.8 2.5 1.8 2.8 1.9

E 6.0 5.5 5.1 4.6 4.6 5.8 9.3 9.6 8.9 8.1 7.4

Draw a scatter diagram of the inflation rate and the interest rate. Describe the relationship. To make a scatter diagram of the inflation rate and the interest rate, plot the inflation rate on the x-axis and the interest rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.4. The pattern made by the dots tells us that as the inflation rate increases, the interest rate usually increases so there is a (weak) positive relationship.

Draw a scatter diagram of the growth rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the growth rate and the unemployment rate, plot the growth rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.5. The pattern made by the dots tells us that when the growth rate increases, the unemployment rate usually decreases so there is a negative relationship.

GRAPHS IN ECONOMICS

Draw a scatter diagram of the interest rate and the unemployment rate. Describe the relationship. To make a scatter diagram of the interest rate and the unemployment rate, plot the interest rate on the x-axis and the unemployment rate on the y-axis. The graph will be a set of dots and is shown in Figure A1.6. The pattern made by the dots tells us that when the interest rate increases, the unemployment rate usually decreases so there is a negative relationship.

Use the following news clip to work Problems 4 to 6. Lego Shatters More Records: Source: Boxofficemojo.com, Data for weekend of February 14-17, 2014 4.

Draw a graph of the relationship between the revenue per theater on the y-axis and the number of theaters on the x-axis. Describe the relationship.

Movie The LEGO Movie About Last Night RoboCop The Monument Men

Figure A1.7 shows the relationship. As the figure shows, there is a positive relationship.

Calculate the slope of the relationship between 3,775 and 2,253 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($16,551 − $12,356)/(3,775 − 2,253) which equals $2.76 per theater.

Calculate the slope of the relationship in Problem 4 between 2,253 and 3,372 theaters. The slope equals the change in revenue per theater divided by the change in the number of theaters. The slope equals ($12,356 − $7,432)/(2,253 − 3,372 which equals −$4.40 per theater.

Theaters (number ) 3,775 2,253 3,372 3,083

Revenue (dollars per theater) $16,551 $12,356 $7,432 $5,811

APPENDIX 1

Calculate the slope of the relationship shown in Figure A1.8. The slope is −5/4. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the x-axis. To calculate the slope, you must select two points on the line. One point is at 10 on the y-axis and 0 on the x-axis, and another is at 8 on the x-axis and 0 on the y-axis. The change in y from 10 to 0 is associated with the change in x from 0 to 8. Therefore the slope of the curve equals −10/8, which equals −5/4.

Use the relationship shown in Figure A1.9 to work Problems 8 and 9. 8.

Calculate the slope of the relationship at point A and at point B. The slope at point A is −2, and the slope at point B is −0.25. To calculate the slope at a point on a curved line, draw the tangent to the curved line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the y-axis at 10. The slope of the tangent equals the change in y divided by the change in x. The change in y equals −4 (6 minus 10) and the change in x equals 2 (2 minus 0). The slope at point A is −4/2, which equals −2. Similarly, the slope at point B is −0.25. The tangent at point B goes through the point (4, 2). The change in y equals 0.5, and the change in x equals −2. The slope at point B is −0.25.

Calculate the slope across the arc AB. The slope across the arc AB is −1.125. The slope across an arc AB equals the change in y, which is 4.5 (6.0 minus 1.5) divided by the change in x, which equals −4 (2 minus 6). The slope across the arc AB equals 4.5/−4, which is −1.125.

Price (dollars per ride) 5 10 15

Balloon rides (number per day) 50F 70F 90F 32 40 50 27 32 40 18 27 32

GRAPHS IN ECONOMICS

Use the table to work Problems 10 and 11. The table gives the price of a balloon ride, the temperature, and the number of rides a day. 10.

Draw a graph to show the relationship between the price and the number of rides, when temperature is 70°F. Describe this relationship. Figure A1.10 shows the relationship between the price and the number of balloon rides when the temperature is 70F. The relationship between the price and the number of rides is inverse; that is, when the price rises, the number of rides decreases.

11.

What happens in the graph in Problem 10 if the temperature rises to 90°F? If the temperature rises to 90F, the curve shifts rightward. This shift is illustrated in Figure A1.11. In that figure, both the initial curve, which applies when the temperature is 70F, and the new curve, which applies when the temperature is 90F, are illustrated. The curve when the temperature is 90F lies to the right of the curve when the temperature is 70F indicating that at every price, more balloon rides are taken when the temperature is 90F rather than 70F.

APPENDIX 1

Answers to Additional Problems and Applications Use the spreadsheet to work Problems 12 to 14. The spreadsheet provides data on oil and gasoline: Column A is the year, column B is the price of oil (dollars per barrel), column C is the price of gasoline (cents per gallon), column D is U.S. oil production, and column E is the U.S. quantity of gasoline refined (both in millions of barrels per day).

12.

1 2 3 4 5 6 7 8 9 10 11

A 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

B 31 42 57 66 72 100 62 79 95 94 98

C 160 190 231 262 284 330 241 284 354 364 353

D 5.7 5.4 5.2 5.1 5.1 5.0 5.4 5.5 5.7 6.5 7.5

E 8.9 9.1 9.2 9.3 9.3 9.0 9.0 9.0 9.1 9.0 9.1

Draw a scatter diagram of the price of oil and the quantity of U.S. oil produced. Describe the relationship. Figure A1.12 shows the scatter diagram between the price of a barrel of oil and the quantity of U.S. oil produced. It shows a very weak relationship.

13.

Draw a scatter diagram of the price of gasoline and the quantity of gasoline refined. Describe the relationship. Figure A1.13 shows the scatter diagram between the price of a gallon of gasoline and the quantity of gasoline refined. It shows a weak positive relationship.

GRAPHS IN ECONOMICS

14.

Draw a scatter diagram of the quantity of U.S. oil produced and the quantity of gasoline refined. Describe the relationship. Figure A1.14 shows the scatter diagram between the quantity of U.S. oil produced and the quantity of gasoline refined. It shows a negative relationship.

Use the following data to work Problems 15 to 17. Draw a graph that shows the relationship between the two variables x and y in the table to the right.

x y

0 25

1 24

2 22

3 18

4 12

To make a graph that shows the relationship between x and y, plot the x variable on the x-axis and the y variable on the y-axis. Figure A1.15 shows this graph.

15. a. Is the relationship positive or negative? The relationship is negative because x and y move in opposite directions: As x increases, y decreases.

b. Does the slope of the relationship become steeper or flatter as the value of x increases? The slope becomes steeper as x increases.

c. Think of some economic relationships that might be similar to this one. The less expensive a good, the greater is the number of people who buy it. The higher the interest rate, the smaller is the number of people who take out home mortgages. The less expensive gasoline, the greater the miles car owners drive.

16.

Calculate the slope of the relationship between x and y when x equals 3. The slope equals −4.0. The slope of the curve at the point where x is 3 is equal to the slope of the tangent to the curve at that point. Plot the relationship and then draw the tangent line at the point where x is 3 and y is 18. Now calculate the slope of this tangent line by finding another point on the tangent. When x equals 5, y equals 10 on the tangent, so another point is x equals 5 and y equals 10. The slope equals the change in y, 8, divided by the change in x, −2, so the slope is −4.0.

5 0

17.

APPENDIX 1

Calculate the slope of the relationship across the arc as x increases from 4 to 5. The slope is –12. The slope of the relationship across the arc when x increases from 4 to 5 is equal to the slope of the straight line joining the points on the curve at x equals 4 and x equals 5. When x increases from 4 to 5, y falls from 12 to 0. The slope equals the change in y, 12 (12 minus 0), divided by the change in x, −1 (4 minus 5), so the slope across the arc is −12.0.

18.

Calculate the slope of the curve in Figure A1.16 at point A. The slope is −2. The curve is a straight line, so its slope is the same at all points on the curve. Slope equals the change in the variable on the y-axis divided by the change in the variable on the xaxis. To calculate the slope, select two points on the line. One point is at 18 on the y-axis and 0 on the x-axis, and another is at 9 on the x-axis and 0 on the y-axis. The change in y from 18 to 0 is associated with the change in x from 0 to 9. Therefore the slope of the curve equals −18/9, which equals −2.

Use Figure A1.17to work Problems 19 and 20. 19. Calculate the slope at point A and at point B. The slope at point A is −4, and the slope at point B is −1. To calculate the slope at a point on a curved line, draw the tangent to the line at the point. Then find a second point on the tangent and calculate the slope of the tangent. The tangent at point A cuts the x-axis at 2.5. The slope of the tangent equals the change in y divided by the change in x. The change in y equals 6 (6 minus 0) and the change in x equals −1.5 (1 minus 2.5). The slope at point A is 6/−1.5, which equals −4. Similarly, the slope at point B is −1. The tangent at point B cuts the y-axis at 5. The change in y equals 3, and the change in x equals −3. The slope at point B is −1.

20.

Calculate the slope across the arc AB. The slope across the arc AB is −2. The slope across the arc AB equals the change in y, which is 4 (6 minus 2) divided by the change in x, which equals −2 (1 minus 3). The slope across the arc AB equals 4/−2, which equals −2.

GRAPHS IN ECONOMICS

Use the following table to work Problems 21 to 23. The table gives information about umbrellas: price, the number purchased, and rainfall in inches. 21.

Draw a graph to show the relationship between the price and the number of umbrellas purchased, holding the amount of rainfall constant at 1 inch. Describe this relationship.

Price (dollars per umbrella) 20 30 40

Figure A1.18 shows the relationship. To draw a graph of the relationship between the price and the number of umbrellas when the rainfall equals 1 inch, keep the rainfall at 1 inch and plot the data in that column against the price. This curve is the relationship between price and number of umbrellas when the rainfall is 1 inches. The relationship between the price and the number of umbrellas is an inverse relationship; as the price rises, the number of umbrellas decreases.

22.

What happens in the graph in Problem 21 if the price rises and rainfall is constant? If the price rises, the number of umbrellas decreases. In Figure A1.18, there is a movement upward along the (unchanged) curve.

23.

What happens in the graph in Problem 21 if the rainfall increases from 1 inch to 2 inches? As shown in Figure A1.19, the curve shifts rightward. In that figure, both the initial curve, which applies when the rainfall is 1 inch, and the new curve, which applies when the rainfall is 2 inches, are illustrated. The curve when the rainfall is 2 inches lies to the right of the curve when the rainfall is 1 inch indicating that at every price, more umbrellas are purchased when the rainfall is 2 inches than when the rainfall is 1 inch.

0 4 2 1

Umbrellas (numbers per day) 1 2 (inches of rainfall) 7 4 2

8 7 4

C h a p t e r

THE ECONOMIC PROBLEM

Answers to the Review Quizzes Page 72 1.

How does the production possibilities frontier illustrate scarcity? The unattainable combinations of production that lie beyond the PPF illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. Additionally, while moving along the PPF to increase the production of one good requires that the production of another good be reduced, which also illustrates scarcity.

How does the production possibilities frontier illustrate production efficiency? The combinations of outputs that lie on the PPF illustrate the concept of production efficiency. These points are the maximum production points possible and are attained only by producing the goods and services at the lowest possible cost. Any point inside the frontier reflects production where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient.

How does the production possibilities frontier show that every choice involves a tradeoff? Movements along the PPF frontier illustrate that producing more of one good requires producing less of other good. This observation reflects the result that a tradeoff must be made when producing output efficiently.

How does the production possibilities frontier illustrate opportunity cost? The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good.

Why is opportunity cost a ratio? The slope of the PPF is a ratio that expresses the quantity of lost production of the good on the y-axis to the increase in the production of the good on the x-axis moving downward along the PPF. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured on the horizontal axis.

Why does the PPF bow outward and what does that imply about the relationship between opportunity cost and the quantity produced? Some resources are better suited to produce one type of good or service, like pizza. Other resources are better suited to produce other goods or services, like DVDs. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. Consider a PPF with pizza measured on the x-axis and DVDs measured on the y-axis. A small increase in pizza output when pizza production is relatively low requires only a small increase in the use of those resources still good at making pizza and not good at making DVDs. This yields a small decrease in DVD production for a

CHAPTER 2

large increase in pizza production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF over this range of output. However, the same small increase in pizza output when pizza production is relatively large will require society to devote to pizza production those resources that are less suited to making pizza and more suited to making DVDs. This reallocation of resources yields a relatively small increase in pizza output for a large decrease in DVD output, creating a relatively high opportunity cost reflected in the steep slope of the PPF over this range of output. The opportunity cost of pizza production increases with the quantity of pizza produced as the slope of the PPF becomes ever steeper. This effect creates the bowed out effect (the concavity of the PPF function) and means that as more of a good is produced, the opportunity cost of producing additional units increases.

Page 75 1.

What is marginal cost? How is it measured? Marginal cost is the opportunity cost of producing one more unit of a good or service. Along a PPF marginal cost is reflected in the absolute value of the slope of the PPF. In particular, the magnitude of the slope of the PPF is the marginal cost of a unit of the good measured along the x-axis. As the magnitude of the slope changes moving along the PPF, the marginal cost changes.

What is marginal benefit? How is it measured? The marginal benefit from a good or service is the benefit received from consuming one more unit of it. It is measured by what an individual is willing to give up (or pay) for an additional that last unit.

How does the marginal benefit from a good change as the quantity produced of that good increases? As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit from the unit consumed immediately after it. This set of results is known as the principle of decreasing marginal benefit and is often assumed by economists to be a common characteristic of an individual’s preferences over most goods and services in the economy.

What is allocative efficiency and how does it relate to the production possibilities frontier? Production efficiency occurs when production takes place at a point on the PPF. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. Allocative efficiency, however, requires that the goods and services produced are those that provide the greatest possible benefit. This definition means that the allocative efficient level of output is the point on the PPF (and hence is a production efficient point) for which the marginal benefit equals the marginal cost.

What conditions must be satisfied if resources are used efficiently? Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost of producing the last unit.

Page 77 1.

What generates economic growth? The two key factors that generate economic growth are technological change and capital accumulation. Technological change allows an economy to produce more with the same amount of limited resources, Capital accumulation, the growth of capital resources including human capital, means that an economy has increased its available resources for production.

How does economic growth influence the production possibilities frontier? Economic growth shifts the PPF outward. Persistent outward shifts in the production possibility frontier—economic growth—are caused by the accumulation of resources, such as more capital equipment or by the development of new technology.

What is the opportunity cost of economic growth? When a society devotes more of its scarce resources to research and development of new technologies, or devotes additional resources to produce more capital equipment, both decisions lead

THE ECONOMIC PROBLEM

to increased consumption opportunities in future periods at the cost of less consumption today. The loss of consumption today is the opportunity cost borne by society for creating economic growth.

CHAPTER 2

Explain why Hong Kong has experienced faster economic growth than the United States. Hong Kong chose to devote a greater proportion of its available resources to the production of capital than the United States. This allowed Hong Kong to grow at a faster rate than the United States. By foregoing consumption and producing a greater proportion of capital goods over the last few decades, Hong Kong was able to achieve output per person equal to 94 percent of that in the United States.

Does economic growth overcome scarcity? Scarcity reflects the inability to satisfy all our wants. Regardless of the amount of economic growth, scarcity will remain present because it will never be possible to satisfy all our wants. For instance it will never be possible to satisfy all the wants of the several thousand people who all would like to ski the best slopes on Vail with only their family and a few best friends present. So economic growth allows more wants to be satisfied but it does not eliminate scarcity.

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What gives a person a comparative advantage? A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else, If the person gives up the least amount of other goods and services to produce a particular good or service, the person has the lowest opportunity cost of producing that good or service.

Distinguish between comparative advantage and absolute advantage. A person has a comparative advantage in producing a good when he or she has the lowest opportunity cost of producing it. Comparative advantage is based on the output forgone. A person has an absolute advantage in production when he or she uses the least amount of time or resources to produce one unit of that particular good or service. Absolute advantage is a measure of productivity in using inputs.

Why do people specialize and trade? People can compare consumption possibilities from producing all goods and services through selfsufficiency against specializing in producing only those goods and services that reflect their comparative advantage and trading their output with others who do the same. People can then see that the consumption possibilities from specialization and trade are greater than under self-sufficiency. Therefore it is in people’s own self-interest to specialize. It was Adam Smith who first pointed out in the Wealth of Nations how individuals voluntarily engage in this socially beneficial and cooperative activity through the pursuit of their own self-interest, rather than for society’s best interests.

What are the gains from specialization and trade? From society’s standpoint, the total output of goods and services available for consumption is greater with specialization and trade. From an individual’s perspective, each person who specializes enjoys being able to consume a larger bundle of goods and services after trading with others who have also specialized, than would otherwise be possible under self-sufficiency. These increases are the gains from specialization and trade for society and for individuals.

What is the source of the gains from trade? As long as people have different opportunity costs of producing goods or services, total output is higher with specialization and trade than if each individual produced goods and services under self-sufficiency. This increase in output is the gains from trade.

THE ECONOMIC PROBLEM

Page 83 1.

Why are social institutions such as firms, markets, property rights, and money necessary? These social institutions factors necessary for a decentralized economy to coordinate production. Firms are necessary to allow people to specialize. Without firms, specialization would be limited because a person would need to specialize in the entire production of a good or service. With firms people are able to specialize in producing particular bits of a good or service. For a society to enjoy the fruits of specialization and trade, the individuals who comprise that society must voluntarily desire to specialize in the first place. Discovering trade opportunities after a person has specialized in his or her comparative advantage in production is what allows that person to gain from his or her own specialization efforts. Trading opportunities can only take place if a market exists where people observe prices to discover available trade opportunities. Money is necessary to allow low-cost trading in markets. Without money, goods would need to be directly exchanged for other goods, a difficult and unwieldy situation. Finally people must enjoy social recognition of and government protection of property rights to have confidence that their commitments to trade arrangements will be respected by everyone in the market.

What are the main functions of markets? The main function of a market is to enable buyers and sellers to get information and to do business with each other. Markets have evolved because they facilitate trade, that is, they facilitate the ability of buyers and sellers to trade with each other.

What are the flows in the market economy that go from firms to households and the flows from households to firms? On the real side of the economy, goods and services flow from firms to households. On the monetary side of the economy, payments for factors of production, wages, rent, interest, and profits, flow from firms to households. Flowing from households to firms on the monetary side of the economy are the expenditures on goods and services and on the real side are the factors of production, labor, land, capital, and entrepreneurship.

CHAPTER 2

Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3. Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. The table to the right sets out Brazil’s production possibilities for ethanol and food crops. 1. a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity. Figure 2.1 shows Brazil’s PPF. The production possibilities frontier indicates scarcity because it shows the limits to what can be produced. In particular, production combinations of ethanol and food crops that lie outside the production possibilities frontier are not attainable.

Ethanol (barrels per day) 70 64 54 40 22 0

and and and and and and

Food crops (tons per day) 0 1 2 3 4 5

b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce to achieve production efficiency? If Brazil produces 40 barrels of ethanol per day, it achieves production efficiency if it also produces 3 tons of food per day.

c. Why does Brazil face a tradeoff on its PPF? Brazil faces a tradeoff on its PPF because Brazil’s resources and technology are limited. For Brazil to produce more of one good, it must shift factors of production away from the other good. Therefore to increase production of one good requires decreasing production of the other, which reflects a tradeoff.

2. a. If Brazil increases ethanol production from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol? When Brazil is production efficient and increases its production of ethanol from 40 barrels per day to 54 barrels per day, it must decrease its production of food crops from 3 tons per day to 2 tons per day. The opportunity cost of the additional ethanol is 1 ton of food per day for the entire 14 barrels of ethanol or 1/14 of a ton of food per barrel of ethanol.

b. If Brazil increases food production from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food? When Brazil is production efficient and increases its production of food crops from 2 tons per day to 3 tons per day, it must decrease its production of ethanol from 54 barrels per day to 40 barrels per day. The opportunity cost of the additional 1 ton of food crops is 14 barrels of ethanol.

c. What is the relationship between your answers to parts (a) and (b)? The opportunity costs of an additional barrel of ethanol and the opportunity cost of an additional ton of food crop are reciprocals of each other. That is, the opportunity cost of 1 ton of food crops is 14 barrels of ethanol and the opportunity cost of 1 barrel of ethanol is 1/14 of a ton of food crops.

Does Brazil face an increasing opportunity cost of ethanol? What feature of Brazil’s PPF illustrates increasing opportunity cost? Brazil faces an increasing opportunity cost of ethanol production. For instance, when increasing ethanol production from 0 barrels per day to 22 barrels the opportunity cost of a barrel of ethanol is 1/22 of a ton of food while increasing ethanol production another 18 barrels per day (to a total of 40 barrels per day) has an opportunity cost of 1/18 of a ton of food per barrel of ethanol. The PPF’s bowed outward shape reflects the increasing opportunity cost.

THE ECONOMIC PROBLEM

Use the above table (for Problems 1 to 3) to work Problems 4 and 5. 4. Define marginal cost and calculate Brazil’s marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day. The marginal cost of a good is the opportunity cost of producing one more unit of the good. When the quantity of food produced is 2.5 tons, the marginal cost of a ton of food is the opportunity cost of increasing the production of food from 2 tons per day to 3 tons per day. The production of ethanol falls from 54 barrels per day to 40 barrels per day, a decrease of 14 barrels per day. The opportunity cost of increasing food production is the decrease in ethanol product, so the opportunity cost of producing a ton of food when 2.5 tons of food per day are produced is 14 barrels of ethanol per day.

Define marginal benefit. Explain how it is measured and why the data in the table does not enable you to calculate Brazil’s marginal benefit from food. The marginal benefit of a good is the benefit received from consuming one more unit of the good. The marginal benefit of a good or service is measured by the most people are willing to pay for one more unit of it. The data in the table do not provide information on how much people are willing to pay for an additional unit of food. The table has no information on the marginal benefit of food.

Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency. Production efficiency occurs when goods and services are produced at the lowest cost. This definition means that production efficiency occurs at any point on the PPF. Therefore all of the production points on the PPF are production efficient. Allocative efficiency occurs when goods and services are produced at the lowest cost and in the quantities that provide the greatest possible benefit. The allocatively efficient production point is the single point on the PPF that has the greatest possible benefit.

A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. The PPF is illustrated in Figure 2.2 as PPF0. Because the marginal cost of both wheat and pork increase as more of the good is produced, the PPF displays increasing opportunity cost so it has the “conventional” bowedoutward shape.

b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. On your graph sketch the impact of the new technology on the farm’s PPF. The new technology rotates the PPF outward from PPF0 to PPF1.

c. With the farm using the new technology described in part (b), has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. The opportunity cost of producing wheat has increased. The opportunity cost of a bushel of wheat is equal to the magnitude of 1/(slope of the PPF). As illustrated in Figure 2.2, for each quantity of wheat the slope of PPF1 has a smaller magnitude than the slope of PPF0 so the opportunity cost of a bushel of wheat is higher along PPF1. For a specific example, the opportunity cost of increasing wheat product from 600 bushels per week to 800 bushels per week along PPF1 is 6,000 pounds of pork but is only 3,000 pounds of pork along PPF0.

d. Is the farm more efficient with the new technology than it was with the old one? Why? The farm is able to produce more with the new technology than with the old, but it is not necessarily more efficient. If the farm was producing on its PPF before the new technology and after, the farm was production efficient both before the new technology and after.

CHAPTER 2

In one hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue’s opportunity cost of producing a cap. Sue forgoes 4 jackets to produce 40 caps, so Sue’s opportunity cost of producing one cap is (4 jackets)/(40 caps) or 0.1 jacket per cap.

b. Calculate Tessa’s opportunity cost of producing a cap. Tessa forgoes 4 jackets to produce 80 caps, so Tessa’s opportunity cost of producing one cap is (4 jackets)/(80 caps) or 0.05 jacket per cap.

c. Who has a comparative advantage in producing caps? Tessa’s opportunity cost of a cap is lower than Sue’s opportunity cost, so Tessa has a comparative advantage in producing caps.

d. If Sue and Tessa specialize in producing the good in which they have a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade? Tessa specializes in caps and Sue specializes in jackets. Both Sue and Tessa gain from trade. Sue gains because she can obtain caps from Tessa at a cost of (1 jacket)/(15 caps), which is 0.067 jacket per cap, a cost that is lower than what it would cost her to produce caps herself. Tessa also gains from trade because she trades caps for jackets for 0.067 jacket per cap, which is higher than her cost of producing a cap.

Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets? Sue forgoes 40 caps to produce 4 jackets, so Sue’s opportunity cost of producing one jacket is (40 caps)/(4 jackets) or 10 caps per jacket. Tessa forgoes 80 caps to produce 20 jackets, so Tessa’s opportunity cost of producing one jacket is (80 caps)/(20 jackets) or 4 caps per jacket. Tessa has the comparative advantage in producing jackets because her opportunity cost of a jacket is lower than Sue’s opportunity cost.

b. Can Sue and Tessa still gain from trade? Tessa and Sue can still gain from trade because Tessa (now) has a comparative advantage in producing jackets and Sue (now) has a comparative advantage in producing caps. Tessa will produce jackets and Sue will produce caps.

c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer. Sue and Tessa will not be willing to trade 1 jacket for 15 caps. In particular, Sue, whose comparative advantage lies in producing caps, can produce 1 jacket at an opportunity cost of only 10 caps. So Sue will be unwilling to pay any more than 10 caps per jacket.

10.

For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. a. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States? Cuba’s economy is almost surely less efficient than the U.S. economy. The Cuban central planners do not know people’s production possibilities or their preferences. The plans that are created wind up wasting resources and/or producing goods and services that no one wants. Because firms in Cuba are owned by the government rather than individuals, no one in Cuba has the self-interested incentive to operate the firm efficiently and produce goods and services that consumers desire. Additionally Cuba does not actively trade so Cuba produces most of its consumption goods rather than buying them from nations with a comparative advantage. Because Cuba uses its resources to produce consumption goods, it cannot produce many capital goods so its economic growth rate has been low.

THE ECONOMIC PROBLEM

b. What are the social institutions that Cuba might lack that help the United States to achieve allocative efficiency? Of the four social institutions, firms, money, markets, and property rights, Cuba’s economy has firms and money. Markets, however, are less free of government intervention in Cuba. But the major difference is the property rights in the Cuban economy. In Cuba the government owns most of the firms; that is, the government has the property right to run the producers. Because the firms are not motivated to make a profit, the managers of these firms have little incentive to operate the firm efficiently or to produce the goods and services that consumers desire. In the United States, firms are owned by individuals; that is, people have the property right that allows them to run firms. These owners have the self-interested incentive to operate the firm efficiently and to produce the goods and services people want, an incentive sorely lacking in the Cuban economy.

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Answers to Additional Problems and Applications Use the table to work Problems 11 and 12. Suppose that Yucatan’s production possibilities are given in the table. 11. a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. Yucatan’s PPF is illustrated in Figure 2.3. The figure illustrates a tradeoff because moving along Yucatan’s PPF producing more of one good requires producing less of the other good. Yucatan trades off more production of one good for less production of the other.

Food (pounds per month) 300 200 100 0

and and and and

Sunscreen (gallons per month) 0 50 100 150

b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency? If Yucatan produces 150 pounds of food per month, then the point labeled A on the PPF in Figure 2.11 shows that Yucatan must produce 75 gallons of sunscreen per month to achieve production efficiency.

c. What is Yucatan’s opportunity cost of producing (i) 1 pound of food and (ii) 1 gallon of sunscreen? Yucatan’s PPF is linear so the opportunity cost of producing 1 pound of food is the same at all quantities. Calculate the opportunity cost of producing 1 pound of food when increasing the production of food from 0 to 100 pounds per month. Between these two ranges of production, the quantity of sunscreen produced falls from 150 gallons per month to 100 gallons per month, a decrease of 50 gallons. The opportunity cost is 50 gallons of sunscreen to gain 100 pounds of food. The opportunity cost per pound of food equals (50 gallons of sunscreen)/(100 pounds of food), or an opportunity cost of 0.5 gallon of sunscreen per pound of food. Yucatan’s PPF is linear so the opportunity cost of producing 1 gallon of sunscreen is the same at all quantities. Calculate the opportunity cost of producing 1 gallon of sunscreen when increasing the production of sunscreen from 0 to 50 gallons per month. Between these two ranges of production, the quantity of food produced falls from 300 pounds per month to 200 pounds per month, a decrease of 100 pounds. The opportunity cost is 100 pounds of food to gain 50 gallons of sunscreen, or (100 pounds of food)/(50 gallons of sunscreen) which yields an opportunity cost of 2.0 pounds of food per gallon of sunscreen.

e. What is the relationship between your answers to part (c)? Answers (c) and (d) reflect the fact that opportunity cost is a ratio. The opportunity cost of gaining a unit of a good moving along the PPF equals the quantity of the other good or service forgone divided by the quantity of the good or service gained. The opportunity cost of one good, food, is equal to the inverse of the opportunity cost of the other good, sunscreen.

12.

What feature of a PPF illustrates increasing opportunity cost? Explain why Yucatan’s opportunity cost does or does not increase. If opportunity costs increase, the PPF bows outward. Yucatan’s PPF is linear and along a linear PPF the opportunity cost is constant. Yucatan does not face an increasing opportunity cost of food because the opportunity cost remains constant, equal to 0.5 gallons of sunscreen per pound of food. Yucatan’s resources must be equally productive in both activities.

THE ECONOMIC PROBLEM

13.

In problem 11, what is the marginal cost of 1 pound of food in Yucatan when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? The marginal cost of a pound of food in Yucatan is constant at all points along Yucatan’s PPF and is equal to 0.5 gallons of sunscreen per pound of food. The special point about Yucatan’s marginal cost is the fact that the marginal cost is constant. This result reflects Yucatan’s linear PPF.

14.

The table describes the preferences in Yucatan. a. What is the marginal benefit from sunscreen and how is it measured?

Sunscreen (gallons per month) 25 75 125

The marginal benefit from sunscreen is the benefit enjoyed by the person who consumes one more gallon of sunscreen. It is equal to the willingness to pay for an additional gallon. For example, in the table when 75 gallons of sunscreen are produced, the marginal benefit of a gallon is 2 pounds of food per gallon.

Willingness to pay (pounds of food per gallon) 3 2 1

b. Use the table in Problem 11. What does Yucatan produce to achieve allocative efficiency? To achieve allocative efficiency, the marginal benefit of a gallon of sunscreen must equal the marginal cost of a gallon of sunscreen. Yucatan’s marginal cost of a gallon of sunscreen is 2 pounds of food per gallon. When Yucatan produces 75 gallons of sunscreen, the table shows that Yucatan’s marginal benefit is 2 pounds of food per gallon. Therefore allocative efficiency is achieved when 75 gallons of sunscreen and, from the PPF, 150 pounds of food are produced.

15.

Sales of Digital Movies Surge The U.S. home entertainment market is changing; online movie sales have surged to a significant proportion, while sales and rentals of physical discs are declining. Source: The Wall Street Journal, January 7, 20147 a. Draw the PPF curves for online movie sales before and after the Internet became available. Before the availability of Internet, there were no online movie sales and the production possibilities frontier was PPF0 in Figure 2.4. After the Internet was developed, several companies started selling movies online. The Internet is a technological advance that rotates the production possibilities frontier outward to PPF1 in Figure 2.4.

CHAPTER 2

b. Draw the marginal cost and marginal benefit curves for physical disc retailers and online movie retailers before and after the Internet became available. Online movie retailers have a lower marginal cost of delivering digital movies than do physical disc retailers. The marginal benefit for digital movie is the same regardless of whether the movie is bought online or from a physical disc retailer. Therefore in Figure 2.5, the marginal benefit curve for digital movies is MB, the marginal cost of physical disc retailers is MC0 and the marginal cost of online movie sales is MC1.

c. Explain how changes in production possibilities, preferences or both have changed the way digital movies are retailed. The change in production possibilities, which has created online digital movie stores such as iTunes, has changed the way digital movies are purchased. Because the marginal cost of buying movies is less using an online store, and also because of easy and early availability of digital movies on online stores, today purchasing movies online is preferred. Consequently, sales and rentals of physical discs are declining.

Use the following news clip to work Problems 16 and 17. Malaria Eradication Back on the Table In response to the Gates Malaria Forum in October 2007, countries are debating the pros and cons of eradication. Dr. Arata Kochi of the World Health Organization believes that with enough money malaria cases could be cut by 90 percent, but it would be very expensive to eliminate the remaining10 percent of cases, so countries should not strive to eradicate malaria. Source: The New York Times, March 4, 2008 16.

Is Dr. Kochi talking about production efficiency or allocative efficiency or both? Dr. Kochi is talking about allocative efficiency. His assessment is that the last 10 percent eradication has such a high marginal cost that it almost surely exceeds its marginal benefit.

THE ECONOMIC PROBLEM

17.

Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph: (i) Draw a marginal cost curve and marginal benefit curve that are consistent with Dr. Kochi’s opinion. (ii) Identify the quantity of malaria eradicated that achieves allocative efficiency. Figure 2.6 shows a marginal cost curve and a marginal benefit curve that are consistent with Dr. Kochi’s views. Dr. Kochi believes the last 10 percent of malaria would be very expensive to eradicate. The marginal cost curve in the figure reflects this view because marginal cost curve rises rapidly after 90 percent of malaria is eradicated. The marginal benefit curve is downward sloping, reflecting diminishing marginal benefit from malaria eradication. The allocatively efficient quantity malaria eradicated is 90 percent because that the quantity for which the marginal benefit of eradication equals the marginal cost of eradication. This outcome demonstrates Dr. Kochi’s conclusion that countries should not attempt to completely

18.

that the

of is

Capital accumulation and technological change bring economic growth: Production that was unattainable yesterday becomes attainable today; production that is unattainable today will become attainable tomorrow. Why doesn’t economic growth bring an end to scarcity one day? Scarcity is always being defeated yet will never suffer defeat. Scarcity reflects the existence of unmet wants. People’s wants are infinite—regardless of what a person already possesses, everyone can easily visualize something else he or she wants, if only more time in the day to enjoy their possessions. Because people’s wants are insatiable, scarcity will always exist regardless of economic growth.

19.

Toyota Plans to Build a Better Company Toyota will continue to produce 3 million cars per year and use the balance of its resources to upgrade its workers’ skills and create new technology. In three years’ time, Toyota plans to produce better cars and be more productive. Source: Financial Post, April 7, 2014 a. What is the opportunity cost of upgrading its workers’ skills and creating new technology? The opportunity cost of upgrading workers’ skills and creating new technology is the next best alternative forgone by these changes. The story indicates that the next best alternative for Toyota is building new cars, so the opportunity cost of upgrading workers’ skills and creating new technology is the current production of new cars that are forgone.

CHAPTER 2

b. Sketch Toyota’s PPF and mark its production point in 2014. Now show on your graph Toyota’s PPF in 2018. Figure 2.7 shows Toyota's PPF in 2014 and in 2018. The upgrade in workers’ skills and the new technology shift Toyota’s PPF outward so that its PPF in 2018 lies beyond its PPF in 2014. Toyota’s production point in 2014 is labeled A.

Use the following data to work Problems 20 and 21. Kim can produce 40 pies or 400 cakes an hour. Liam can produce 100 pies or 200 cakes an hour. 20. a. Calculate Kim’s opportunity cost of a pie and Liam’s opportunity cost of a pie. If Kim spends an hour baking pies, she gains 40 pies but forgoes 400 cakes. Kim’s opportunity cost of 1 pie is (400 cakes)/(40 pies), or 10 cakes per pie. If Liam spends an hour baking pies, he gains 100 pies but forgoes 200 cakes. Liam’s opportunity cost of 1 pie is (200 cakes)/(100 pies), or 2 cakes per pie.

b. If each spends 30 minutes of each hour producing pies and 30 minutes producing cakes, how many pies and cakes does each produce? Kim produces 20 pies and 200 cakes. Liam produces 50 pies and 100 cakes. The total number produced is 70 pies and 300 cakes.

c. Who has a comparative advantage in producing (i) pies and (ii) cakes? Liam has the comparative advantage in producing pies because his opportunity cost of a pie is less than Kim’s opportunity cost. Kim has the comparative advantage in producing cakes because her opportunity cost of a cake is less than Liam’s opportunity cost.

THE ECONOMIC PROBLEM

21. a

Draw a graph of Kim’s PPF and Liam’s PPF and show the point at which each produces when they spend 30 minutes of each hour producing pies and 30 minutes producing cakes.

Kim’s PPF is illustrated in Figure 2.8; Liam’s PPF is illustrated in Figure 2.9. Point A in both figures shows their production points when each spends 30 minutes making cakes and 30 minutes making pies.

b. On your graph, show what Kim produces and what Liam produces when they specialize. Kim will specialize in cakes and Liam will specialize in pies. Point B in both figures shows the production points when each specializes.

c. When they specialize and trade, what are the total gains from trade? Kim will specialize in cakes and Liam will specialize in pies. If they specialize and trade, the total production of both cakes and pies increase. When each spends 30 minutes making cakes and 30 minutes making pies, together they produce 300 cakes and 70 pies. When they specialize, together they produce 400 cakes and 100 pies. The 100 increase in cakes and the 30 increase pies is the gains from trade.

d. If Kim and Liam share the total gains equally, what trade takes place between them? Kim will trade 50 cakes (half of the gain in cake production) to Liam in exchange for 15 pies (half of the increase in pie production).

Tony’s Production Possibilities Snowboards Skis (units per (units per week) week) 25 and 0 20 and 10 15 and 20 10 and 30 5 And 40 0 And 50

Patty’s Production Possibilities Snowboards Skis (units per week) (units per week) 20 and 0 10 and 5 0 and 10

22.

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Tony and Patty produce skis and snowboards. The tables show their production possibilities. Tony produces 5 snowboards and 40 skis a week; Patty produces 10 snowboards and 5 skis a week. a. Who has a comparative advantage in producing (i) snowboards and (ii) skis? (i) Tony’s opportunity cost of a snowboard is (10 skis)/(5 snowboards), or 2 skis per snowboard. Patty’s opportunity cost of a snowboard is (5 skis)/(10 snowboards), or 0.5 skis per snowboard. Patty’s opportunity cost of a snowboard is lower than Tony’s opportunity cost, so Patty has the comparative advantage. (ii) Tony’s opportunity cost of a ski is (5 snowboards)/(10 skis), or 0.5 snowboards per ski. Patty’s opportunity cost of a ski is (10 snowboards)/(5 skis), or 2.0 snowboards per ski. Tony’s opportunity cost of a ski is lower than Patty’s opportunity cost, so Tony has the comparative advantage.

b. If Tony and Patty specialize and trade 1 snowboard for 1 ski, what are the gains from trade? Tony has a comparative advantage in producing skis, so he specializes in producing skis. Patty has a comparative advantage in producing snowboards, so she specializes in snowboards. Tony now produces 50 skis and Patty produces 20 snowboards. Before specializing they produced a total of 45 skis (Tony’s 40 plus Patty’s 5) and 15 snowboards (Tony’s 5 plus Patty’s 10). By specializing, the total production of skis increases by 5 and the total production of snowboards increases by 5. This increase in total production is the gains from trade. By trading 1 ski for 1 snowboard, they can share these gains. Tony obtains snowboards from Patty for less than it costs him to produce them and Patty obtains skis from Tony for less than it costs her to produce them.

23.

Indicate on a graph of the circular flows in the market economy, the real and money flows in which the following items belong: a. You buy an iPad from the Apple Store. Figure 2.10 shows the circular flows in a market economy. Your purchase of an iPad from Apple is the purchase of a good from a firm. This flow is in the black arrow indicated by point a in the figure. When you pay for the iPad, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled a.

b. Apple Inc. pays the designers of the iPad. Apple’s payment to the designers of the iPad is the payment of a wage to a factor of production. This flow is in the grey arrow indicated by point b in the figure. The flow of design services from the designer to Apple is in the black arrow in the opposite direction to the grey arrow labeled b.

c. Apple Inc. decides to expand and rents an adjacent building. Apple’s decision to expand by renting a building means that Apple is increasing the capital it uses. This flow is in the black arrow indicated by point c in the figure. The flow of the payment for the rental services of the building is in the grey arrow in the opposite direction to the black arrow labeled c.

THE ECONOMIC PROBLEM

d. You buy a new e-book from Amazon. Your purchase of an e-book from Amazon is the purchase of a good from a firm. This flow is in the black arrow indicated by point d in the figure. When you pay for the e-book, the corresponding money flow is in the grey arrow in the opposite direction to the black arrow labeled d.

e. Apple Inc. hires a student as an intern during the summer. Apple’s decision to hire a student intern is Apple increasing the labor it uses. The flow of labor services is in the black arrow indicated by point e in the figure. The flow of the payment for the labor services is in the grey arrow in the opposite direction to the black arrow labeled c.

Economics in the News 24.

After you have studied Reading Between the Lines on pp. 84–85, answer the following questions. a. How has “fracking” changed U.S. production possibilities? Fracking has expanded U.S. production possibilities.

b. How have advances in technologies for producing other goods and services changed the U.S. production possibilities? The advances in technology have expanded U.S. production possibilities.

c. If “fracking” had been the only technological advance, how would the PPF have changed? If fracking had been the only technological advance, the PPF would have rotated outward. The maximum quantity of other goods and services would not have changed but the maximum quantity of oil and gas would have increased. For any quantity of other goods and services, more oil and gas could be produced after the introduction of fracking technology.

d. If “fracking” had been the only technological advance, how would the opportunity cost of producing oil and gas have changed? Would it have been lower or higher than it actually was? If fracking had been the only technological advance, the PPF would have rotated so that for any quantity of other goods and services the slope of the new PPF would be smaller than the slope of the initial PPF. Consequently, for any quantity of other goods and services the opportunity cost of producing oil and gas would be lower after the fracking technology was used.

25.

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LCD, LED, Plasma Impact: Curved-box TV Set To Be History In 4 Years CRT televisions will soon disappear from the market as the focus has shifted to LCD technology. According to analysts the speed of adoption of newer technology is very fast. CRT television segment will eventually be phased out of the market. Source: The Economic Times, December 27, 2010 a. How has LCD technology changed the production possibilities of television sets and other goods and services? LCD technology has increased the production possibilities.

b. Sketch a PPF for television sets and other goods and services before LCD technology. The PPF should have television sets on one axis and other goods and services on the other as illustrated in Figure 2.11 by PPF0. The PPF is bowed outward as a conventional PPF.

c. Show how the arrival of LCD technology has changed the PPF. The arrival of LCD technology shifts the PPF outward as shown by the change from PPF0 to PPF1 in Figure 2.11. The intersection of the new PPF along the axis measuring television sets increases and the intersection of the new PPF along the axis measuring other goods and services does not change.

d. Sketch a marginal benefit curve for video entertainment. The marginal benefit curve should be a conventional downward-sloping marginal benefit curve as shown in Figure 2.12. The marginal benefit from visual entertainment at home is measured along the vertical axis and the quantity of video entertainment is measured along the horizontal axis.

e. Show how LCD technology which provides a better television-viewing experience to the consumer than the traditional CRT TV sets has changed the marginal benefit for video entertainment. The marginal benefit to the consumer increases because the consumer will be able to take advantage of a better television-viewing experience through LCD technology than the traditional CRT TV sets. In Figure 2.12, the marginal benefit curve shifts rightward from the initial marginal benefit curve, MB0, to the new marginal benefit curve, MB1.

THE ECONOMIC PROBLEM

Explain how the efficient quantity of video entertainment has changed. The arrival of broadband has decreased the marginal cost of providing video entertainment, so the marginal cost curve shifts rightward. This shift is illustrated in the Figure 2.13 by the rightward shift of the marginal cost curve from MC0 to MC1. As Figure 2.13 shows, the allocatively efficient quantity of video entertainment increases. In Figure 2.13, the allocatively efficient quantity increases from 5 million units per year to 8 million units per year.

C h a p t e r

DEMAND AND SUPPLY

Answers to the Review Quizzes Page 94 1.

What is the distinction between a money price and a relative price? The money price of a good is the dollar amount that must be paid for it. The relative price of a good is its money price expressed as a ratio to the money price of another good. Thus the relative price is the amount of the other good that must be foregone to purchase a unit of the first good.

Explain why a relative price is an opportunity cost. The relative price of a good is the opportunity cost of buying that good because it shows how much of the next best alternative good must be forgone to buy a unit of the first good.

Think of examples of goods whose relative price has risen or fallen by a large amount. Some examples of items where both the money price and the relative price have risen over time are gasoline, college tuition, and food. Some examples of items where both the money price and the relative price have fallen over time are personal computers, HD televisions, and calculators.

Page 99 1.

Define the quantity demanded of a good or service. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

What is the law of demand and how do we illustrate it? The law of demand states: “Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.” The law of demand is illustrated by a downward-sloping demand curve drawn with the quantity demanded on the horizontal axis and the price on the vertical axis. The slope is negative to show that the higher the price of a good, the smaller is the quantity demanded and the lower the price of a good, the greater is the quantity demanded.

What does the demand curve tell us about the price that consumers are willing to pay? For any fixed quantity of a good available, the vertical distance of the demand curve from the x-axis shows the maximum price that consumers are willing to pay for that quantity of the good. The price on the demand curve at this quantity indicates the marginal benefit to consumers of the last unit consumed at that quantity.

List all the influences on buying plans that change demand, and for each influence, say whether it increases or decreases demand.

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Influences that change the demand for a good include: The prices of related goods. A rise (fall) in the price of a substitute increases (decreases) the demand for the first good. A rise (fall) in the price of a complement decreases (increases) the demand for the first good. The expected future price of the good. A rise (fall) in the expected future price of a good increases (decreases) the demand in the current period. Income. An increase (decrease) in income increases (decreases) the demand for a normal good. An increase in income decreases (increases) the demand for an inferior good. Expected future income and credit. An increase (decrease) in expected future income or credit increases (decreases) the demand. The population. An increase (decrease) in population increases (decreases) the demand. People’s preferences. If people’s preferences for a good rise (fall), the demand increases (decreases).

Why does demand not change when the price of a good changes with no change in the other influences on buying plans? If the price of a good falls and nothing else changes, then the quantity of the good demanded increases and there is a movement down along the demand curve, but the demand for the good remains unchanged and the demand curve does not shift.

Page 103 1.

Define the quantity supplied of a good or service. The quantity supplied of a good or service is the amount of the good or service that firms plan to sell in a given period of time at a specified price.

What is the law of supply and how do we illustrate it? The law of supply states that “other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.” The law of supply is illustrated by an upward-sloping supply curve drawn with the quantity supplied on the horizontal axis and the price on the vertical axis. The slope is positive to show that the higher the price of a good, the greater is the quantity supplied and the lower the price of a good, the smaller is the quantity supplied.

What does the supply curve tell us about the producer’s minimum supply price? For any quantity, the vertical distance between the supply curve and the x-axis shows the minimum price that suppliers must receive to produce that quantity of output. As a result, the price is the marginal cost of the last unit produced at this level of output.

List all the influences on selling plans, and for each influence, say whether it changes supply. Changes in the price of the good change the quantity supplied. They do not change the supply of the good. Influences that change the supply of a good include: Prices of factor of production. A rise (fall) in the price of a factor of production increases firms’ costs of production and decreases (increases) the supply of the good. Prices of related goods produced. If the price of a substitute in production rises (falls), firms decrease (increase) their sales of the original good and the supply for the original good decreases (increases). A rise (fall) in the price of a complement in production increases (decreases) production of the original good, causing the supply of the original good to increase (decrease). The expected future price of the good. A rise (fall) in the expected future price of the good decreases (increases) the amount suppliers sell today. This change in expectations decreases (increases) the supply in the current period. The number of sellers. An increase (decrease) in the number of sellers in a market increases the quantity of the good available at every price, and increases (decreases) the supply.

DEMAND AND SUPPLY

Technology. An advance in technology increases the supply. The state of nature. A good (bad) state of nature, such as good (bad) weather for agricultural products, increases (decreases) the supply.

What happens to the quantity of cell phones supplied and the supply of cell phones if the price of a cell phone falls? If the price of cell phones falls and nothing else changes, then the quantity of cell phones supplied will decrease and there is a movement down along the supply curve for cell phones. The supply of cell phones, however, remains unchanged and the supply curve does not shift.

Page 105 1.

What is the equilibrium price of a good or service? The equilibrium price is the price at which the quantity demanded by the buyers is equal to the quantity supplied by the sellers.

Over what range of prices does a shortage arise? What happens to the price when there is a shortage? A shortage arises at market prices below the equilibrium price. A shortage causes the price to rise, decreasing quantity demanded and increasing quantity supplied until the equilibrium price is attained.

Over what range of prices does a surplus arise? What happens to the price when there is a surplus? A surplus arises at market prices above the equilibrium price. A surplus causes the price to fall, decreasing quantity supplied and increasing quantity demanded until the equilibrium price is attained.

Why is the price at which the quantity demanded equals the quantity supplied the equilibrium price? At the equilibrium price, the quantity demanded by consumers equals the quantity supplied by producers. At this price, the plans of producers and consumers are coordinated and there is no influence on the price to move away from equilibrium.

Why is the equilibrium price the best deal available for both buyers and sellers? The equilibrium price reflects that the highest price consumers are willing to pay for that amount of the good or service and is just equal to the minimum price that suppliers require for delivering it. Demanders would prefer to pay a lower price, but suppliers are unwilling to supply that quantity at a lower price. Suppliers would prefer a higher price, but demanders are unwilling to pay a higher price for that quantity. Hence neither demanders not suppliers can do business at a better price.

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What is the effect on the price and quantity of MP3 players (such as the iPod) if 1. The price of a PC falls or the price of an MP3 download rises? (Draw the diagrams!) A fall in the price of a PC decreases the demand for MP3 players because a PC is a substitute for an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases. A rise in the price of an MP3 download decreases the demand for MP3 players because an MP3 download is a complement of an MP3 player. The demand curve for MP3 players shifts leftward. Supply remains unchanged. The price of an MP3 player falls and the quantity of MP3 players decreases.

More firms produce MP3 players or electronics workers’ wages rise? (Draw the diagrams!) An increase in the number of firms that produce MP3 players increases the supply of MP3 players. The supply curve of MP3 players shifts rightward. Demand remains unchanged. The price of an MP3 player falls and the quantity of MP3 players increases. You can illustrate this outcome by drawing a diagram like Figure 3.9 on page 108. A rise in the wages of electronic workers decreases the supply of MP3 players because it increases the cost of producing MP3 players. The supply curve of MP3 players shifts leftward. Demand remains unchanged. The price of an MP3 player rises and the quantity of MP3 players decreases.

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Any two of these events in questions 1 and 2 occur together? (Draw the diagrams!) There are six combinations: (1) If the price of a PC falls and the price of an MP3 download rises, demand decreases, supply is unchanged, so the price falls and the quantity decreases. (2) If the price of a PC falls and more firms produce MP3 players, demand decreases and supply increases so the price falls and the quantity might increase, decrease, or not change. (3) If the price of PC falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise, fall, or not change. (4) If the price of an MP3 download rises and more firms produce MP3 players, demand decreases and supply increases so the price falls and quantity might increase or decrease or remain the same. (5) If the price of an MP3 download falls and the wages paid electronic workers rise, demand decreases and supply decreases so the quantity decreases and the price might rise or fall or remain the same. (6) If more firms produce MP3 players and the wages paid electronics workers rise, supply might increase or decrease or remain unchanged, demand is unchanged, so the outcome cannot be predicted.

DEMAND AND SUPPLY

Answers to the Study Plan Problems and Applications 1.

In April 2014, the money price of a carton of milk was $2.01 and the money price of gallon of gasoline was $3.63. Calculate the relative price of a gallon of gasoline in terms of milk. The relative price of a gallon of gasoline in terms of milk equals ($3.63 per gallon of gasoline)/($2.01 per carton of milk) = 1.81 cartons of milk per gallon of gasoline.

The price of food increased during the past year. a. Explain why the law of demand applies to food just as it does to other goods and services. The law of demand applies to food because there is both a substitution and an income effect that reinforce each other. When the price of food rises, people substitute to different foods. For instance, some might substitute home cooked meals for dining at a restaurant. And when the price rises, there is a negative income effect, so people buy less food overall with the rising price. On both counts, the higher price of food decreases the quantity of food demanded.

b. Explain how the substitution effect influences food purchases when the price of food rises and other things remain the same. When the price of food rises, people substitute away from (some) foods and toward other foods and other activities. People substitute cheaper foods for more expensive foods and they also substitute diets for food.

c. Explain how the income effect influences food purchases and provide some examples of the income effect. Food is a normal good so a rise in the price, which decreases people’s real incomes, decreases the quantity of food demanded. In the United States, restaurants suffer as the negative income effect from a higher price of food leads people to cut back their trips to restaurants. At home, people will buy fewer steaks and instead will buy more noodles. In poor countries (and among the poor in the United States), people literally eat less when the price of food rises and in extremely poor countries starvation increases.

Which of the following goods are likely substitutes and which are likely complements? (You may use an item in more than once.): coal, oil, natural gas, wheat, corn, pasta, pizza, sausage, skateboard, roller blades, video game, laptop, iPad, cellphone, text message, email Substitutes include: coal and oil; coal and natural gas; oil and natural gas; wheat and corn; pasta and pizza; pasta and sausage; pizza and sausage (they type of sausage that cannot be used as a topping on pizza); skateboard and roller blades; skateboard and video game; roller blades and video game; laptop and iPad; and, text message and email. Complements include: pizza and sausage (the type of sausage that can be used as a topping on pizza); skateboard and iPad; roller blades and iPad; video game (those played on a computer) and laptop; cellphone and text message; and, cellphone (smart cellphone) and email.

As the average income in China continues to increase, explain how the following would change: a. The demand for beef Beef is a normal good. The increase in income increases the demand for beef.

b. The demand for rice Rice is probably an inferior good. The increase in income decreases the demand for rice.

In 2013, the price of corn fell and some corn farmers will switch from growing corn in 2014 to growing soybeans. a. Does this fact illustrate the law of demand or the law of supply? Explain your answer. This fact illustrates the law of supply: the lower price of corn decreases the quantity of corn grown.

b. Why would a corn farmer grow soybeans? Corn and soybeans are substitutes in production and soybeans have become more profitable. A corn farmer would switch to soybeans because the profit from growing soybeans exceeds that from growing corn.

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Dairies make low-fat milk from full-cream milk, and in the process they produce cream, which is made into ice cream. The following events occur one at a time: (i) The wage rate of dairy workers rises. (ii) The price of cream rises. (iii) The price of low-fat milk rises. (iv) With a drought forecasted, dairies raise their expected price of low-fat milk next year. (v) New technology lowers the cost of producing ice cream. Explain the effect of each event on the supply of low-fat milk. (i) Dairy workers are a factor used to produce low-fat milk. The price of a factor of production rises, which decreases the supply of low-fat milk. (ii) Cream and low fat milk are complements in production. The price of a complement in production rises, which increases the supply of low fat milk. (iii) A rise in the price of low-fat milk does not change the supply of low-fat milk. It does, however, increase the quantity of low-fat milk supplied. (iv) The higher expected price of low-fat milk decreases the (current) supply of low-fat milk. (v) Ice cream and low-fat milk are complements in production. The lower cost of producing ice cream increases the quantity of ice cream produced, which increases the supply of low-fat milk.

The demand and supply schedules for gum are in the table. a. Suppose that the price of gum is 70¢ a pack. Describe the situation in the gum market and explain how the price adjusts.

Price (cents per pack) 20 40 60 80

Quantity Quantity demanded supplied (millions of packs a week) 180 60 140 100 100 140 60 180

At 70 cents a pack, there is a surplus of gum and the price falls. At 70 cents a pack, the quantity demanded is 80 million packs a week and the quantity supplied is 160 million packs a week. There is a surplus of 80 million packs a week. The price falls until market equilibrium is restored at a price of 50 cents a pack.

b. Suppose that the price of gum is 30¢ a pack. Describe the situation in the gum market and explain how the price adjusts. At 30 cents a pack, there is a shortage of gum and the price rises. At 30 cents a pack, the quantity demanded is 160 million packs a week and the quantity supplied is 80 million packs a week. There is a shortage of 80 million packs a week. The price rises until market equilibrium is restored at a price of 50 cents a pack.

The following events occur one at a time: (i) The price of crude oil rises. (ii) The price of a car rises. (iii) All speed limits on highways are abolished. (iv) Robots cut car production costs. Explain the effect of each of these events on the market for gasoline. (ii) and (iii) and (iv) change the demand for gasoline. The demand for gasoline will change if the price of a car rises, all speed limits on highways are abolished, or robot production cuts the cost of producing a car. If the price of a car rises, the quantity of cars bought decrease and the demand for gasoline decreases. If all speed limits on highways are abolished, people will drive faster and use more gasoline. The demand for gasoline increases. If robot production plants lower the cost of producing a car, the supply of cars will increase. With no change in the demand for cars, the price of a car will fall and more cars will be bought. The demand for gasoline increases. (i) changes the supply of gasoline. The supply of gasoline will change if the price of crude oil (a factor of production used in the production of gasoline) changes. If the price of crude oil rises, the cost of producing gasoline rises and the supply of gasoline decreases.

DEMAND AND SUPPLY

In Problem 7, a fire destroys some factories that produce gum and the quantity of gum supplied decreases by 40 million packs a week at each price. a. Explain what happens in the market for gum and draw a graph to illustrate the changes. As the number of gum-producing factories decreases, the supply of gum decreases. There is a new supply schedule and, in Figure 3.1, the supply curves shifts leftward by 40 million packs at each price to the new supply curve S1. After the fire, the quantity supplied at 50 cents is now only 80 million packs, and there is a shortage of gum. The price rises to 60 cents a pack, at which the new quantity supplied equals the quantity demanded. The new equilibrium price is 60 cents and the new equilibrium quantity is 100 million packs a week.

b. If, at the time as the fire the teenage population increases and the quantity of gum demanded increases 40 million packs a week at each price. What is the new market equilibrium? Show the changes on your graph. The new price is 70 cents a pack, and the quantity is 120 million packs a week. The demand for gum increases and the demand curve shifts rightward by 40 million packs at each price. Supply decreases by 40 millions packs a week and the supply curve shifts leftward by 40 million packs at each price. These changes are shown in Figure 3.2 by the shift of the demand curve from D to D1 and the shift of the supply curve from S to S1. At any price below 70 cents a pack there is a shortage of gum. The price of gum rises until the shortage is eliminated.

10.

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Frigid Florida Winter is Bad News for Tomato Lovers An unusually cold January in Florida destroyed entire fields of tomatoes. Florida’s growers are shipping only a quarter of their usual 5 million pounds a week. The price has risen from $6.50 for a 25-pound box a year ago to $30 now. Source: USA Today, March 3, 2010 a. Make a graph to illustrate the market for tomatoes before the unusually cold January and show how the events in the news clip influence the market for tomatoes. Figure 3.3 shows the tomato market in January 2009 and January 2010. In both years the demand curve is labeled D. The supply curve for 2009 is labeled S0 and the supply curve for 2010 is labeled S1. The supply curve for 2010 lies to the left of the supply curve for 2009 because the cold January was a bad state of nature and decreased the supply of tomatoes. The cold weather shifted the supply curve leftward, from S0 to S1. The equilibrium price of a box of tomatoes rises from $6.25 per box to $30.00 per box and the equilibrium quantity decreases from 5 million pounds of tomatoes per week to 1.25 million pounds of tomatoes per week.

b. Why is the news “bad for tomato lovers”? The news is bad for tomato lovers because the price of tomatoes rises and “tomato lovers” respond to the higher price by decreasing the quantity of tomatoes they consume. Tomato lovers consume fewer of the tomatoes they love.

DEMAND AND SUPPLY

Answers to Additional Problems and Applications 11.

What features of the world market for crude oil make it a competitive market? The world oil market is a competitive market because there are a large number of sellers and a large number of buyers. There are so many sellers and so many buyers that no individual seller or individual buyer can influence he price of oil.

12.

The money price of a Persian rug is $100 and the money price of an Egyptian kaftan is $25. a. What is the opportunity cost of a Persian rug in terms of an Egyptian kaftan? A Persian rug costs $100 and an Egyptian kaftan costs $25. Purchasing 1 Persian rug, forces the buyer to give up 4 Egyptian kaftans. So the opportunity cost of a Persian rug in terms of Egyptian kaftans is 4 Egyptian kaftans per Persian rug.

b. What is the relative price of an Egyptian kaftan in terms of Persian rugs? The relative price of an Egyptian kaftan in terms of Persian rugs equals ($25 per Egyptian kaftan)/($100 per Persian rug), which is 1/4 of a Persian rug per Egyptian kaftan.

13.

The price of gasoline has increased during the past year. a. Explain why the law of demand applies to gasoline just as it does to all other goods and services. When the price of gasoline rises, people decrease the quantity of gasoline they demand. Both the substitution effect and the income effect lead consumers to decrease the quantity of gasoline demanded.

b. Explain how the substitution effect influences gasoline purchases and provide some examples of substitutions that people might make when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people substitute other goods and services for gasoline. For instance, people substitute public transport (such as buses), carpools, motorcycles, walking, and bicycles for driving alone in a car to work.

c. Explain how the income effect influences gasoline purchases and provide some examples of the income effects that might occur when the price of gasoline rises and other things remain the same. When the price of gasoline rises, people’s real incomes fall. People respond by decreasing their demand for normal goods, such as gasoline. In the gasoline market, some people trade in large, fuel guzzling cars because they can no longer afford to fuel the large vehicle. Others will not purchase a car or truck because they are not able to afford the gasoline necessary to use it.

14.

Think about the demand for the three game consoles: Xbox One, PlayStation 4, and Wii U. Explain the effect of the following events on the demand for Xbox One games and the quantity of Xbox One games demanded, other things remaining the same. The events are: a. The price of an Xbox One falls. An Xbox One and an Xbox One game are complements. When the price of an Xbox One falls, consumers respond by increasing the quantity of Xbox Ones demanded so the equilibrium quantity of Xbox Ones increases. Consumers increase their demand for Xbox one games because an Xbox One console is useless without Xbox One games.

b. The prices of a PlayStation 4 and a Wii U fall. A PlayStation 4 and a Wii U are substitutes for an Xbox One. When these game consoles fall in price, the demand for Xbox One consoles decreases and so the equilibrium quantity of Xbox Ones decreases. Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

c. The number of people writing and producing Xbox One games increases. The increase in the number of people writing Xbox One games increases the supply of Xbox One games. The demand for Xbox One games does not change but the increase in the supply lowers the price of an Xbox One game. The fall in the price of Xbox One games increases the quantity of Xbox Ones demanded.

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d. Consumers’ incomes increase. Xbox One games are surely a normal good. So an increase in consumers’ incomes increases the demand for Xbox One games.

e. Programmers who write code for Xbox One games become more costly to hire. The increase in the cost of programmers decreases the supply of Xbox One games. When the supply of a good or service decreases, the price of that good or service rises. Xbox One games are not an exception, so the price of an Xbox One game rises. The rise in the price of an Xbox One game decreases the quantity of Xbox One games demanded.

The expected future price of an Xbox One game falls. When the price of an Xbox One game is expected to fall, the (current) demand for Xbox One games decreases.

g. A new game console that is a close substitute for Xbox One comes onto the market. The new game console decreases the demand for Xbox One consoles. As a result, the equilibrium quantity of Xbox One consoles decreases. Consumers decrease their demand for Xbox One games because an Xbox One game is useless without an Xbox One console.

15.

Classify the following pairs of goods and services as substitutes in production, complements in production, or neither. a. Lumber and sawdust For a sawmill that produces both lumber and sawdust, they are complements in production.

b. Condominiums and bungalows For a construction company that builds both condominiums and bungalows, they are substitutes in production. (For a consumer, they are substitutes.)

c. Cheeseburger and fries For a restaurant that produces both cheeseburgers and fries, they are neither complements nor substitutes in production. (For consumers, they are complements.)

d. Cars and gasoline Cars and gasoline are neither complements nor substitutes in production. (For a consumer, cars and gasoline are complements.)

e. Cappuccino and latte For a café that produces both cappuccino and latte, they are substitutes in production. (For a consumer, cappuccino and latte are substitutes.)

16.

When a farmer uses raw milk to produce skim milk, he also produces cream which is used to make butter. a. Explain how a rise in the price of cream influences the supply of skim milk. The rise in the price of cream motivates farmers to make more cream, which increases the quantity supplied of skim milk, as skim milk and cream are complements in production.

b. Explain how a rise in the price of cream influences the supply of butter. As cream is a factor of production used to make butter, a rise in the price of cream will reduce the supply of butter.

DEMAND AND SUPPLY

17.

New Maple Syrup Sap Method With the new way to tap maple trees, farmers could produce 10 times as much maple syrup per acre. Source: cbc.ca, February 5, 2014 Will the new method change the supply of maple syrup or the quantity supplied of maple syrup, other things remaining the same. Explain. The new technology increases the supply of maple syrup. At each price, the new technology increases the quantity that will be supplied. The supply curve shifts rightward.

Use Figure 3.4 to work Problems 18 and 19. 18. a. Label the curves. Which curve shows the willingness to pay for a pizza?

The demand curve is the downward sloping curve and the supply curve is the upward sloping curve. The demand curve shows the willingness to pay for a pizza.

b. If the price of a pizza is $16, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $16, there is a surplus of pizza; the quantity supplied of pizzas exceeds the quantity demanded. The surplus forces the price lower to the equilibrium price of $14 a pizza.

c. Sellers want to receive the highest possible price, so why would they be willing to accept less than $16 a pizza? Sellers are willing to accept less than $16 because if they charge $16 the surplus means that some sellers have unsold pizzas. From their perspective it is better to have a lower price for the pizza and sell the (decreased) quantity they produce than to keep the price at $16 and be left with unsold pizza.

19. a. If the price of a pizza is $12, is there a shortage or a surplus and does the price rise or fall? If the price of a pizza is $12, there is a shortage of pizza; the quantity demanded of pizzas exceeds the quantity supplied. The shortage forces the price higher to the equilibrium price of $14 a pizza.

b. Buyers want to pay the lowest possible price, so why would they be willing to pay more than $12 for a pizza? If the price of a pizza is $12 the shortage means that not all buyers can buy a pizza. From their perspective they would rather pay more than $12 and be able to purchase a pizza than to keep the price at $12 and leave them without a pizza.

20.

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The demand and supply schedules for potato chips are in the table. a. Draw a graph of the potato chip market and mark in the equilibrium price and quantity. Figure 3.5 draws the supply and demand curves for this market. The equilibrium price is 65¢ a bag, and the equilibrium quantity is 145 million bags a week.

Price (cents per bag) 50 60 70 80 90 100

b. If the price is 60¢ a bag, is there a shortage or a surplus, and how does the price adjust? At 60¢ a bag, there is a shortage of potato chips and the price rises. At 60¢ a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 140 million bags a week. The difference is a shortage of 10 million bags a week. The price rises until market equilibrium is restored—65¢ a bag and 145 million bags a week.

21.

In Problem 20, a new dip increases the quantity of potato chips that people want to buy by 30 million bags per week at each price. a. Does the demand for chips change? Does the supply of chips change? Describe the change. As the new dip comes onto the market, the demand for potato chips increases. Supply does not change. The demand curves shifts rightward.

b. How do the equilibrium price and equilibrium quantity of chips change? Demand increases by 30 million bags a week. The demand curve shifts rightward as shown in Figure 3.6 by the shift from D to D1. The quantity demanded at each price increases by 30 million bags. The quantity demanded at 65¢ is now 175 million bags a week of potato chips. The price rises to 80¢ a bag, at which the quantity supplied equals the quantity demanded (160 million bags a week). The new equilibrium price is 80¢ per bag and the new equilibrium quantity is 160 million bags.

Quantity Quantity demanded supplied (millions of bags a week) 160 130 150 140 140 150 130 160 120 170 110 180

DEMAND AND SUPPLY

22.

In Problem 20, if a virus destroys potato crops and the quantity of potato chips produced decreases by 40 million bags a week at each price, how does the supply of chips change? The supply of potato chips decreases, and the supply curve shifts leftward by 40 million bags. The price rises to 85¢ a bag and the quantity decreases to 125 million bags a week.

23.

If the virus in Problem 22 hits just as the new dip in Problem 21 comes onto the market, how do the equilibrium price and equilibrium quantity of chips change? The result by itself of the new dip entering the market is a price of 80¢ a bag and a quantity of 160 million bags. But now with the virus affecting the market, at this price there is a shortage of potato chips. The price of potato chips rises until the shortage is eliminated. The new equilibrium price is 100¢ a bag, and the new equilibrium quantity is 140 million bags a week.

24.

Asian Rubber Farmers Switch Crops as Prices Dive For the last four years, the price of rubber has been falling. With the sagging price, many Southeast Asian producers of rubber have switched to other crops such as oil palm, and those employed in rubber tapping have begun to look for jobs in factories and mines. Source: Reuters, May 29, 2014 a. Explain how the market for rubber would have changed if farmers had continued to plant rubber trees instead of switching to palm oil trees. If farmers continued to plant rubber trees, the supply of rubber would have increased. The demand for rubber would have remained unchanged. The supply curve would have shifted rightward as a result of the increase in supply and the demand curve would have remained unchanged. As a result, the equilibrium price of rubber would have decreased and the equilibrium quantity would have increased.

b. Describe the changes in demand and supply in the market for palm oil. Farmers are cultivating oil palm, which bears fruit within three years unlike rubber trees that takes six years to mature and produce latex. As a result, they have increased the supply of palm oil, while the demand for palm oil did not change.

25.

“Popcorn Movie” Experience Gets Pricier Cinemas are raising the price of popcorn. Demand for field corn, which is used for animal feed, corn syrup, and ethanol, has increased and its price has exploded. That’s caused some farmers to shift from growing popcorn to easierto-grow field corn. Source: USA Today, May 24, 2008 Explain and illustrate graphically the events described in the news clip in the market for a. Popcorn As illustrated in Figure 3.7, the farmers’ actions decrease the supply of popcorn and the supply curve of popcorn shifts leftward. The demand curve does not shift. The equilibrium price of popcorn rises and the quantity decreases.

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b. Movie tickets In the market for movie tickets—essentially the market for viewing movies in the theater— popcorn and viewing movies are complements. The increase in the price of popcorn decreases the demand for attending movies in the theater. As a result, Figure 3.8 shows the demand curve shifting leftward. The equilibrium price of attending a movie in the theater falls and the equilibrium quantity decreases.

26.

Watch Out for Rising Dry-Cleaning Bills In the past year, the price of dry-cleaning solvent doubled. More than 4,000 dry cleaners across the United States disappeared as budget-conscious consumers cut back. This year the price of hangers used by dry cleaners is expected to double. Source: CNN Money, June 4, 2012 a. Explain the effect of rising solvent prices on the market for dry cleaning. Solvents are used to produce dry cleaning, so a rise in the price of solvents increases the cost of dry cleaning. The increase in the cost of dry cleaning decreases the supply of dry cleaning and the supply curve of dry cleaning shifts leftward. The demand for dry cleaning does not change. By itself, the decrease in the supply raises the equilibrium price of dry cleaning and decreases the equilibrium quantity of dry cleaning.

b. Explain the effect of consumers becoming more budget conscious along with the rising price of solvent on the price of dry cleaning. Consumers becoming more budget conscious means that the demand for dry cleaning decreases and the demand curve for dry cleaning shifts leftward. Combined with the decrease in supply from rising solvent prices, the equilibrium quantity of dry cleaning decreases. The effect on the equilibrium price of dry cleaning, however, is ambiguous. If the decrease in supply exceeds the decrease in demand, the price rises; if the decrease in supply is less than the decrease in demand, the price falls; and, if the decrease in supply equals the decrease in demand, the price does not change.

c. If the price of hangers does rise this year, do you expect additional dry cleaners to disappear? Explain why or why not. The increase in the price of hangers raises the costs of dry cleaners but the cost increase is much smaller than the cost increase that resulted from the doubling of the price of dry-cleaning solvent. Therefore the decrease in supply is smaller, which means that the decrease in the equilibrium quantity of dry cleaning also is smaller. If the small decrease in the equilibrium quantity leads some additional dry cleaners to close, the number will be small.

DEMAND AND SUPPLY

Economics in the News 27.

After you have studied Economics in the news on pp. 112–113, answer the following questions: a. What would happen to the price of bananas if TR4 spread to Central America? The price of bananas would rise.

b. What are some of the substitutes for bananas and what would happen to demand, supply, price, and quantity in the markets for these items if TR4 were to come to America? Banana consumers could substitute other fruits, such as apples, peaches, or apricots. These changes would not change the supply of these products. The demand for these products, however, would increase, thereby raising their price and quantity.

c. What are some of the complements of bananas and what would happen to demand, supply, price, and quantity in the markets for these items if TR4 were to come to America? The classic complement for bananas is cereal. A rise in the price of bananas decreases the demand for cereal, so the demand curve for cereal shifts leftward. The supply of cereal is unaffected. The decrease in the demand for cereal lowers the equilibrium price of cereal and decreases the equilibrium quantity of cereal.

d. When the price of bananas increased in 2008, did it rise by as much as the rise in the rise in the price of oil? Why or why not? In 2008 the price of oil rose by about 70 percent, so the 20 percent price hike in the price of bananas was much less than the rise in price of oil. The price of oil is a cost of producing bananas. When the price of oil rose, the cost of producing bananas rose, so that the supply of bananas decreased. In response, the price of bananas rose. But there are other costs of producing bananas. The other costs did not rise by as much as the price of oil, so the decrease in the supply of bananas was smaller and, accordingly, the rise in the price of bananas was less than of oil.

e. Why would the expectation of the future arrival of TR4 in the Americas have little or no effect on today's price of bananas? If TR4 arrives in the Americas, the supply of bananas will decrease, thereby raising the price. The rise in the future expected for some goods can decrease the current supply and increase the current demand. But these changes assume that the good is storable. For example, the current supply decreases when the expected future price rises because producers store the product to sell in the future when its price is expected to be higher. Bananas, however, are not storable. Therefore producers (and demanders) do not respond to the higher expected future price.

C h a p t e r

ELASTICITY

Answers to the Review Quizzes Page 128 1.

Why do we need a units-free measure of the responsiveness of the quantity demanded of a good or service to a change in its price? The elasticity of demand is a units-free measure. Compare it as a measure of the responsiveness to some other candidate that depends on the units, such as the slope. The slope of the demand curve changes as the units measuring the same quantity of the good change (going from pounds to ounces, for example). The value of the elasticity is independent of the units used to measure the price and quantity of the product. As a result, the elasticity can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. The elasticities of different goods also can be compared even though they are measured in different units.

Define the price elasticity of demand and show how it is calculated. The price elasticity of demand is units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. It equals the absolute value (or magnitude) of the ratio of the percentage change in the quantity demanded to the percentage change in the price. The percentage change in quantity (price) is measured as the change in quantity (price) divided by the average quantity (price).

What makes the demand for some goods elastic and the demand for other goods inelastic? The magnitude of the price elasticity of demand for a good depends on three main influences: Closeness of substitutes. The more easily people can substitute other items for a particular good, the larger is the price elasticity of demand for that good. The proportion of income spent on the good. The larger the portion of the consumer’s budget being spent on a good, the greater is the price elasticity of demand for that good. The time elapsed since a price change. Usually, the more time that has passed after a price change, the greater is the price elasticity of demand for a good.

Why is the demand for a luxury generally more elastic (or less inelastic) than the demand for a necessity? Demand for a necessity is generally less elastic than demand for a luxury because there are fewer substitutes for a necessity. Because there are more substitutes for a luxury than a necessity, the elasticity of demand for a luxury is larger is than the elasticity of demand for a necessity.

What is the total revenue test? The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue, given a change in price, holding all other things constant. The total revenue test shows

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that a price cut increases total revenue if demand is elastic, decreases total revenue if demand is inelastic, and does not change total revenue if demand is unit elastic.

Page 132 1.

What does the income elasticity of demand measure? The income elasticity of demand measures how the quantity demanded of a good responds to a change in income. The formula for the income elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in income.

What does the sign (positive/negative) of the income elasticity tell us about a good? The sign of the income elasticity of demand reveals whether a good is a normal good or an inferior good: The income elasticity of demand is positive for normal goods and negative for inferior goods.

What does the cross elasticity of demand measure? The cross elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good. The formula for the cross elasticity of demand is the percentage change in the quantity of the good demanded divided by the percentage change in the price of the related good.

What does the sign (positive/negative) of the cross elasticity of demand tell us about the relationship between two goods? The sign of the cross elasticity of demand reveals whether two goods are substitutes or compliments: The cross elasticity of demand is positive for substitutes and negative for complements.

Page 134 1.

Why do we need a units-free measure of the responsiveness of the quantity supplied of a good or service to a change in its price? The elasticity of supply is a units-free measure. We need a units-free measure of the elasticity of supply for the same reason we need a units-free measure of the elasticity of demand: Because the value of the elasticity of supply is independent of the units used to measure the price and quantity of the good, the elasticity of supply can be compared across the same good when quantity is measured in different units and/or the price is measured in different currencies. In addition, the elasticities of supply of different goods also can be compared even though they are measured in different units.

Define the elasticity of supply and show how it is calculated. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. The elasticity of supply is calculated by the percentage change in the quantity supplied divided by the percentage change in the price.

What are the main influences on the elasticity of supply that make the supply of some goods elastic and the supply of other goods inelastic? The main influences on the elasticity of supply are: Resource substitution possibilities: the greater the suppliers’ ability to substitute resources, the greater will be their ability to react to price changes and the greater the elasticity of supply. Time frame for the supply decision: the greater the amount of time available after the price change, the greater is the suppliers’ ability to adjust quantity supplied, and the greater the elasticity of supply.

Provide examples of goods or services whose elasticities of supply are (a) zero, (b) greater than zero but less than infinity, and (c) infinity. Here are some examples: a)

The momentary supply of wheat is perfectly inelastic. Once farmers have brought their wheat to market, there is no other alternative use for it and they sell it all regardless of the going price.

The short-run supply of wheat. If the farmers already have a mature wheat crop but have not yet harvested it, farmers with both relatively high and low yield fields may chose to harvest both types of fields if the price for wheat is high. However, the farmers will not harvest their low yield fields when the price of wheat is relatively low to economize on added labor costs.

ELASTICITY

The supply of wheat to an individual buyer. Any one buyer can purchase as much wheat at the going price as he or she desires. However, no quantity of wheat will be supplied at a lower price.

How does the time frame over which a supply decision is made influence the elasticity of supply? Explain your answer. The momentary supply, short-run supply, and long-run supply all illustrate the response of suppliers to changes in the price, but they differ according to how much time has elapsed after the price change. The momentary supply is frequently the least elastic and shows how suppliers cannot easily respond to a price change immediately after the price change occurs. Changing the quantity produced means changing the inputs into the production process, which takes time to complete. Sometimes the momentary supply is perfectly inelastic. The short-run supply shows suppliers’ response after enough time has elapsed for some, but not all, of the possible technological adjustments have occurred. Short-run supply generally is intermediate in elasticity between the momentary supply and the long-run supply. The long-run supply shows how suppliers react after enough time has passed that all possible adjustments to factors of production have been made to accommodate the price change. It usually is the most elastic of the three supplies.

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Answers to the Study Plan Problems and Applications 1.

Rain spoils the strawberry crop, the price rises from $4 to $6 a box, and the quantity demanded decreases from 1,000 to 600 boxes a week. a. Calculate the price elasticity of demand over this price range. The price elasticity of demand is 1.25. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price rises from $4 to $6 a box, a rise of $2 a box. The average price is $5 a box. So the percentage change in the price is $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 1,000 to 600 boxes, a decrease of 400 boxes. The average quantity is 800 boxes. So the percentage change in quantity is 400 divided by 800, which equals 50 percent. The price elasticity of demand for strawberries is 50 percent divided by 40 percent, which equals 1.25.

b. Describe the demand for strawberries. The price elasticity of demand exceeds 1, so the demand for strawberries is elastic.

If the quantity of dental services demanded increases by 10 percent when the price of dental services falls by 10 percent, is the demand for dental services inelastic, elastic, or unit elastic? The demand for dental services is unit elastic. The price elasticity of demand for dental services equals the percentage change in the quantity of dental services demanded divided by the percentage change in the price of dental services. The price elasticity of demand is 10 percent divided by 10 percent, which equals 1. The demand is unit elastic.

The demand schedule for hotel rooms is in the table. a. What happens to total revenue when the price falls from $400 to $250 a room per night and from $250 to $200 a room per night?

Price (dollars per night) 200 250 400 500 800

Quantity demanded (millions of rooms per night) 100 80 50 40 25

When the price is $400, the total revenue is equal to $400 × 50 million rooms, or $20 billion. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night. When the price is $250, the total revenue is equal to $250 × 80 million rooms, or $20 billion. When the price is $200, the total revenue is equal to $200 × 100 million rooms, or $20 billion. So the total revenue does not change when the price falls from $400 to $250 a night.

b. Is the demand for hotel rooms elastic, inelastic or unit elastic? The total revenue is the same at all prices, $20 billion. Because a change in price does not change the total revenue at any price, the demand is unit elastic at all prices.

ELASTICITY

The figure shows the demand for pens. Calculate the elasticity of demand when the price rises from $4 to $6 a pen. Over what price range is the demand for pens elastic? The price elasticity of demand is 0.72. When the price of a pen rises from $4 to $6, the quantity demanded of pens decreases from 80 to 60 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $4 to $6, an increase of $2 a pen. The average price is $5 per pen. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity decreases from 80 to 60 pens, a decrease of 20 pens. The average quantity is 70 pens. So the percentage change in quantity demanded equals 20 divided by 70 and then multiplied by 100, which equals 28.6 percent. The price elasticity of demand for pens equals 28.6 percent divided by 40 percent, which is 0.72. The demand for pens is elastic at all prices higher than the price at the midpoint of the demand curve, which indicates that the demand for pens is elastic at prices between $12 per pen and $6 per pen.

In 2003, when music downloading first took off, Universal Music slashed the average price of a CD from $21 to $15. The company expected the price cut to boost the quantity of CDs sold by 30 percent, other things remaining the same. a. What was Universal Music’s estimate of the price elasticity of demand for CDs? Using the data in the question, the price elasticity of demand is 0.90. The change in the price is $6 and the average of the two prices is $18, so the percentage change in the price is ($6/$18)  100, which equals 33.3 percent. The increase in the quantity demanded was estimated to be 30 percent. The price elasticity of demand equals (30.0 percent)/(33.3 percent), or 0.90.

b. If you were making the pricing decision at Universal Music, what would be your pricing decision? Explain your decision. The demand is inelastic, so if nothing else changes the price cut leads to a decrease in Universal Music’s total revenue. However, downloaded music and CDs are substitutes for each other and the quantity of downloaded music was forecast to rise substantially. Effectively, the price of downloading music fell as more people gained access to the Internet and download sites proliferated. The fall in the price of the substitute, downloaded music, decreases the demand for Universal Music’s CDs, so the decision to cut prices most likely was forced as the result of the (forecasted) decrease in demand for CDs.

When Judy’s income increased from $130 to $170 a week, she increased her demand for concert tickets by 15 percent and decreased her demand for bus rides by 10 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

a. b.

The income elasticity of demand for (a) concert tickets is 0.56 and (b) bus rides is −0.375. The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $40 and the average income is $150, so the percentage change in income equals 26.7 percent. The change in the quantity demanded of concert tickets is 15 percent. The income elasticity of demand for concert tickets equals 15/26.7, which is 0.56. The change in the quantity demanded of bus rides is 10 percent. The income elasticity of demand for bus rides equals 10/26.7, which is 0.375.

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If a 12 percent rise in the price of orange juice decreases the quantity of orange juice demanded by 22 percent and increases the quantity of apple juice demanded by 14 percent, calculate the a. Price elasticity of demand for orange juice. The price elasticity of demand for orange juice is 1.83. The price elasticity of demand is the percentage change in the quantity demanded of the good divided by the percentage change in the price of the good. So the price elasticity of demand equals 22 percent divided by 12 percent, which is 1.83.

b. Cross elasticity of demand for apple juice with respect to the price of orange juice. The cross elasticity of demand between orange juice and apple juice is 1.17. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. So the cross elasticity of demand is the percentage change in the quantity demanded of apple juice divided by the percentage change in the price of orange juice. The cross elasticity equals 14 percent divided by 12 percent, which is 1.17.

If a rise in the price of sushi from 98¢ to $1.02 a piece decreases the quantity of soy sauce demanded from 101 units to 99 units an hour and decreases the quantity of sushi demanded by 1 percent an hour, calculate the: a. Price elasticity of demand for sushi. The price of sushi rises by ($1.02 − $0.98)/$1.00 = 4 percent. Therefore the price elasticity of demand for sushi equals |( −1 percent)/(4 percent)|, which is 0.25.

b. Cross elasticity of demand for soy sauce with respect to the price of sushi. The quantity of soy sauce decreases by (99 – 101)/100 = −2 percent. Therefore the cross elasticity of demand for soy sauce with respect to the price of sushi equals |( −2 percent)/(4 percent), which is −0.5.

The table sets out the supply schedule of jeans. a. Calculate the elasticity of supply when the price rises from $125 to $135 a pair.

Price (dollars per pair) 120 125 130 135

Quantity supplied (millions of pairs per year) 24 28 32 36

The elasticity of supply equals the percentage change in the quantity supplied divided by the percentage change in price. The percentage change in the quantity demanded equals [(36 − 28)/32] × 100, which is 25.0 percent. The percentage change in the price equals [($135 − $125)/$130] × 100, which is 7.7 percent. The elasticity of supply equals (25.0 percent/7.7 percent), which is 3.25.

b. Calculate the elasticity of supply when the average price is $125 a pair. To find the elasticity at an average price of $125 a pair, change the price such that $125 is the average price—for example, a rise in the price from $120 to $130 a pair. To calculate the elasticity when the average price is $125, calculate the elasticity over the price range from $120 to $130. The percentage change in the quantity demanded equals [(32 − 24)/28] × 100, which is 28.6 percent. The percentage change in the price equals [($130 − $120)/$125] × 100, which is 8.0 percent. The elasticity of supply equals (28.6 percent/8.0 percent), which is 3.58.

c. Is the supply of jeans elastic, inelastic, or unit elastic? The supply of jeans is elastic.

ELASTICITY

Answers to Additional Problems and Applications 10.

With higher fuel costs, airlines raised their average fare from 75¢ to $1.25 per passenger mile and the number of passenger miles decreased from 2.5 million a day to 1.5 million a day. a. What is the price elasticity of demand for air travel over this price range? The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The quantity demanded changes by 1.0 million passenger miles and the average passenger miles is 2.0 million. The percentage change in the quantity demanded is (1.0 million)/(2.0 million)  100, which is 50 percent. The price changes by $0.50 and the average price is $1.00. The percentage change in the quantity demanded is ($0.50 /($1.00)  100, which is 50 percent. So the price elasticity of demand is (50 percent)/(50 percent), or 1.00.

b. Describe the demand for air travel. The demand for air travel between these two prices is unit elastic. The 50 percent price hike leads to a 50 percent decrease in the quantity of air miles traveled.

11.

Figure 4.2 shows the demand for DVD rentals. a. Calculate the elasticity of demand when the price of a DVD rental rises from $3 to $5. The price elasticity of demand is 2. When the price of a DVD rental rises from $3 to $5, the quantity demanded of DVDs decreases from 75 to 25 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $3 to $5, an increase of $2 a DVD. The average price is $4 per DVD. So the percentage change in the price equals $2 divided by $4 and then multiplied by 100, which equals 50 percent. The quantity decreases from 75 to 25 DVDs, a decrease of 50 DVDs. The average quantity is 50 DVDs. So the percentage change in quantity demanded equals 50 divided by 50 and then multiplied by 100, which equals 100 percent. The price elasticity of demand for DVD rentals equals 100 percent divided by 50 percent, which is 2.

b. At what price is the elasticity of demand for DVD rentals equal to 1? The price elasticity of demand equals 1 at $3 a DVD. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve intersects the y-axis. That price is $3 a DVD.

Use the following table to work Problems 12 to 14. The demand schedule for computer chips is in the table. 12. a. What happens to total revenue if the price falls from $400 to $350 a chip and from $350 to $300 a chip? When the price of a chip is $400, 30 million chips are sold and total revenue equals $12,000 million. When the price of a chip falls to $350, 35 million chips are sold and total revenue is $12,250 million. The total revenue increases when the price falls.

Price (dollars per chip) 200 250 300 350 400

Quantity demanded (millions of chips per year) 50 45 40 35 30

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When the price is $350 a chip, 35 million chips are sold and total revenue is $12,250 million. When the price of a chip is $300, 40 million chips are sold and total revenue decreases to $12,000 million. The total revenue decreases as the price falls.

b. At what price is total revenue at a maximum? Total revenue is maximized at $350 a chip. When the price of a chip is $300, 40 million chips are sold and total revenue equals $12,000 million. When the price is $350 a chip, 35 million chips are sold and total revenue equals $12,250 million. Total revenue increases when the price rises from $300 to $350 a chip. When the price is $400 a chip, 30 million chips are sold and total revenue equals $12,000 million. Total revenue decreases when the price rises from $350 to $400 a chip. Total revenue is maximized when the price is $350 a chip.

13.

At an average price of $350, is the demand for chips elastic, inelastic, or unit elastic? Use the total revenue test to answer this question. The demand for chips is unit elastic. The total revenue test says that if the price changes and total revenue remains the same, the demand is unit elastic at the average price. For an average price of $350 a chip, cut the price from $400 to $300 a chip. When the price of a chip falls from $400 to $300, the total revenue remains at $12,000 million. So at the average price of $350 a chip, demand is unit elastic.

14.

At $250 a chip, is the demand for chips elastic or inelastic? Use the total revenue test to answer this question. The demand for chips is inelastic. The total revenue test says that if the price falls and total revenue falls, the demand is inelastic. When the price falls from $300 to $200 a chip, total revenue decreases from $12,000 million to $10,000 million. So at an average price of $250 a chip, demand is inelastic.

15.

Your price elasticity of demand for bananas is 4. If the price of bananas rises by 5 percent, what is a. The percentage change in the quantity of bananas you buy? The quantity of bananas you buy decreases by 20 percent. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. Rearranging this formula shows that the percentage change in the quantity demanded equals the price elasticity of demand multiplied by the percentage change in the price. The percentage change in the quantity demanded equals 4  5 percent, which is 20 percent.

b. The change in your expenditure on bananas? Your total expenditure decreases because your demand is elastic. The fall in expenditure is approximately 15 percent, the 5 percent rise in price offset by the 20 percent decrease in the quantity purchased.

16.

Over 15 million households plan to ration energy use this winter to cope with soaring bills The cost of energy is rising and British consumers are left to cope with a harsh winter. Seeing their energy bills rise, millions of households are planning to cut back as much as they can on their energy use despite the cold temperature, putting their health at risk. Many bill payers will cope by spending less on food so that they can afford to keep their homes warm. Household disposable income has been substantially affected by rising energy costs and prices are expected to keep increasing. Some estimate that the average UK home will spend £53 more on energy this year. Source: This is Money, November 6, 2014 a. List and explain the elasticities of demand that are implicitly referred to in the news clip. The elasticities of demand to which the clip refers are the income elasticity of demand, the price elasticity of demand, and the cross elasticity of demand. The price elasticity of demand is reflected in the news clip’s discussion of the rising price of energy. As the price increases, people will try to cut back on their energy consumption as much as possible (and decrease the quantity of energy demanded), despite the cold temperature. The income elasticity of demand is implied through references to the substantial effect rising energy costs have on household disposable income. In order to pay their high energy bills, people will ration their energy use with some saying they will even spend less on food. This

ELASTICITY

implies that there are things that households can do in response to increasing energy price, making a reference to cross elasticity of demand.

b. Why, according to the news clip, is the demand for energy inelastic? The demand for energy is inelastic because as the price of energy rises, the quantity demanded of energy decreases by as small an amount as possible. People will cut back on energy consumption, yet it remains a necessity.

Use this information to work Problems 17 and 18. Recession Has Led To Spending On Food Falling By 8.5%, Say Researchers Families in Britain, especially the ones with children, have altered their eating habits in the face of recession. Less is spent on fruit and vegetables and more on processed foods lacking in nutrition. Source: The Guardian, November 4, 2013 17.

Given the prices, is the income elasticity of demand for fruit and vegetables positive or negative? Are fruit and vegetables a normal good or an inferior good? Are processed foods a normal good or inferior good? As income falls in the recession, the income spent on fruits and vegetables decreases, the income elasticity of demand for fruit and vegetables is positive, so fruit and vegetables are a normal good. As income falls in the recession, the income spent on processed foods increases, the income elasticity of demand for processed foods is negative, so processed foods are an inferior good.

18.

Are fruits and vegetables and processed foods substitutes? Explain. Fruits and vegetables and processed foods are substitutes as food is a necessity. The article points out that in the face of the recession which began in 2008, families in Britain were substituting processed foods for fruits and vegetables. However, to be sure that they are substitutes, the cross price elasticity of demand should be calculated. In this case, prices are not given, so it cannot be computed.

19.

When Alex’s income was $3,000, he bought 4 bagels and 12 donuts a month. Now his income is $5,000 and he buys 8 bagels and 6 donuts a month. Calculate Alex’s income elasticity of demand for (a) bagels and (b) donuts. a.

20.

The income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $4,000, so the percentage change in income equals 50 percent. The change in the quantity demanded is 4 bagels and the average quantity demanded is 6 bagels, so the percentage change in the quantity demanded equals 66.67 percent. The income elasticity of demand for bagels equals (66.67 percent)/(50 percent), which is 1.33. From part (a), the percentage change in income is 50 percent. The change in the quantity demanded is −6 donuts and the average quantity demanded is 9 donuts, so the percentage change in the quantity demanded is −66.67 percent. The income elasticity of demand for donuts equals (−66.67 percent)/(50 percent), which is −1.33.

Pampered Pets UK! The economy has slowed down again but Britain’s animal lovers have not stopped themselves from spending on gourmet pet food, spoiling their pets even though their budgets are tight. In fact, more than a third of pet owners claim that they would cut back on their own food purchases before that of their pets. Source: The Independent, April 14, 2015 a. What does this news clip imply about the income elasticity of demand for gourmet pet food? The news clip implies that the income elasticity of demand for gourmet food is positive but very small. As income falls, the quantity demanded of pet food barely changed, so the income elasticity of demand is very small.

b. Would the income elasticity of demand be greater or less than 1? Explain. The income elasticity of demand for gourmet pet food is less than 1 because the percentage change in the quantity demanded of pet food is smaller than the percentage change in income.

21.

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If a 5 percent fall in the price of chocolate sauce increases the quantity demanded of chocolate sauce by 10 percent and increases the quantity of ice cream demanded by 15 percent, calculate the: a. Price elasticity of demand for chocolate sauce. The price elasticity of demand for chocolate sauce equals the percentage change in the quantity of chocolate sauce demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the price elasticity of demand equals (10 percent)/(−5 percent), which is 2.0.

b. Cross elasticity of demand for ice cream with respect to the price of chocolate sauce. The cross elasticity of demand for ice cream with respect to the price of chocolate sauce equals the percentage change in the quantity of ice cream demanded divided by the percentage change in the price of chocolate sauce. Using the data in the problem, the cross elasticity of demand equals (15 percent)/(−5 percent), which is −3.0. Ice cream and chocolate sauce are complements.

22.

To Love, Honor, and Save Money In a survey of caterers and event planners, nearly half of them said that they were seeing declines in wedding spending in response to the economic slowdown; 12% even reported wedding cancellations because of financial concerns. Source: Time, June 2, 2008 a. Based upon this news clip, are wedding events a normal good or inferior good? Explain. Based on the news clip, wedding events are a normal good. The economic slowdown means that people’s incomes are falling and, as a result, the demand for wedding events is decreasing.

b. Are wedding events more a necessity or a luxury? Would the income elasticity of demand be greater than 1, less than 1, or equal to 1? Explain. Wedding events are a luxury. Wedding events are not necessities because couples can marry with plain weddings; indeed, couples can marry using a civil ceremony and with no wedding event at all. If wedding events are a luxury, their income elasticity of demand is greater than 1.

23.

The table sets out the supply schedule of long-distance phone calls. Calculate the elasticity of supply when a. The price falls from 40¢ to 30¢ a minute.

Price (cents per minute)

Quantity supplied (millions of minutes per day)

The elasticity of supply is 1. The elasticity 10 200 of supply is the percentage change in the 20 400 quantity supplied divided by the 30 600 percentage change in the price. When the price falls from 40 cents to 30 cents, the 40 800 change in the price is 10 cents and the average price is 35 cents. The percentage change in the price is 28.57 percent. When the price falls from 40 cents to 30 cents, the quantity supplied decreases from 800 to 600 calls. The change in the quantity supplied is 200 calls, and the average quantity is 700 calls, so the percentage change in the quantity supplied is 28.57 percent. The elasticity of supply equals (28.57 percent)/(28.57 percent), which is 1.

b. The average price is 20¢ a minute. The elasticity of supply is 1. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity at an average price of 20 cents a minute, change the price such that 20 cents is the average price—for example, a fall in the price from 30 cents to 10 cents a minute. When the price falls from 30 cents to 10 cents, the change in the price is 20 cents and the average price is 20 cents. The percentage change in the price is 100 percent. When the price falls from 30 cents to 10 cents, the quantity supplied decreases from 600 to 200 calls. The change in the quantity supplied is 400 calls and the average quantity is 400 calls. The percentage change in the quantity supplied is 100 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 1.

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24.

Weak Coal Prices Hit China’s Third-Largest Coal Miner The chairman of Yanzhou Coal Mining reported that the recession had decreased the demand for coal, with its sales falling by 11.9 per cent to 7.92 million tons from 8.99 million tons a year earlier, despite a 10.6 percent cut in the price. Source: Dow Jones, April 27, 2009 Calculate the price elasticity of supply of coal. Is the supply of coal elastic or inelastic? The price elasticity of supply of coal equals the percentage change in the quantity of coal supplied divided by the percentage change in the price of coal. Using the data in the problem, the price elasticity of supply equals (–11.9 percent)/( –10.6 percent), which is 1.12. The elasticity exceeds 1.0 in value, so the supply of coal is elastic.

Economics in the News 25.

After you have studied Economics in the News on pp. 136–137, answer the following questions. a. Looking at Fig. 1 on p. 137, explain what must have happened in 2014 to the supply of coffee. The price of coffee soared in 2014, which indicates that the supply of coffee decreased.

b. Given the information in Fig. 1 and the estimated elasticity of demand for coffee, by what percentage did the quantity of coffee change in 2014 and in which direction? The price of coffee rose from $1.00 per pound to $1.60 per pound. Therefore the percentage increase in the price of coffee is ($1.60 – $1.00)/$1.30 = 46 percent. The price elasticity of demand is 0.26. Therefore the quantity of coffee decreased by 0.26 × 46 percent, which is 12 percent.

c. The news article says that farmers’ revenue shrank as the price of coffee fell. Explain why this fact tells us that the demand for coffee is inelastic. The total revenue test shows that total revenue falls when the price falls only if the demand for the product is inelastic. Therefore, because farmers’ total revenue from coffee fell when the price of coffee fell, the total revenue test means that the demand for coffee must be inelastic.

d. How does the total revenue test work for a rise in the price? What do you predict happened to total revenue in 2014? Why? If the demand for a product is inelastic and the price rises, the total revenue increases. Therefore, in 2014 when the price of coffee rose, coffee farmers’ total revenue increased.

e. Coffee isn’t just coffee. It comes in different varieties, the main two being Arabica and Robusta. Would you expect the elasticity of demand for Arabica to be the same as the elasticity of demand for coffee? Explain why or why not. There are more close substitutes for the specific type of coffee, Arabica, than there are for coffee in general, so the price elasticity of demand for Arabica is larger than the price elasticity of demand for coffee.

26.

Mobile Merger Set for Poor Reception from Users If Prices Rise Hutchinson Whampoa, owner of Three, UK’s fastest growing mobile network, has started exclusive talks to buy Telefónica’s O2 for £10.25 billion. This has caused price-rise concerns among British phone users. Source: The Financial Times, January 23, 2015 a. If the prices of telecom services rise because of the deal, how will this influence the supply of telecom services? The new clip points out that the deal has caused price-rise concerns among the users. It is likely that the deal will lead to higher prices for mobile tariffs and as a result will cause the overall supply to increase. As the price of telecom services rises, the quantity supplied of telecom services will increase. The supply of telecom service will not change.

b. Given your answer to part (a), explain why Hutchison Whampoa can afford to raise mobile tariffs? Hutchison Whampoa can afford to raise their prices for mobile tariffs because it assumes that the deal will leave fewer players in an essential market like the telecoms so users will not have many alternatives to choose from. This is because when consumers have less substitutes, their elasticity of demand for

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telecom services will be inelastic. When demand is inelastic, a price rise will increase Hutchison Whampoa’s total revenue.

c. What can you say about the price elasticity of demand for services in the UK telecoms market with respect to the deal between Hutchinson Whampoa and Telefónica? The price elasticity of demand for services in the UK telecoms market will become more inelastic as the deal would mean fewer available substitutes.

C h a p t e r

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Answers to the Review Quizzes Page 145 1.

Why do we need methods of allocating scarce resources? Because resources are scare, it is not possible to fulfill everyone’s wants. As a result, some method of deciding which wants will be fulfilled and which will not—that is, some method of allocating resources—must be utilized.

Describe the alternative methods of allocating scarce resources. Resources can be allocated using: • Market price: People who are willing and able to pay the price get the resource. • Command: Someone in command decides who gets the resource. • Majority rule: The majority vote decides how resources are allocated. • Contest: Winners receive the resource. • First-come, first-served: People first in line get the resource. • Lottery: Randomly selected winners receive the resource. • Personal characteristics: People with the “right” characteristics get the resource. • Force: The stronger person or group gets the resource.

Provide an example of each allocation method that illustrates when it works well. Below are examples of when each allocation scheme works well: • Market price: Generally works well in competitive markets and for most goods and services. An example is the allocation of cat food. • Command: Generally works well in organizations where lines of authority are clear and it is easy to monitor subordinates. An example is in a fast food restaurant when the supervisor tells a worker to clean the tables. • Majority rule: Generally works well when large numbers of people are affected by the allocation. An example is an election in which people vote whether or not to support a tax to build more parks. • Contest: Generally works well when the efforts of the participates are hard to monitor. An example is the contest run by Pfizer in which three top managers competed to see who would be appointed CEO. • First-come, first-served: Generally works well when a resource can be used by only one user at a time. An example is a line at a movie ticket booth. • Lottery: Generally works well when there is no way to easily distinguish which user of a resource would use it most effectively. An example is the lottery used to allocate cell phone frequencies.

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• •

Personal characteristics: Generally works well when resource use is such that different people consume the same resources. An example is the decision whom to marry. Force: Generally works well when used to uphold the rule of law. An example is the state imprisoning thieves and thereby preventing resource allocation by the thief stealing the resource.

Provide an example of each allocation method that illustrates when it works badly. Below are examples of when each allocation scheme would work poorly: • Market price: Deciding court cases on the basis of who will pay the most for the decision. • Command: Running an economy. • Majority rule: Deciding how many acres of wheat to plant. • Contest: Allocating food in a winner-take-all contest. • First-come, first-served: Admitting students to college based on who applied first. • Lottery: Assigning grades based on random chance. • Personal characteristics: Renting only to married couples. • Force: Stealing by threat of physical harm.

Page 149 1.

What is the relationship between the marginal benefit, value, and demand? The value of one more unit of a good is its marginal benefit. The marginal benefit of a good or service is measured by the maximum amount that consumers are willing to pay for one more unit of a good or service. The demand curve shows the maximum consumers are willing to pay for each additional unit, so the demand curve is the same as the marginal benefit curve.

What is the relationship between individual demand and market demand? The market demand equals the sum of the individual quantities demanded by all the demanders at each price. Therefore the market demand curve equals the horizontal sum of the individual demand curves.

What is consumer surplus? How is it measured? Consumer surplus is the excess of the benefit received from a good over the amount paid for it. The total consumer surplus is the sum of the consumer surpluses on all the units purchased. It is measured as the area under the demand curve and above the price.

What is the relationship between the marginal cost, minimum supply-price, and supply? The marginal cost is the cost of producing an additional unit of a good. The marginal cost is the minimum price that producers must receive to induce them to offer one more unit of a good or service for sale. This minimum supply-price determines the supply of the good, so the supply curve is the same as the marginal cost curve.

What is the relationship between individual supply and market supply? The market supply equals the sum of the individual quantities supplied by all the producers at each price. The market supply curve is equal to the horizontal sum of all the individual supply curves.

What is producer surplus? How is it measured? Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it. The producer surplus is measured as the area under the price and above the supply curve over the entire quantity sold.

Page 153 1.

Do competitive markets use resources efficiently? Explain why or why not. In the absence of the obstacles mentioned earlier in the chapter, competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit. This condition will be met in a competitive market because the quantity occurs

EFFICIENCY AND EQUITY

where the demand curve (which equals the marginal social benefit curve) intersects the supply curve (which equals the marginal social cost curve).

What is deadweight loss and under what conditions does it occur? The deadweight loss is the decrease in total surplus that results from an inefficient level of production. This is the decrease in consumer surplus plus the decrease in producer surplus that occurs when the market either overproduces or underproduces relative to the efficient quantity.

What are the obstacles to achieving an efficient allocation of resources in the market economy? Markets with price or quantity regulations, taxes or subsidies, externalities, public goods or common resources, monopoly power, or high transactions costs will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal social benefit of the last unit produced be equal to the marginal social cost. The equilibrium at the intersection of the demand and supply curves in the competitive market creates this result. When the market price or quantity is pulled away from the market equilibrium, the marginal social benefit of the last unit produced does not equal its marginal social cost.

Page 157 1.

What are the two big approaches to thinking about fairness? The two big approaches to thinking about fairness are: “It’s not fair if the result isn’t fair,” or utilitarianism. “It’s not fair if the rules aren’t fair,” or equality of opportunity.

What is the utilitarian idea of fairness and what is wrong with it? The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be “fair.” There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism: It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller. It ignores the Big Tradeoff, the tradeoff between efficiency and fairness. Taxing people’s incomes makes them work less, which decreases the size of the economic pie and thereby diminishes the total amount that can be transferred to the poor.

Explain the big tradeoff. What idea of fairness has been developed to deal with it? The big tradeoff is the tradeoff between efficiency and fairness. Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases. The big tradeoff has led to the idea that the fairest distribution is that which makes the poorest person as well off as possible.

What is the idea of fairness based on fair rules? The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be “fair.” This is the economic application of the symmetry principle, that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed: The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

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Answers to the Study Plan Problems and Applications

1. At Chez Panisse, a restaurant in Berkeley, reservations are essential. At Mandarin Dynasty, a restaurant near the University of California San Diego, reservations are recommended. At Eli Cannon’s, a restaurant in Middletown, Connecticut, reservations are not accepted. Describe the method of allocating scarce table resources at these three restaurants. Why do you think restaurants don’t use the market price to allocate their tables? All these restaurants use a first-come, first-serve system. Eli Cannon’s uses this system directly. Chez Panisse uses a first-come, first-serve system because the first person to call to make a reservation at a particular time is allocated the table at that time. Mandarin Dynasty uses a combination of the immediate first-come, first-serve system and the reservation based first-come, first-serve system. Market allocation requires that customers pay for a table and the price would fluctuate from one hour to the next depending on the number of customers who arrive. Customers would be highly uncertain about the price they would need to pay and such uncertainty decreases the demand for meals from the restaurant. The decreased demand lowers the restaurant’s profit.

Use the following table to work Problems 2 to 4. The table gives the demand schedules for train travel for the only buyers in the market, Ann, Beth, and Cy. 2. a. Construct the market demand schedule.

Price (dollars per mile) 3 4 5 6 7 8 9

Ann 30 25 20 15 10 5 0

Quantity demanded (miles) Beth 25 20 15 10 5 0 0

Cy 20 15 10 5 0 0 0

The market demand schedule shows the sum of the quantities demanded by Ann, Beth, and Cy at each price. When the price is $3 per mile, the market quantity demanded is 75 miles; when the price is $4 per mile, the market quantity demanded is 60 miles; when the price is $5 per mile, the marker quantity demanded is 45 miles; when the price is $6 per mile, the market quantity demanded is 30 miles; when the price is $7 per mile, the market quantity demanded is 15 miles; when the price is $8 per mile, the market quantity demanded is 5 miles; and when the price is $9 per mile, the market quantity demanded is 0 miles.

b. What is the maximum price that each traveler, Ann, Beth, and Cy, is willing to pay to travel 20 miles? Why? Each person’s demand schedule shows the maximum price that person is willing to pay to travel 20 miles. The maximum price Ann is willing to pay to travel 20 miles is $5 per mile, the maximum price Beth is willing to pay is $4 per mile, and the maximum price Cy is willing to pay is $3 per mile.

3. a. What is the marginal social benefit when the total distance travelled is 60 miles? The marginal social benefit when the quantity is 60 miles is $4 per mile. The marginal social benefit is determined from the consumers’ demand schedules and equals the maximum price that consumers will pay for the quantity. The demand schedule shows that the maximum price consumers will pay for 60 miles is $4 per mile and this price equals the marginal social benefit.

b. When the total distance traveled is 60 miles, how many miles does each travel and what is their marginal private benefit? The three travel a total distance of 60 miles when the price is $4 a mile. Each person’s marginal benefit is $4 per mile. At this price Ann travels 25 miles, Beth travels 20 miles, and Cy travels 15 miles.

4. a. What is each traveler’s consumer surplus when the price is $4 a mile? What is the market consumer surplus when the price is $4 a mile? Ann’s consumer surplus is $62.50; Beth’s consumer surplus is $40.00; and, Cy’s consumer surplus is $22.50.

EFFICIENCY AND EQUITY

When the price is $4 per mile, Ann buys 25 miles. Ann’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Ann’s consumer surplus is 1/2  ($9 − $4)  25, which equals $62.50. When the price is $4 per mile, Beth buys 20 miles. Beth’s consumer surplus is the triangular area under her demand curve and above the price. The demand curve is linear, so Beth’s consumer surplus is 1/2  ($8 − $4)  20, which equals $40.00 When the price is $4 per mile, Cy buys 15 miles. Cy’s consumer surplus is the triangular area under his demand curve and above the price. The demand curve is linear, so Cy’s consumer surplus is 1/2  ($7 − $4)  15, which equals $22.50. The market consumer surplus is the sum of Ann’s consumer surplus, Beth’s consumer surplus, and Cy’s consumer surplus, or $125.00.

Use the following table to work Problems 5 to 7. The table gives the supply schedules of hot air balloon rides for the only sellers in the market, Xavier, Yasmin, and Zack. 5. a. Construct the market supply schedule.

Price (dollars per ride) 100 90 80 70 60 50 40

Xavier 30 25 20 15 10 5 0

Quantity supplied (rides per week) Yasmin 25 20 15 10 5 0 0

Zack 20 15 10 5 0 0 0

The market supply schedule shows the sum of the quantities supplied by Xavier, Yasmin, and Zack at each price. When the price is $100 per ride, the market quantity supplied is 75 rides; when the price is $90 per ride, the market quantity supplied is 60 rides; when the price is $80 per ride, the market quantity supplied is 45 rides; when the price is $70 per ride, the market quantity supplied is 30 rides; when the price is $60 per ride, the market quantity supplied is 15 rides; when the price is $50 per ride, the market quantity supplied is 5 rides; and when the price is $40 per ride, the market quantity supplied is 0 rides.

b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept to supply 20 rides? Why? The minimum supply-price equals the lowest price at which a producer is willing to produce the given quantity. The supply schedule tells us the minimum supply-price. Xavier’s minimum supply-price for 20 rides is $80; Yasmin’s minimum supply-price is $90; and, Zack’s minimum supply-price is $100.

6. a. What is the marginal social cost when the total number of rides is 30? The quantity of rides supplied is 30 when the price is $70 per ride. The marginal social cost of any quantity is equal to the price for which that quantity will be supplied, so when the total number of rides is 30, the marginal social cost equals $70 per ride.

b. What is the marginal cost for each supplier when the total number of rides is 30 and how many rides does each of the firms supply? When the total number of rides is 30, Xavier supplies 15 rides, Yasmin supplies 10 rides, and Zack supplies 5 rides. The marginal cost for each firm is $70.

When the price is $70 a ride, what is each firm’s producer surplus? What is the market producer surplus? Xavier’s producer surplus is $225; Yasmin’s is $100; and, Zack’s is $25. When the price is $70 per ride, Xavier supplies 15 rides. Xavier’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Xavier’s producer surplus is 1/2  ($70 − $40)  15, which equals $225. When the price is $70 per ride, Yasmin supplies 10 rides. Yasmin’s producer surplus is the triangular area under the price and above his supply curve. The supply curve is linear, so Yasmin’s producer surplus is 1/2  ($70 − $50)  10, which equals $100. When the price is $70 per ride, Zack supplies 5 rides. Zack’s producer surplus is the triangular area

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under the price and above his supply curve. The supply curve is linear, so Zack’s producer surplus is 1/2  ($70 − $60)  5, which equals $25. The market producer surplus is equal to the sum of Xavier’s producer surplus, Yasmin’s producer surplus, and Zack’s producer surplus, which is $225 + $100 + $25 or $350.

The figure shows the competitive market for cell phones. a. What is the market equilibrium? The equilibrium price is $30 per cell phone and the equilibrium quantity is 100 cell phones per month.

b. Shade in the consumer surplus and label it. In Figure 5.2 the consumer surplus is the shaded area A.

c. Shade in the producer surplus and label it. In Figure 5.2 the producer surplus is the shaded area B.

d. Calculate total surplus. The total surplus is equal to the sum of the consumer surplus plus the producer surplus, or the triangle with area A + area B. The amount of the total surplus equals ½ × ($60 per cell phone − $15 per cell phone) × 100 cell phones, which is $2,250.

e. Is the competitive market for cellphones efficient? The equilibrium quantity of cell phones is 100 cell phones per month because this is the quantity at which the demand and supply curves intersect. The demand curve is the marginal social benefit curve and the supply curve is the marginal social cost curve. Therefore the efficient quantity of cell phones is 100 cell phones per month because this is the quantity at which these two curves intersect. This competitive market is efficient because the equilibrium quantity equals the efficient quantity.

Explain why the allocation method used by each restaurant in Problem 1 is fair or not fair. According to the “fair rules” approach, all of the methods are fair because everyone faces the same rules and therefore the same chance of obtaining a table. According to the “fair results” approach, none of the methods are fair because in each case some people get a table and others do not.

10.

In the Worked Problem (p. 161), how can the 50 bottles available be allocated to beach-goers? Would the possible methods be fair or unfair? The 50 bottles could be allocated by market price (the price would be $15, the price that allocates the 50 bottles among the buyers), by command (someone, perhaps the beach patrol, declares who gets the bottles), by majority rule (beach goers vote to determine who gets the bottles), by a contest (the winners of a beach volleyball game receive the bottles), by first-come, first-served, by a lottery, by

EFFICIENCY AND EQUITY

personal characteristics (perhaps light-skinned people get the bottles), and by force. None of the methods are fair by the “results” view of fairness unless the personal characteristics method use income, with poorer people getting the bottles. The market exchange method is the only fair method under the “rules” view of fairness.

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Answers to Additional Problems and Applications 11.

At McDonald’s, no reservations are accepted; at Panorama at St. Louis Art Museum, reservations are accepted; at the Bissell Mansion restaurant, reservations are essential. Describe the method of allocating tables in these three restaurants. Why do restaurants have different reservations policies? All these restaurants use a first-come, first-serve system. McDonald’s uses this system directly. Bissell Mansion uses a first-come, first-serve because the first person to call to make a reservation at a particular time is allocated the table at that time. Puck’s uses a combination of the immediate firstcome, first-serve system and the reservation based first-come, first-serve system. The speed with which tables turn over at the different restaurants probably is quite different and the customers probably have quite different values of time. Bissell Mansion has a low turnover rate—only 1 or 2 groups of customers can use a table each night—and its customers have a high value of time. If Bissell Mansion refused to take reservations, its customers would need to wait an inefficiently long time and would go elsewhere so that Bissell Mansion profits would be lower. At McDonald’s, the tables have a high turnover rate (indeed, many customers do not use the tables at all, buying their food to go) and the customers have a lower value of time. Allowing reservations would be costly for McDonald’s and would spare its customers only a slight wait at most so that allowing reservations would decrease McDonald’s profits. At Puck’s, the turnover rate of the tables is between that at Bissell Mansion and McDonald’s, so it uses a combination of phone reservation first-come, first-serve and appear in person first-come, first-serve.

Use the following table to work Problems 12 to 15. The table gives the supply schedules for jet-ski rides by the only suppliers: Rick, Sam, and Tom. 12.

What is each owner’s minimum supply-price of 10 rides a day?

Price (dollars per ride) 10.00 12.50 15.00 17.50 20.00

Rick 0 5 10 15 20

Quantity supplied (rides per week) Sam 0 0 5 10 15

Rick’s minimum supply- price for 10 rides is $15.00, Sam’s minimum supply-price is $17.50, and Tom’s minimum supply-price is $20.00.

13.

Tom 0 0 0 5 10

Which owner has the largest producer surplus when the price of a ride is $17.50? Explain. Rick has the largest producer surplus when the price is $17.50. Rick’s producer surplus is largest because he produces the largest quantity and his costs are lower than those of the other producers. More formally, each supplier’s producer surplus is equal to the area under the price and above that producer’s supply curve. Calculating these areas of producer surplus, Rick’s producer surplus is $56.25, Sam’s producer surplus is $25.00, and Tom’s producer surplus is $6.25.

14.

What is the marginal social cost of 45 rides a day? 45 rides are produced when the price is $20.00, so the marginal social cost of producing 45 rides a day is $20.00.

15.

Construct the market supply schedule of jet-ski rides. When the price is $10.00, the quantity of rides supplied is 0; when the price is $12.50, the quantity supplied is 5 rides; when the price is $15.00, the quantity supplied is 15; when the price is $17.50, the quantity supplied is 30; and, when the price is $20, the quantity supplied is 45.

EFFICIENCY AND EQUITY

16.

The table gives the demand and supply schedules for sandwiches. a. What is the maximum price that consumers are willing to pay for the 200th sandwich? The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price consumers will pay for the 200th sandwich is $2.

b. What is the minimum price that producers are willing to accept for the 200th sandwich?

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

Quantity Quantity demanded supplied (sandwiches per hour) 300 250 200 150 100 50 0

0 50 100 150 200 250 300

The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that producers are willing to accept for the 200th sandwich is $4.

c. If 200 sandwiches a day are available, what is the total surplus? 200 sandwiches a day are more than the efficient quantity because the marginal social benefit (the maximum price consumers will pay) is less than the marginal social cost (the minimum price suppliers will accept). Because production is inefficient, there is a deadweight loss, equal to the sum of the consumer surplus and producer surplus lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (200 − 150) multiplied by ($4 − $2)/2, which is $50. This deadweight loss must be subtracted from the surplus that would be obtained if the market was efficient to calculate the total surplus when 200 sandwiches are produced. When the market produces the efficient quantity, 150 sandwiches are produced. The total surplus at this efficient quantity equals the area of the triangle under the demand curve and above the supply curve to the quantity of 150. This area is ½  ($6 − $0)  150, which is $450. So the total surplus when 200 sandwiches are produced equals $450 − $50, which is $400.

17.

Breakfast Staples Face Surging Prices The price of orange juice is surging because of global supply problems. Florida's orange crop is forecast to be the worst in almost a quarter of a century. A citrus greening disease, which is transmitted by tiny insects that feed on the leaves of oranges, is damaging the harvest. Source: CNBC, March 21, 2014 a. How is the price of orange juice determined? The price of orange juice is determined by demand and supply.

b. When the supply of orange juice decreases, explain the process by which the market adjusts. When supply decreases, at the initial equilibrium price there is a shortage. The shortage forces the price to rise. As the price rises, the quantity demanded decreases and the quantity supplied increases. The price continues to rise until the quantity demanded equals the quantity supplied. That price is the new equilibrium price. Once that price is reached, there are no further changes.

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c. On a graph, show the effect of the decrease in supply on consumer surplus and producer surplus. Figure 5.3a shows the initial in consumer surplus (labeled A) as a blue triangle and producer surplus (labeled B) as a pink triangle, when supply curve is ss0 and demand curve is dd0. Figure 5.3b shows the new consumer surplus (labeled A) as a blue triangle and new producer surplus (labeled B) as a blue triangle, when supply curve ss0 has shifted towards left to ss1 and demand curve is dd0.

18.

Use the data in the table in Problem 16. a. If the sandwich market is efficient, what is the consumer surplus, what is the producer surplus, and what is the total surplus? 150 sandwiches is the efficient quantity and the equilibrium price is $3. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the consumer surplus triangle is ½  ($6 − $3)  150, which is $225. The producer surplus is the area of the triangle above the supply curve below the price. The price is $3 and the quantity is 150. The area of the triangle is 1/2  ($3 − $0)  150, which is $225. The total surplus is the sum of the consumer surplus plus the producer surplus, which is $450.

b. If the demand for sandwiches increases and sandwich makers produce the efficient quantity, what happens to producer surplus and deadweight loss? If the demand for sandwiches increases, the price and quantity of sandwiches both rise. The producer surplus definitely increases. There is no deadweight loss because sandwich makers are producing the efficient quantity.

Use the following news clip to work Problems 19 to 21. The Right Price for Digital Music Apple’s $1.29-for-the-latest-songs model isn’t perfect and isn’t it too much to pay for music that appeals to just a few people? What we need is a system that will be profitable but fair to music lovers. The solution: Price song downloads according to demand. The more people who download a particular song, the higher will be the price of that song; the fewer people who buy a particular song, the lower will be the price of that song. That is a free-market solution—the market would determine the price. Source: Slate, December 5, 2005 Assume that the marginal social cost of downloading a song from the iTunes Store is zero. (This assumption means that the cost of operating the iTunes Store doesn’t change if people download more songs.)

EFFICIENCY AND EQUITY

19. a. Draw a graph of the market for downloadable music with a price of $1.29 for all the latest songs. On your graph, show consumer surplus and producer surplus. Figure 5.4 shows this market. The marginal social cost curve runs along the horizontal axis. The consumer surplus is area A and the producer surplus is area B.

b. With a price of $1.29 for all the latest songs, is the market efficient or inefficient? If it is inefficient, show the deadweight loss on your graph. The market is inefficient. Efficiency requires that the amount be the quantity for which the marginal social benefit equals the marginal social cost, which in this case is the quantity at which the marginal social benefit curve intersects the horizontal axis. The deadweight loss is area C in Figure 5.4.

20.

If the pricing scheme described in the news clip were adopted, how would consumer surplus, producer surplus, and the deadweight loss change? The price of popular songs rises, so the consumer surplus for popular songs decreases. If the demand for popular songs is inelastic, as is likely the case, then the producer surplus increases; if the demand is elastic, then the producer surplus decreases. Unambiguously a larger deadweight loss is created. The price of unpopular songs falls, so the consumer surplus for unpopular songs increases. If the demand for less popular songs is elastic, as is likely the case, then the producer surplus increases; if the demand is inelastic, then the producer surplus decreases. Unambiguously a smaller deadweight loss is created.

21. a. If the pricing scheme described in the news clip were adopted, would the market be efficient or inefficient? Explain. The market would likely become more inefficient because the inefficiency of the popular songs—the songs most people want—increases. The price exceeds the marginal social cost.

b. Is the pricing scheme described in the news clip a “free-market solution”? Explain. With a pure free-market solution the price is determined by supply and demand. The pricing method discussed in the clip uses only demand and so it is not the same as a pure free-market solution. A pure free market solution produces the efficient quantity, 200 downloads in the figure, with the price equal to zero.

22.

Only 1 percent of the world supply of water is fit for human consumption. Some places have more water than they can use; some could use much more than they have. The 1 percent available would be sufficient if only it were in the right place. a. What is the major problem in achieving an efficient use of the world’s water? Water needs to be transported from where it is available to where it is needed. This basic issue leads to two major problems: Overproduction in some areas and underproduction in other areas. Often overproduction in an area leads to underproduction later in the same area. In particular, markets in water are not competitive. In many areas, water is “free” to whoever digs a deep enough well. As a result, too many people dig wells and water is overproduced. If the overproduction is bad enough, the level of groundwater can be reduced so far that it becomes literally impossible to extract any water. Then water needs to be transported to the now arid area. In this case, often the government transports the water and sells it at a very low price or gives it away. But because the government does not sell the water at an equilibrium price (and because the government is not motivated by seeking profit) less water is transported than the efficient quantity.

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b. If there were a global market in water, like there is in oil, how do you think the market would be organized? The market for water would be more efficient than the current situation. Areas with a great deal of water, say Canada, could export water to areas with less water, say Mexico. If water was purchased and sold in markets, there would be greater incentive to build desalination plants where they are practical as well as greater incentive to conserve water where it is in abundance.

c. Would a free world market in water achieve an efficient use of the world’s water resources? Explain why or why not. A free world market in water likely would (eventually) bring an efficient use of resources as the necessary infrastructure was constructed. Of the factors that can lead to inefficiency (government price and quantity regulations, monopoly power, and so forth) the only issue that could possibly lead to inefficiency is the point that water is a common resource in some situations.

23.

Use the information in Problem 22. Would a free world market in water achieve a fair use of the world’s water resources? Explain why or why not and be clear about the concept of fairness that you are using. A “fair results” approach to fairness would argue that in third world countries, very poor inhabitants (for example, nomads) would not be able to afford “enough” water and so some redistribution is needed for the sake of fairness. A “fair rules” approach to fairness asserts that a competitive market is enough to insure fairness because the exchange of water is voluntary.

24.

The winner of the ICC Cricket World Cup is paid $3,975,000, twice as much as the runner-up who receives $1,750,000, but it takes two teams to have a Cricket World Cup final. Is the compensation arrangement fair? The compensation arrangement is efficient because all the participants play their hardest in an attempt to win the prize. As a result, the quality of play is extremely high and the “amount” of cricket produced is large. But the efficient outcome is not necessarily a fair outcome. The fair results approach to fairness asserts that the compensation scheme is unfair because income is not equally distributed. The fair rules approach asserts that the scheme is fair because the players voluntarily enter the tournament and the symmetry principle is not violated.

25.

Storm Surge: Uber Just Doubled Car Service Pricing in NYC In the wake of Hurricane Sandy, Uber, which provides a mobile application for locating and booking car service, has reinstated "Surge Pricing" in New York City. This means that car drivers can charge exorbitant fees to shuttle riders around. This is an incentive for more drivers to ferry passengers. The higher fares tripled the number of cars on the road and kept the drivers out longer, the company says, but it also cost Uber more than $100,000 in additional payments to drivers. Source: CNET, November 1, 2012 a. Who is practicing price gouging: Uber or the car drivers or both? Explain. Although Uber alone appears to be price gouging; both Uber and the car drivers are price gouging. Uber is gouging because it charges a higher price for providing car service to its customers in the wake of Hurricane Sandy than it does in normal conditions. The hired car drivers are price gouging because they charge Uber a higher salary following Hurricane Sandy than they do otherwise.

b. Evaluate the fairness of “surge pricing” reinstated by Uber in the wake of Hurricane Sandy. According to the “rules” view of fairness, “surge pricing” reinstated by Uber in the wake of Hurricane Sandy is fair because the customers’ decision to hire a car is voluntary. According to the “results” view of fairness, it is almost surely unfair because the customers are already having a tough time coping with a natural calamity and “surge pricing” has put an additional burden on their pockets.

EFFICIENCY AND EQUITY

Economics in the News 26.

After you have studied Reading Between the Lines on pp. 158–159, answer the following questions. a. What is the method used to allocate highway space in the United States and what is the method used in Singapore? Highway space in the United States is allocated using first-come, first-serve. Highway space in Singapore is allocated using market price.

b. Who benefits from the U.S. method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and producer surplus. In the United States, roads are allocated using first-come, first-served. This allocation is inefficient and so deadweight loss is created. Drivers with a low valuation of time (that is, a low marginal benefit) gain consumer surplus and thereby benefit because they are willing to drive even though they create congestion. Some gas stations, oil refiners, and other producers of highway-related goods and services gain producer surplus because of the extra gallons of gasoline wasted because of the congestion.

c. Who benefits from the Singaporean method of highway resource allocation? Explain your answer using the ideas of marginal social benefit, marginal social cost, consumer surplus, and producer surplus. In Singapore, roads are allocated using market price. Drivers who have marginal benefit that exceeds the price will drive and will gain consumer surplus. Producers of highway services will gain producer surplus. Because market price is used, the allocation is efficient so the sum of consumer surplus and producer surplus is maximized.

d. If road use were rationed by limiting drivers with even-date birthdays to drive only on even days (and odd-date birthdays to drive only on odd days), would highway use be more efficient? Explain your answer. Allocation by personal characteristic, such as birthdays, does not make the use of highways more efficient. Efficiency requires that drivers with the highest marginal benefits from highway use are those who use the highways. Allocation by birthdays means that some drivers with high marginal benefits are forbidden from driving on the freeway on days that do not align with their birthday.

27.

Risks of Cheap Water Water rates in California have little relation to water’s replacement cost. For farmers, who account for 80 percent of the nation’s water consumption, water costs virtually nothing. The urban users who use a mere 20 percent of the water pay higher rates. Source: The New York Times, October 14, 2014 a. Do you think that the allocation of water between farmers and urban users is likely to be efficient? Explain your answer. The allocation of water is inefficient. If the marginal social cost curve of distributing water is the same for farmers and urban users, as is probably the case, the only way that the allocation scheme can be efficient is if the marginal social benefit curve of farmers lies below the marginal social benefit curve of urban users. Such a situation seems unlikely because water is necessary for farmers to grow their crops so the marginal social benefit of water to farmers probably exceeds that for urban users.

b. If farmers paid a higher price, would the allocation of resources be more efficient? If farmers paid a higher rate for water; probably the allocation of resources would be more efficient. Efficiency requires that marginal social benefit equals marginal social cost. Currently it is likely the case that the marginal social benefit of the last unit of water for farmers is less than the marginal social cost of producing the last unit of water.

c. If farmers paid a higher price, what would happen to consumer surplus and producer surplus from water? If the price paid by farmers rises, the consumer surplus of farmers decreases and the producer surplus increases.

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d. Is the difference in price paid by farmers and urban users fair? According to the “fair results” approach, the difference in price is fair urban users, the difference in price is not fair. The difference in price is not fair according to the “fair rules” approach because the price of water is not determined in competitive markets.

C h a p t e r

GOVERNMENT ACTIONS IN MARKETS

Answers to the Review Quizzes Page 168 1.

What is a rent ceiling and what are its effects if it is set above the equilibrium rent? A rent ceiling is a specific example of a price ceiling. A rent ceiling is a government imposed regulation that makes it illegal to charge a rent higher than a specified level. If a rent ceiling is set above the equilibrium rent, it has no effect because it does not make the equilibrium rent illegal.

What are the effects of a rent ceiling that is set below the equilibrium rent? If the rent ceiling is set below the equilibrium rent, the quantity of housing units demanded by renters exceeds the quantity supplied by landlords. Since landlords are not forced to supply more units than the supply curve would indicate for the rent ceiling price, the quantity of housing units actually rented equals the quantity supplied, rather than the quantity demanded. This causes a shortage in the rental housing market.

How are scarce housing resources allocated when a rent ceiling is in place? With an effective rent ceiling, some means for allocation of housing units (other than by price) becomes necessary. Some housing is allocated by first-come, first-serve. Other housing is allocated by discrimination. Black markets also develop, where housing units are allocated at a rent higher than the regulated rent.

Why does a rent ceiling create an inefficient and unfair outcome in the housing market? A rent ceiling creates inefficiency because at the quantity of apartments that are rented, the marginal social benefit exceeds the marginal social cost. Rent ceilings are unfair under the “fair rules” approach because rent ceilings prevent voluntary transactions. Rent ceilings are unfair under the “fair results” approach because there is no assurance that apartments go to those with lower incomes. Indeed, rent ceilings lead to discrimination, which is perhaps the antithesis to fairness.

Page 171 1.

What is a minimum wage and what are its effects if it is set above the equilibrium wage? A minimum wage is a price floor applied to the labor market. A minimum wage is a government imposed regulation that makes it illegal to charge (or pay) a wage rate lower than a specified level. If the minimum wage is set above the equilibrium wage, it creates a surplus of labor—unemployment— and decreases workers’ and firms’ surplus.

What are the effects of a minimum wage set below the equilibrium wage? If the minimum wage is set below the equilibrium wage, then the law has no impact on the labor market equilibrium wage and quantity.

GOVERNMENT ACTIONS IN MARKETS

Explain how scarce jobs are allocated when a minimum wage is in place. If a minimum wage is set above the equilibrium wage, the ability of the competitive market to allocate resources is thwarted and other means must be used. Sometimes the method used is first-come, firstserved so that those who are first in line to apply for openings are given the jobs. Other times discrimination is used so that those from favored groups are allocated the jobs.

Explain why a minimum wage creates an inefficient allocation of labor resources. A competitive labor market allowed to reach its equilibrium creates an efficient allocation of resources. At the equilibrium, the amount of employment is such that the marginal social cost of labor to workers equals the marginal social benefit from labor to firms. A minimum wage set above the equilibrium wage rate creates a surplus of labor—the quantity of labor supplied exceeds the quantity of labor demanded. The minimum wage reduces employment so that it is less than the efficient amount.

Explain why a minimum wage is unfair. Workers who receive wage hikes and retain their jobs gain from the minimum wage but workers who lose their jobs and workers who must extensively search for a job lose. Those who keep (or find) jobs are not necessarily the least well off, so the minimum wage fails the fair results approach to fairness. And the minimum wage also fails the fair rules approach to fairness because the minimum wage blocks voluntary transactions that otherwise would occur.

Page 176 1.

How does the elasticity of demand influence the incidence of a tax, the tax revenue, and the deadweight loss? The more elastic the demand for a given supply, the smaller the increase in the price paid by the buyers and the greater the decrease in the price received by the sellers, which means that the incidence on buyers is smaller. Additionally, the more elastic the demand, the smaller the quantity bought so the smaller the tax revenue; and the larger the deadweight loss.

How does the elasticity of supply influence the incidence of a tax, the quantity bought, the tax revenue, and the deadweight loss? The more elastic the supply for a given demand the larger the increase in the price paid by the buyers and the smaller the decrease in the price received by the sellers, which means that the incidence on buyers is larger. Additionally, the more elastic the supply, the smaller the quantity bought so the smaller the tax revenue and the larger the deadweight loss.

Why is a tax inefficient? The imposition of a tax on a market causes a wedge to be driven between the price received by the seller and the price paid by the buyer. This causes the marginal social benefit from the last unit sold to be higher than its marginal social cost, and the market will under-produce the good or service being taxed. If more of the good or service were produced, the marginal social benefit gained would be greater than the marginal social cost incurred, and the net benefit to society would increase.

When would a tax be efficient? A tax is efficient, that is, creates no deadweight loss, when demand is perfectly inelastic or supply is perfectly inelastic. In both these cases a tax does not change the quantity produced and so creates no deadweight loss.

What are the two principles of fairness that are applied to tax systems? The two principles of fairness are the benefits principle and the ability-to-pay principle. The benefits principle asserts that people should pay taxes equal to the benefits they receive from the government provided services. The ability-to-pay principle asserts that people should pay taxes according to how easily they can bear the burden of the tax.

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Page 179 1.

Summarize the effects of a production quota on the market price and the quantity produced. A production quota set below the equilibrium quantity raises the price and decreases the quantity.

Explain why a production quota is inefficient. A production quota is inefficient because it decreases production. As a result the marginal social benefit of the last unit produced exceeds the marginal cost. Because the marginal benefit exceeds the marginal social cost, there is a deadweight loss.

Explain why a voluntary production quota is difficult to operate. A voluntary quota is difficult to operate because a production quota results in a massive incentive to “cheat” on the production quota by increasing production. A production quota decreases the quantity produced. By decreasing the quantity produced, a production quota raises the price and reduces the marginal social cost of the last unit produced. Because the price exceeds the marginal social cost, producers have an incentive to increase their production (beyond the quota amount) to boost their profit.

Summarize the effects of a subsidy on the market price and the quantity produced. A subsidy increases the price received by sellers, shifts the supply curve rightward, and places a wedge between the marginal social benefit and marginal social cost of producing the good. The subsidy creates a deadweight loss, a higher equilibrium quantity sold, over-production, and a lower price paid by the consumers. The subsidy increases farm revenues to all farmers.

Explain why a subsidy is inefficient. A subsidy creates inefficiency because a subsidy leads to a lower price and increased production. Marginal social benefit equals the price and so the lower price signals that the marginal social benefit falls. And the increased production means that the marginal social cost of production rises. So at the level of production with a subsidy, the marginal social benefit is less than the marginal social cost and inefficiency is created.

Page 181 1.

How does the imposition of a penalty for selling an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If the penalty is levied on the seller, the penalty is added to the minimum price required for supplying the good or service. The demand curve remains unchanged but the supply curve shifts leftward, so that the vertical distance between the initial supply curve and the supply curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good rises and the equilibrium quantity decreases.

How does the imposition of a penalty for possessing an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If the penalty is levied on the buyer, the penalty is subtracted from the maximum willingness to pay for the good. The supply curve remains unchanged and the demand curve shifts leftward, so that the vertical distance between the initial demand curve and the demand curve with the penalty equals the dollar value of the penalty. In this case, the equilibrium price of the good falls and the equilibrium quantity decreases.

How does the imposition of a penalty for selling or possessing an illegal drug influence demand, supply, price, and the quantity of the drug consumed? If buyers and sellers face penalties, both the demand and supply curves shift leftward. If the shift of the supply curve is larger, the equilibrium price rises and quantity decreases; if the shift of the demand curve is larger, the price falls and quantity decreases; if the shifts are the same magnitude, the price is unchanged and the quantity decreases.

GOVERNMENT ACTIONS IN MARKETS

Is there any case for legalizing drugs? To reduce the consumption of drugs, they can be legalized and taxed. Legalizing and then taxing drugs has the benefit of raising funds for the government that could be used to help educate people about the danger of consuming drugs. However, if very high taxes are necessary to reduce the consumption of illegal drugs to the level of use when they were banned, this will cause buyers and sellers to engage in unreported trade in the black market and avoid the tax through tax evasion.

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Answers to the Study Plan Problems and Applications Use Figure 6.1, which shows the market for rental housing in Townsville, to work Problems 1 and 2. 1. a. What are the equilibrium rent and equilibrium quantity of rental housing? The equilibrium rent is $450 a month and the equilibrium quantity is 20,000 housing units.

b. If a rent ceiling is set at $600 a month, what is the rent paid? What is the shortage of housing? If the rent ceiling is set at $600 per month, it is above the equilibrium rent and so is ineffective because renters still pay the equilibrium rent, $450 per month. There is no shortage of housing units: The quantity of housing demanded, 20,000 units, equals the quantity of units supplied.

If the rent ceiling is $300 a month, what is the quantity rented, the shortage of housing, and the maximum price that someone is willing to pay for the last unit of housing available? The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling. The shortage of housing is 20,000 housing units. At the rent ceiling, the quantity of housing demanded is 30,000, but the quantity supplied is 10,000, so there is a shortage of 20,000 housing units. The maximum price that someone is willing to pay for the 10,000th unit available is $600 a month. The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

Use the following data on the demand and supply schedules of teenage labor to work Problems 3 and4. 3.

Calculate the equilibrium wage rate, the hours worked, and the quantity of unemployment. The equilibrium wage rate is $6 an hour and 2,000 hours a month are worked. Unemployment is zero. Everyone who wants to work for $6 an hour is employed.

Wage rate (dollars per hour) 5 6 7 8

Quantity Quantity demanded supplied (hours per month) 2,500 2,000 1,500 1,000

1,500 2,000 2,500 3,000

The minimum wage for teenagers is $7 an hour, a. How many hours are unemployed? At $7 an hour, 1,500 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $7 an hour. Unemployment is equal to the quantity of labor supplied at $7 an hour minus the quantity of labor demanded at $7 an hour. The quantity supplied is 2,500 hours a month and the quantity demanded is 1,500 hours a month, so 1,000 hours a month are unemployed.

b. If the demand for teenage labor increases by 500 hours a month, what is the wage rate and how many hours are unemployed? The wage rate is $7 an hour, and unemployment is 500 hours a month. At the minimum wage of $7 an hour, the quantity demanded is 2,000 hours a month and the quantity supplied is 2,500 hours a month so 500 hours a month are unemployed.

GOVERNMENT ACTIONS IN MARKETS

The table sets out the demand and supply schedules for chocolate brownies. a. If sellers are taxed 20¢ a brownie, what is the price and who pays the tax? The price paid by buyers, including the tax, is 70 cents a brownie. The price received by sellers, excluding the tax, is 50 cents a brownie. If there is no tax, the price is 60 cents a brownie, so consumers and sellers each pay 10 cents of the tax on a brownie.

Price (cents per brownie) 50 60 70 80

Quantity Quantity demanded supplied (millions per day) 5 3 4 4 3 5 2 6

b. If buyers are taxed 20¢ a brownie, what is the price and who pays the tax? The price received by sellers, excluding the tax, is 50 cents a brownie, and 3 million brownies a day are consumed. The price paid by buyers, including the tax, is 70 cents a brownie. Consumers and sellers each pay 10 cents of the tax.

Use the following data to work Problems 6 and 7. The demand and supply schedules for rice are in the table. Calculate the price, the marginal cost of rice, and the quantity produced if the government 6. Sets a production quota of 2,000 boxes a week.

Price (dollars per box) 1.20 1.30 1.40 1.50 1.60

Quantity Quantity demanded supplied (boxes per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500

With a production quota of 2,000 boxes a week, the price is $1.60 a box, the marginal cost $1.30 a box, and the quantity produced is 2,000 boxes a week. The production quota decreases the quantity supplied to 2,000 boxes a week. The marginal cost of producing 2,000 boxes of rice is given by the supply schedule and is $1.30 a box.

Introduces a subsidy of $0.30 a box. With a subsidy of $0.30 a box for rice, the price is $1.20 a box, the marginal cost $1.50 a box, and the quantity produced is 3,000 boxes a week. The subsidy of $0.30 lowers the price at which each quantity in the table is supplied. For example, rice farmers will supply 3,000 boxes a week if the price is $1.50 minus $0.30, which is $1.20. With a subsidy, the market equilibrium occurs at a price of $1.20 a box. At this price, the quantity demanded is 3,000 boxes and the quantity supplied is 3,000 boxes. The marginal cost of producing rice is given by the supply schedule and is $1.50 a box.

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Figure 6.2 shows the market for an illegal good. Calculate the market price and the quantity bought if a penalty of $20 a unit is imposed on a. Sellers only or buyers only. With a penalty of $20 a unit on sellers, the price is $70 a unit and the quantity consumed is 100 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve remains D. With this new supply curve, the equilibrium is at point A in Figure 6.3, with an equilibrium price of $70 a unit and an equilibrium quantity of 100 units. If the penalty is imposed on only buyers, the price is $50 a unit and the quantity consumed is 100 units. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the demand curve shifts to D1 and the supply curve remains S. With this new demand curve, the equilibrium is at point B in Figure 6.3, with an equilibrium price of $50 a unit and an equilibrium quantity of 100 units.

b. Both sellers and buyers. With a penalty of $20 a unit on sellers and on buyers, the price is $60 a unit and the quantity consumed is 90 units. The $20 penalty on sellers decreases the supply. The supply curve shifts leftward so that the vertical distance between the initial supply curve and the new supply curve is $20. The $20 penalty on buyers decreases the demand. The demand curve shifts leftward so that the vertical distance between the initial demand curve and the new demand curve is $20. In Figure 6.3, the supply curve shifts to S1 and the demand curve shifts to D1. With these new supply and demands curves, the equilibrium is at point C in Figure 6.3, with an equilibrium price of $60 a unit and an equilibrium quantity of 90 units.

GOVERNMENT ACTIONS IN MARKETS

Answers to Additional Problems and Applications The table sets out the demand and supply schedules for college meals. 9. a. What are the equilibrium meal price and equilibrium quantity of meals? The equilibrium price of a meal is $6 per meal and the equilibrium quantity is 2,500 meals per week.

b. If the college put a price ceiling on meals at $7 a meal, what is the price students pay for a meal? How many meals do they buy?

Price (dollars per meal) 4 5 6 7 8 9 10

Quantity Quantity demanded supplied (meals per week) 3,000 1,500 2,750 2,000 2,500 2,500 2,250 3,000 2,000 3,500 1,750 4,000 1,500 4,500

The price ceiling is above the equilibrium price, so it is ineffective. The price of a meal remains at $6 per meal and students buy 2,500 meals per week.

10.

If the college put a price ceiling on meals at $4 a meal, what is the quantity bought, the shortage of meals, and the maximum price that someone is willing to pay for the last meal available? The price ceiling is below the equilibrium price, so it has an effect. The quantity of meals purchased is the quantity supplied at the price of $4 per meal, 1,500 meals per week. At this price, the quantity of meals demanded is 3,000, so the shortage of meals is 3,000 meals demanded minus 1,500 meals supplied, or 1,500 meals. For 1,500 meals the demand schedule shows that someone is willing to pay $10 for the last meal.

Use the following news clip to work Problems 11 and 12. Malaysia Passes Its First Minimum Wage Law About 3.2 million low-income workers across Malaysia are expected to benefit from the country’s first minimum wage, which the government says will transform Malaysia into a high-income nation. Employer groups argue that paying the minimum wage, which is not based on productivity or performance, would raise their costs and reduce business profits. Source: The New York Times, May 1, 2012 11.

On a graph of the market for low-skilled labor, show the effect of the minimum wage on the quantity of labor employed. Figure 6.4 shows the effect in the labor market. Before the hike in the minimum wage, the equilibrium wage rate was 3 ringgits per hour and equilibrium employment was 3.4 million workers. After the imposition of the minimum wage, assumed to 5.5 ringgits an hour, employment falls to 3.2 million and unemployment equals 0.3 million workers (the difference between 3.5 million workers, the quantity of labor supplied at a wage rate of 5.5 ringgits an hour, and quantity of labor demanded at the same wage rate.)

12.

Explain the effects of the minimum wage on the workers’ surplus, the firms’ surplus, and the efficiency of the market for low-skilled workers. Taking account of the cost of job search, workers’ surplus decreases. Firms’ surplus also decreases because they must pay a higher wage rate. The labor market becomes less efficient and a deadweight loss is created.

13.

CHAPTER 6

Use the news clip in Problem 11. a. If the Malaysian government cut the tax on business profits, would it offset the effect of the minimum wage on employment? Explain. The tax cut on small businesses would offset some of the harm imposed on small businesses but it would not offset much of the decrease in employment. The higher wage rate leads firms to decrease the quantity of labor they demand. If a tax cut increases firms’ profitability and they respond by increasing their production, then the demand for labor increases. This increase would offset some of the initial fall in employment. But the offset likely would be small because the cut in taxes will be shared between the businesses and the consumers.

b. Would a cut in the Social Security tax that small businesses pay offset the effect of the higher minimum wage on employment? Explain. A cut in the Social Security tax imposed on small businesses could offset the effect the minimum wage hike had on decreasing employment. If Social Security taxes are cut, firms’ demand for labor would increase which would result in an increase in employment. Of course the size of the offset would depend on the size of the cut in the Social Security tax and the elasticity of demand for labor and the elasticity supply of labor. Because the supply of labor is probably quite inelastic, most of the benefit of the cut in Social Security tax would be received by workers, which also makes the potential offset small.

14.

The demand and supply schedules for salmon are: a. If salmon is not taxed, what is the price and how many kilograms are bought? The price is $6 per kilogram and 80 kilograms are purchased.

b. If salmon is taxed $3 a kilogram, what is the price and what is the quantity bought? Who pays the tax?

Price (dollars per kilogram) 4 5 6 7 8

Quantity Quantity demanded supplied (kilograms per week) 120 60 100 70 80 80 60 90 40 100

If salmon is taxed $3 a kilogram, consumers pay $7 per kilogram, suppliers receive $4 per kilogram, and 60 kilograms per week are bought. Of the $3 tax, consumers pay $1 in the form of a higher price paid and suppliers pay $2 in the form of a lower price received.

15.

Cigarette Taxes, Black Markets, and Crime: Lessons from New York’s 50-Year Losing Battle New York City has the highest cigarette taxes in the country. During the four months following the recent tax hike, sales of taxed cigarettes in the city fell by more than 50 percent as consumers turned to the city’s bustling black market. The thriving illegal market for cigarettes has diverted billions of dollars from legitimate businesses and governments to criminals. Source: Cato Institute, February 6, 2003 a. How has the market for cigarettes in New York City responded to the high cigarette taxes? Consumers (and some suppliers!) have turned to the black market. In the black market taxes are not collected so the price to consumers is significantly lower. So the tax decreases the quantity demanded in the legal market and increases demand in the black market.

b. How does the emergence of a black market impact the elasticity of demand in a legal market? The black market is a close substitute for the legal market, so the emergence of the black market increased the price elasticity of demand in the legal market.

c. Why might an increase in the tax rate actually cause a decrease in the tax revenue? If the demand is elastic, then the decrease in the equilibrium quantity from the tax is large enough so that the government collects less tax revenue. More specifically, if the magnitude of the percentage decrease in the quantity exceeds the percentage increase in the tax rate, then the tax revenue collected by the government decreases.

GOVERNMENT ACTIONS IN MARKETS

Use the following to work problems 16 to 18. China Set To Introduce Iron Ore Subsidy China may introduce a nationwide subsidy for local iron ore producers amid slumping prices. Many of these massive iron ore mines are state-owned and the government would naturally support them. But the introduction of a subsidy may further hurt prices that fell to a 10-year low last week. Source: Mail & Guardian, April 10, 2015 16. a. Why are Chinese iron ore producers subsidized? The Chinese government subsidizes iron ore producers to help sustain domestic production. The subsidies help local producers to survive in the global competitive market.

b. Explain how a subsidy paid to Chinese iron ore producers affects the price of iron ore and the marginal cost of producing it. A subsidy increases the supply of iron ore. The increase in supply lowers the price of iron ore and increases the quantity produced. With the increase in the quantity produced the marginal cost of producing iron ore rises.

17.

Show on a graph how a subsidy paid to iron ore producers affects the consumer surplus and the producer surplus from iron ore. Does the subsidy make the iron ore market more efficient or less efficient? Explain. In Figure 6.5, with no subsidy, the equilibrium price is P1 and Q1 is the quantity of iron ore produced. The total surplus is the triangular area abc. The upper half of the triangle is the consumer surplus and the lower half is the producer surplus. With the subsidy the price falls to P2 and the equilibrium quantity rises to Q2. There is a deadweight loss, equal to the area of the grey triangle. The total surplus with the subsidy is the initial total surplus minus the total deadweight loss. With the subsidy, the expanded level of production means that marginal social cost exceeds marginal social benefit s the subsidy makes the market less efficient.

18.

In the market for iron ore, where iron ore producers are subsidized, do you think the price of iron ore will decrease? Explain. In the market for iron ore, if the demand increases by more than supply, the equilibrium price of iron ore will increase. This may happens as a result of an increase in the production of cars, airplanes and the booming construction industry. Therefore, the price may finally decrease or increase depending on the demand.

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Use the following figure, which shows the market for tomatoes, to work Problems 19 and 20. 19.

If the government subsidizes growers at $4 a pound, what is the quantity produced, the quantity demanded, and the subsidy paid to growers? If the government subsidizes growers at $4 a pound, the supply increases. As shown in Figure 6.7, the supply curve shifts downward by $4. The demand does not change. The new price is $4 per pound and at this price the quantity produced is 3 billion pounds and the quantity demanded is 3 billion pounds. The government pays ($4 a pound) × (3 billion pounds), which is $12 billion.

20.

If the government subsidizes growers at $4 a pound, who gains and who loses from the subsidy? What is the deadweight loss? Could the subsidy be regarded as being fair? The suppliers and demanders of tomatoes gain from the subsidy. The taxpayers, who must send the government $12 billion in taxes, lose. Tomato producers in other countries lose because they receive a lower price. The deadweight loss is equal to the area of the grey triangle in Figure 6.7. Accordingly, the deadweight loss is equal to ½ × (3 billion pounds – 2 billion pounds) × $4 a pound, which is $2 billion. Using the “fair results” approach, the subsidry is fair if the growers and consumers of tomatoes have lower incomes than the tax payers. If not, then the tax is unfair. Using the “fair rules” view, the subsidy is unfair because the taxpayers are forced to pay the tax.

21.

The table gives the demand and supply schedules for an illegal drug. a. What is the price and how many units are bought if there is no penalty on drugs? The price is $60 per unit and 400 units are consumed.

b. If the penalty on sellers is $20 a unit, what are the price and quantity consumed?

Price (dollars per unit) 50 60 70 80 90

Quantity Quantity demanded supplied (units per day) 500 300 400 400 300 500 200 600 100 700

The price is $70 per unit and 300 units are consumed.

c. If the penalty on buyers is $20 a unit, what are the price and quantity consumed? The price $50 per unit and 300 units are consumed.

GOVERNMENT ACTIONS IN MARKETS

Economics in the News 22.

After you have studied Economics in the News on pp. 182–183, answer the following questions. a. When a state raises its minimum wage above the federal minimum, what would you expect to happen to unemployment in that state? Illustrate your answer with a graph. Unemployment will increase in that state. In Figure 6.8, the federal minimum wage is $8 an hour. With that minimum wage, unemployment is 0.2 million workers. When the state sets a minimum were of $10 an hour, unemployment in the state rises to 0.4 million workers.

b. The news article reports that the percentage of hourly paid workers paid the minimum wage or less decreased from 13.4 percent in 1979 to 4.3 percent in 2013. Would you expect the rise in the minimum wage to have a smaller effect on unemployment today than in 1979? This factor decreases the impact the minimum wage has on unemployment. The fewer the number of workers paid the minimum wage, the smaller the number of labor markets in which an increase in the minimum wage will above the equilibrium wage. Consequently the smaller the amount of unemployment the minimum wage can create.

c. The news article reports that during the recovery from the 2008–2009 recession, wage rates grew slowly and the bottom wage rates grew slower than top wage rates, straining the budgets of low-paid workers. How would you expect this fact to have influenced the effect of the minimum wage on unemployment? This factor increases the impact the minimum wage has on unemployment. The more low-wage jobs in the U.S. economy, the larger the number of labor markets in which the minimum wage can be set above the equilibrium wage, which means the greater the amount of unemployment the minimum wage can create.

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23.

Mayweather vs. Pacquiao: Fight Night in Las Vegas Floyd Mayweather Jr. and Manny Pacquiao will fight tonight in Las Vegas in a match which people have been waiting for almost six years. The police said that there are concerns regarding illegal scalping of tickets and it would be monitored. Source: LA Times, May 2, 2015 a. Draw a graph of the market for tickets sold by scalpers, assuming that there are no effective penalties on either buyers or sellers. Figure 6.9 shows the market for tickets sold by scalpers. With no penalties the supply curve is SS0 and the demand curve is DD. In the figure, the equilibrium price is $3500 per ticket and the equilibrium quantity is 7000 tickets.

b. If the police have caught the scalpers and 2,000 tickets have been seized, how would it change the market outcome? Show the effects in your graph. If the police manage to crackdown on some of the ticket scalpers, the seizure of 2000 tickets decreases (at least temporarily) the supply. In the Figure, the supply curve shifts from SS0 to SS1. The price rises, in the market to $4000 per ticket, and the quantity decreases to 5,000 for the show.

c. With no penalty on buyers, if a penalty for breaking the law is imposed on ticket scalpers at more than $500 a ticket, how does the market work and what is the equilibrium price? The marginal cost of ticket scalping increases from $3500 per ticket to $3500 per ticket + penalty. The supply curve shifts upward by the amount of the penalty so it becomes an upward sloping curve at a price higher than $4000. For instance, if a $1500 penalty was imposed, the supply curve would shift upward by $1500 from the initial supply curve SS0. With the demand and supply curves in the figure, the new equilibrium price for a ticket sold by scalpers paid by buyers becomes $5000, the equilibrium price received by sellers becomes $3500, and the equilibrium quantity becomes 4500.

d. With no penalty on sellers, if a penalty for breaking the law is imposed on buyers at more than $500 a ticket, how does the market work and what is the equilibrium price? With a penalty imposed on buyers of more than $500 per ticket, the demand curve for tickets sold by scalpers shifts downward by the amount of the penalty, that is, shifts downward by more than $500. If the penalty imposed is, say, $1500, the demand curve shifts downward by $1500. With the demand and supply curves in the figure, the new equilibrium price for a ticket paid by buyers becomes $5000, the equilibrium price received by sellers becomes $3500, and the equilibrium quantity becomes 4500..

e. What is the marginal benefit of a ticket bought from scalpers in the situations described in parts (c) and (d)? The marginal benefit of a ticket bought from scalpers is determined by the willingness to pay and shown by the demand curve. In part (c) the marginal benefit of a ticket with 4500 tickets being transacted is $3500 and in part (d), it is $5000.

Why does law enforcement usually focus on sellers rather than buyers? Law enforcement typically focuses on sellers because there are fewer sellers and their locations are easier to find.

C h a p t e r

GLOBAL MARKETS IN ACTION

Answers to the Review Quizzes Page 192 1.

Describe the situation in the market for a good or service that the United States imports. The goods and services the United States will import are those in which the United States has a higher opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is higher than the world price. With trade the quantity produced in the United States is less than the quantity consumed and the difference is imported.

Describe the situation in the market for a good or service that the United States exports. The goods and services the United States will export are those in which the United States has a lower opportunity cost of production relative to other countries. In those markets the U.S. no-trade price is lower than the world price. With trade the quantity produced in the United States exceeds the quantity consumed and the excess is exported.

Page 194 1.

How is the gain from imports distributed between consumers and domestic producers? Consumers gain consumer surplus from imports and domestic producers lose producer surplus from imports.

How is the gain from exports distributed between consumers and domestic producers? Consumers lose consumer surplus from exports and domestic producers gain producer surplus from exports.

Why is the net gain from international trade positive? The net gain from international trade is positive because the gain to the winners exceeds the losses to the losers. For instance, in the case of an imported good, all the loss of producer surplus is transferred to consumers as consumer surplus. In addition, however, consumers also gain additional consumer surplus from the units imported. The total gain of consumer surplus exceeds the loss of producer surplus so that the net surplus increases. The situation is similar for exports: The total gain of producer surplus exceeds the loss of consumer surplus.

Page 201 1.

What are the tools that a country can use to restrict international trade? A country can use tariffs, import quotas, other import barriers such as health, safety, and regulation barriers, and voluntary export restraints to restrict international trade. Export subsidies given by a nation decrease other countries’ exports and thereby restrict their international trade.

CHAPTER 7

Explain the effects of a tariff on domestic production, the quantity bought, and the price. A tariff raises the domestic price of the product. The higher price increases domestic production and decreases the domestic quantity purchased.

Explain who gains and who loses from a tariff and why the losses exceed the gains. Domestic consumers lose consumer surplus from the tariff. Domestic producers gain producer surplus from the tariff. The government also gains revenue from the tariff. But the gain in producer surplus plus the gain in government revenue is less than the loss of consumer surplus, so on net a tariff creates a deadweight loss.

Explain the effects of an import quota on domestic production, consumption, and price. An import quota raises the domestic price of the product. The higher price increases domestic production and decreases domestic purchases.

Explain who gains and who loses from an import quota and why the losses exceed the gains. Domestic consumers lose consumer surplus from the import quota. Domestic producers gain producer surplus from the import quota. The importers also gain additional profit from the import quota. But the gain in producer surplus plus the importers’ profits is less than the loss of consumer surplus, so on net an import quota creates a deadweight loss.

Page 205 1.

What are the infant industry and dumping arguments for protection? Are they correct? The attempt to stimulate the growth of new industries is the infant-industry argument for protection, which states that it is necessary to protect a new industry from import competition to facilitate the growth of that industry, making it competitive in the world markets. This argument is based on the idea that as firms mature they become more productive. However this argument for protection only works if the benefits also spill over into other industries and other parts of the economy. This is rarely the case, as the entrepreneurs of infant industries and their financial supporters take this risk into account and all returns usually accrue only to them, not to other industries. And it is more efficient to subsidize the infant industry needing protection than it is to protect it by restricting trade. The dumping argument for protection states that a foreign firm is selling its exports at a lower price than its cost of production. Foreign firms trying to monopolize the international market may use this practice. Once the competition is gone, the foreign firm will raise prices and reap profits. This argument fails for several reasons. First, it is virtually impossible to detect the occurrence of dumping since it is impossible to verify a firm’s production costs. The test most commonly used is if the firm’s price when it exports is lower than its domestic price. This test only examines the supply side of the two markets and ignores the demand side. If the domestic market is inelastic and the export market is elastic (which is almost always the case) then it is natural for a firm to price the domestic goods higher than the exports. Second, it is difficult to see how a global firm could have a monopoly for the goods or services it exports. There are too many foreign suppliers (and potential suppliers), making global competition too extensive for a monopoly to exist in the global market. And, even if there is global monopoly it is more efficient to regulate it than to impose trade restrictions on its products.

Can protection save jobs and the environment and prevent workers in developing countries from being exploited? There are many myths about trade restrictions. The problem mentions three of them, all false reasons often offered as reasons to restrict international trade. These arguments are: Trade restrictions save domestic jobs: Free international trade does, indeed, cost jobs in the importcompeting markets. But this argument ignores the fact that, under free trade, consumers in the exporting country will have greater disposable income. These consumers will use part of their higher income to buy goods and services from other countries, thereby increasing employment in the exporting sector of the nation. So, although international trade rearranges jobs—decreasing them in import-competing markets and increasing them in exporting markets—it does not, on net, cost jobs.

GOVERNMENT ACTIONS IN MARKETS

Trade restrictions penalize lax environmental standards: Not all developing countries have lax environmental standards. Also, a clean environment is a normal good. Countries that are relatively poor and have lax pollution standards do not care as much about the environment because imposing clean air, water, and land standards have a high opportunity cost because they will slow economic development. The best way to encourage environmental quality is not to restrict economic development but to encourage rapid economic growth, which will more quickly increase citizen demand for a cleaner environment in those developing countries. Trade restrictions prevent rich countries from exploiting poorer countries: Importing goods made in countries with low wage levels increases the demand for labor in those countries, increasing the number of jobs available and raising wages over time. The more free trade that occurs with these countries, the more quickly the wages will rise and the working conditions will increase in quality and safety.

What is offshore outsourcing? Who benefits from it and who loses? Offshore outsourcing occurs when a firm in the United States buys finished goods, components, or services from firms in other countries. Workers who have skills for jobs that have been sent abroad lose from offshore outsourcing. Consumers who consume the goods and services produced abroad and imported into the United States benefit.

What are the main reasons for imposing a tariff? There are two main reasons for imposing tariffs on imports. First the government receives tariff revenues from imports, which can be useful when revenues from income taxes and sales taxes are less effective ways of gaining government revenue. Second rent seeking by individuals in industries that would be hurt by foreign competition can influence the government to impose tariffs.

Why don’t the winners from free trade win the political argument? Trade restrictions are enacted despite the inherent inefficiency because of the political actions of rent seeking groups, which fear that foreign competition might have a negative impact on their industry, firm, or jobs. The anti-trade groups are easily organized and have much to gain from trade restrictions, whereas the vast millions of consumers, who would win from free trade, are difficult to organize because each individual has only a small amount of loss when trade restrictions are imposed. Hence the winners from trade restrictions frequently out-lobby the winners from free trade.

CHAPTER 7

Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 to 3. Price Quantity Quantity Wholesalers buy and sell roses in containers that (dollars per demanded supplied hold 120 stems. The table provides information container) (millions of containers per year) about the wholesale market for roses in the 100 15 0 United States. The demand schedule is the 125 12 2 wholesalers’ demand and the supply schedule is 150 9 4 the U.S. rose growers’ supply. Wholesalers can 175 6 6 buy roses at auction in Aalsmeer, Holland, for 200 3 8 $125 per container. 225 0 10 1. a. Without international trade, what would be the price of a container of roses and how many containers of roses a year would be bought and sold in the United States? Without international trade, in the United States the price of a container of roses is $175 and 6 million containers of roses are bought and sold.

b. At the price in your answer to part (a), does the United States or the rest of the world have a comparative advantage in producing roses? The price of roses in the United States exceeds the price in the rest of the world, so the rest of the world has a comparative advantage in producing roses.

If U.S. wholesalers buy roses at the lowest possible price, how many do they buy from U.S. growers and how many do they import? The price of roses in the United States is $125 per container. At this price, U.S. rose growers supply 2 million containers per year and U.S. wholesalers demand 12 million containers of roses. U.S. wholesalers buy the 2 million containers from U.S. growers and purchase 10 million containers from foreign sources, which are imported into the United States.

Draw a graph to illustrate the U.S. wholesale market for roses. Show the equilibrium in that market with no international trade and the equilibrium with free trade. Mark the quantity of roses produced in the United States, the quantity imported, and the total quantity bought. In Figure 7.1, the equilibrium without international trade is determined at the intersection of the demand curve and the supply curve. Without international trade the equilibrium price is $175 per container and 6 million containers per year are bought and produced. With international trade the world price is $125 per container, as shown in Figure 7.1. The quantity produced in the United States is 2 million containers and the quantity bought in the United States is 12 million containers. Imports into the United States account for the difference between the quantity bought and the quantity produced, 10 million containers.

Use the information on the U.S. wholesale market for roses in Problem 1 to a. Explain who gains and who loses from free international trade in roses compared to a situation in which Americans buy only roses grown in the United States. U.S. rose wholesalers, who are the consumers in the problem, gain from free international trade. U.S. rose growers lose from free international trade.

GOVERNMENT ACTIONS IN MARKETS

b. Draw a graph to illustrate the gains and losses from free trade. Figure 7.2 illustrates the market with free trade. Consumer surplus before international trade is equal to area A; after international trade consumer surplus is equal to area A + area B + area C. Producer surplus before international trade is equal to area B + area D; after international trade producer surplus is equal to area D.

c. Calculate the gain from international trade. The gain from international trade is area C in Figure 7.2. It is equal to ½  ($175 − $125)  (10 million containers) which is $250 million.

Use the information on the U.S. wholesale market for roses in Problem 1 to work Problems 5 to 10. 5. If the United States puts a tariff of $25 per container on imports of roses, explain how the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported changed. The U.S. price of roses rises from $125 per container (the price with free trade) to $150 per container. The quantity of roses produced in the United States increases from 2 million containers (the quantity produced with free trade) to 4 million containers. The quantity of roses consumed in the United States decreases from 12 million containers (the quantity consumed with free trade) to 9 million containers. The quantity imported decreases from 10 million containers to 5 million containers.

Who gains and who loses from this tariff? U.S. rose consumers lose from the tariff. U.S. rose producers gain from the tariff. The U.S. government gains revenue from the tariff.

CHAPTER 7

Draw a graph of the U.S. market for roses to illustrate the gains and losses from the tariff and on the graph identify the gains and losses, the tariff revenue, and the deadweight loss created. Figure 7.3 shows the effect of the tariff. The amount of the tariff per container is equal to the height of the light gray arrow. Before the tariff U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the tariff U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the tariff U.S. producer surplus was equal to area G. After the tariff U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the tariff the U.S. government gains tariff revenue equal to area E. The deadweight loss from the tariff is equal to area C + area F.

If the United States puts an import quota on roses of 5 million containers, what happens to the U.S. price of roses, the quantity of roses bought, the quantity produced in the United States, and the quantity imported? The U.S. price of roses rises to $150 per container. 9 million containers of roses are purchased in the United States and 4 million containers of roses are produced in the United States. The difference, 5 million containers, is imported into the United States.

Who gains and who loses from this quota? U.S. rose growers and importers of roses gain from the quota. U.S. rose wholesalers lose from the quota.

10.

Draw a graph to illustrate the gains and losses from the import quota and on the graph identify the gains and losses, the importers’ profit, and the deadweight loss. Figure 7.4 shows the effect of the import quota. The amount of the quota is equal to the length of the gray arrow. Before the quota U.S. consumer surplus was equal to area A + area B + area C + area E + area F. After the quota U.S. consumer surplus is equal to area A. U.S. consumers lose consumer surplus equal to area B + area C + area E + area F. Before the quota U.S. producer surplus was equal to area G. After the quota U.S. producer surplus is equal to area G + area B. U.S. producers gain producer surplus equal to area B. After the quota the importers of the rose containers earn profit equal to area E. The deadweight loss from the import quota is equal to area C + area F.

GOVERNMENT ACTIONS IN MARKETS

11.

Chinese Tire Maker Rejects Charge of Defects U.S. regulators ordered the recall of more than 450,000 faulty tires. The Chinese producer of the tires disputed the allegations and hinted that the recall might be an effort to hamper Chinese exports to the United States. Source: International Herald Tribune, June 26, 2007 a. What does the news clip imply about the comparative advantage of producing tires in the United States and China? Because the tires were produced in China, the news clip suggests that China has the comparative advantage in producing tires.

b. Could product quality be a valid argument against free trade? If it could, explain how. Product quality is not a valid argument against free trade. Quality is a valid concern for consumers. If consumers cannot judge quality themselves, then government inspection might be necessary. But in that case government inspection of both imported and domestically produced goods is required. To single out imported goods or services makes little sense. And, by questioning the quality of tires, U.S. producers create questions in the minds of U.S. consumers regarding the safety of imported tires, thereby increasing the demand for domestically produced tires.

CHAPTER 7

Answers to Additional Problems and Applications 12.

Suppose that the world price of rice is 40 cents a kilogram, China does not trade internationally, and the equilibrium price of rice in China is 60 cents a kilogram. China then begins to trade internationally. a. How does the price of rice in China change? The price of rice in China falls.

b. Do Chinese consumers buy more or less rice? As a result of the lower price, Chinese consumers buy more rice.

c. Do Chinese rice growers produce more or less rice? As a result of the lower price, Chinese growers produce less rice.

d. Does China export or import rice and why? China imports rice. The quantity of rice demanded increases while quantity supplied decreases. The difference is made up by imports.

13.

Suppose that the world price of steel is $100 a ton, India does not trade internationally, and the equilibrium price of steel in India is $60 a ton. India then begins to trade internationally. a. How does the price of steel in India change? The price of steel in India rises to equal the world price.

b. How does the quantity of steel produced in India change? Producers respond to the higher price by increasing the quantity of steel produced.

c. How does the quantity of steel bought by India change? Steel users in India respond to the higher price by decreasing the quantity of steel bought.

d. Does India export or import steel and why? Because the price of steel in India is lower than the world, India has a comparative advantage in the production of steel. India will export steel.

14.

A semiconductor is a key component in your laptop, cell phone, and iPod. The table provides information about the market for semiconductors in the United States. Producers of semiconductors can get $18 a unit on the world market. a. With no international trade, what would be the price of a semiconductor and how many semiconductors a year would be bought and sold in the United States?

Price (dollars per unit) 10 12 14 16 18 20

Quantity Quantity demanded supplied (billions of units per year) 25 0 20 20 15 40 10 60 5 80 0 100

With no international trade the price of a semiconductor in the United States is $12 per unit. 20 billion units are bought and sold in the United States.

b. Does the United States have a comparative advantage in producing semiconductors? The United States has a comparative advantage in producing semiconductors because the U.S. price is lower than the price in the world market.

15.

America’s Oil Bonanza The shale revolution has increased the oil and gas flow in America tremendously. The International Energy Agency has predicted that the United States would become the world’s largest oil producer by 2020, leaving Saudi Arabia and Russia behind. Source: The Economist, November 17, 2012 a. What is the effect of the shale revolution in the U.S. on the world price of oil? The shale oil revolution increased the world supply of oil, thereby reducing its price.

b. How does the change in the world price of oil affect the quantity of oil produced by members of the OPEC with a comparative advantage in producing oil, the quantity it consumes, and the

GOVERNMENT ACTIONS IN MARKETS

quantity that it either exports or imports? The lower world price of oil increases the consumption of oil and decreases the production of oil in OPEC countries. Because they have a comparative advantage they will export oil. The lower price causes them to decrease their exports.

16.

Draw a graph of the market for corn in the poor developing country in Problem 15(b) to show the changes in consumer surplus, producer surplus, and deadweight loss. Figure 7.5 shows the situation in the poor country that exports corn. With the initial lower price, the country produces 60 million bushels, exports 20 million bushels, and consumes 40 million bushels. The consumer surplus is equal to area A + area B and the producer surplus is equal to area E. After the world price of corn rises to $8 per bushel, the country produces 80 million bushels of corn, exports 60 million bushels, and consumes 20 million bushels. Consumer surplus decreases to area A and producer surplus increases to area B + area C + area E. There is no deadweight loss; in fact, the country gains additional surplus equal to area C.

17.

South Korea to Resume U.S. Beef Imports South Korea will reopen its market to most U.S. beef. South Korea banned imports of U.S. beef in 2003 amid concerns over a case of mad cow disease in the United States. The ban closed what was then the third-largest market for U.S. beef exporters. Source: CNN, May 29, 2008 a. Explain how South Korea’s import ban on U.S. beef affected beef producers and consumers in South Korea. The South Korean ban raised the price of beef in South Korea. The higher price led to increased production in South Korea, which made South Korean producers better off. The higher price also led to decreased consumption in South Korea, which made South Korean consumers worse off.

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b. Draw a graph of the market for beef in South Korea to illustrate your answer to part (a). Identify the changes in consumer surplus, producer surplus, and deadweight loss. Figure 7.6 shows the effect of South Korea’s import ban. Prior to the ban the price of beef in South Korea was $4 per pound. At this price the quantity consumed in South Korea was 12 million tons of beef per year and the quantity produced in South Korea was 2 million tons of beef per year. The difference, 10 million tons of beef per year, was imported from the United States. Consumer surplus in South Korea was equal to area A + area B + area C and producer surplus in South Korea was equal to area E. With the import ban, the price of beef in South Korea rises to $6 per pound. At this price 6 million tons of beef per year are consumed in South Korea and 6 million tons of beef per year are produced in South Korea. There are no imports. Consumer surplus is South Korea shrinks to only area A and producer surplus grows to equal area B + area E. There is now a deadweight loss which is equal to area C.

18. a. Suppose that China is the only importer of Philippine banana, explain how tighter import controls on Philippine banana imposed by China could affect banana producers and consumers in the Philippines. China’s tighter import controls meant that the Philippines no longer exported banana. (Recall the assumption that China is the only importer of Philippine banana.) In the Philippines, the price of banana falls to the no-trade price. The consumption in the Philippines increases and production in Philippines decreases so Philippine consumers are better off and Philippine producers are worse off.

b. Draw a graph of the market for banana in the Philippines to illustrate your answer to part (a). Identify the changes in consumer surplus, producer surplus, and deadweight loss. Figure 7.7 shows the situation in the Philippine market for banana. With trade, the price of banana is $4 per ton. The Philippines produces 30 million tons of bananas, consumes 20 million tons of bananas, and exports the difference. At this price consumer surplus in the Philippines is equal to area A and producer surplus is equal to area B+ area C+ area E. When China eliminates Philippine exports, the price in the Philippines falls to $3.50 per ton, the no-trade price. The Philippines consumer surplus increases from area A to area A+ area B. Philippine producer surplus falls from area B+ area C+ area E to only area E. The deadweight loss equals area C.

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Use the following information to work Problems 19 to 21. Before 2015, trade between China and South Korea was subject to tariffs. In 2015, China and South Korea signed a free trade agreement that aims to remove most barriers to trade between the countries. 19. Explain how the price that Chinese consumers pay for goods from South Korea and the quantity of China imports from South Korea have changed. Who are the winners and who are the losers from this free trade? With the free trade agreement, the prices that Chinese consumers pay for goods from South Korea will decrease and, as a result, the quantity of imports from South Korea will increase. Winners from this free trade agreement are South Korean producers of goods exported to China and Chinese consumers of these goods. Losers are South Korean consumers of the goods and Chinese producers of the goods.

20.

Explain how the quantity of Chinese exports to South Korea and the Chinese government’s tariff revenue from trade with South Korea have changed. The prices of Chinese goods in South Korea will fall and, as a result, the quantity of Chinese goods exported to South Korea will increase. The Chinese government’s tariff revenue from tariffs imposed on trade with South Korea will decrease.

21.

Suppose that in 2016 automobile producers in China lobby the Chinese government to impose an import quota on South Korean cars. Explain who in China would gain and who would lose from such a quota. Chinese automobile producers will gain from such a quota. The importers who hold the quota rights will also gain. Chinese consumers of cars will lose from such a quota.

Use the following information to work Problems 22 and 23. Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. 22.

Explain how the tariff on textiles will change the price that U.S. buyers pay for textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. The tariff raises the U.S. price of textiles. As a result, the quantity of textiles consumed in the United States decreases and the quantity produced increases. Imports of textiles into the United States decrease.

23.

Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain? The decrease in trade means that the U.S. and Chinese gains from trade decrease. In the United States, U.S. producers gain from the tariff. The U.S. government also gains revenue from the tariff. U.S. textile consumers lose.

Use the following information to work Problems 24 and 25. With free trade between Australia and the United States, Australia would export beef to the United States. But the United States imposes an import quota on Australian beef. 24.

Explain how this quota influences the price that U.S. consumers pay for beef, the quantity of beef produced in the United States, and the U.S. and the Australian gains from trade. The quota raises the price of beef in the United States. By raising the U.S. price, the quota increases the quantity of beef produced in the United States and decreases the quantity of beef consumed in the United States. The U.S. and Australian gains from trade decrease.

25.

Explain who in the United States gains from the quota on beef imports and who loses. U.S. beef producers gain from the quota. The people who hold the import quota rights also gain. U.S. beef consumers lose from the quota.

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Trading Up The cost of protecting jobs in uncompetitive sectors through tariffs is high: Saving a job in the sugar industry costs American consumers $826,000 in higher prices a year; saving a dairy industry job costs $685,000 per year; and saving a job in the manufacturing of women’s handbags costs $263,000. Source: The New York Times, June 26, 2006 a. What are the arguments for saving the jobs mentioned in this news clip? Explain why these arguments are faulty. The arguments for saving these jobs are (explicitly) the argument that protection saves jobs and (implicitly) that protection allows us to compete with cheap foreign labor. The fact these arguments are wrong can be demonstrated by comparing the cost of saving a job to the wage paid on the job. The cost to U.S. consumers of saving a job massively outweighs the benefit of a job to the worker, that is, the wage rate paid on the job. This empirical result demonstrates the conclusion that the cost of protection to the losers, U.S. consumers, exceeds the gain to the winners, U.S. producers.

b. Is there any merit to saving these jobs? There is merit to the workers whose jobs are saved and who might not receive any government assistance if their jobs are not protected. There also is merit to the politicians who can obtain a reward from lobbyists for the protection. There is no merit, however, to society as a whole.

Economics in the News 27.

After you have studied Economics in the News on pp. 206–207, answer the following questions. a. What is the TPP? The TTP is the Trans Pacific Partnership, a trade agreement among 12 nations.

b. Who in the United States would benefit and who would lose from a successful TPP? U.S. exporters of goods whose tariffs are reduced and U.S. consumers of imported goods whose tariffs are reduced benefit from a successful TPP. U.S. consumers of exported goods whose tariffs are reduced and U.S. producers of imported goods whose tariffs are reduced lose from a successful TPP. The government might gain or lose tariff revenue depending on the magnitudes of the consumption and production changes.

c. Illustrate your answer to part (b) with an appropriate graphical analysis assuming that tariffs are not completely eliminated. Figure 7.8a (on the next page) shows the effect in the United States of lowering the U.S. tariff on a good. Initially the price in the United States was $90 per unit. Consumer surplus was equal to area A and producer surplus was equal to area B + area F. When the tariff is lowered, the price in the United States becomes $70 per unit. Consumer surplus increases and equals area A + area B + area C. Producer surplus, however, decreases to area F. The government’s tariff revenue equals area E. Figure 7.8b (on the next page) shows the effect in the United States of lowering the Japanese tariff on rice. Initially the price in the United States was $300 per ton. Consumer surplus was equal to area A + area B and producer surplus was equal to area E. When the tariff is lowered so that the Japanese now import rice, the price in the United States rises to become the world price of $500 per ton. Consumer surplus decreases and equals area A. Producer surplus, however, increases to area B + area C + area E.

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d. Who in Japan and other TPP nations would benefit and who would lose from a successful TPP? In other TPP nations and particularly in Japan, consumers of rice and other farm products would benefit from a successful TPP. In other TPP nations and particularly in Japan, producers of rice and other farm products would lose from a successful TPP. The Japanese government would lose tariff revenue.

e. Illustrate with an appropriate graphical analysis who in Japan would benefit and who would lose from a successful TPP assuming that all Japan's import quotas and tariffs are completely eliminated. Figure 7.9 shows the effect in Japan of eliminating Japan’s tariffs and import quotas. Figure 7.9 shows the effect in the market for rice; the effect in other markets is similar. Before the tariffs and import quotas are eliminated, the price in Japan was $700 per ton of rice. The consumer surplus is equal to area A, the producer surplus was equal to area B + area C and the government’s tariff revenue (and/or importers’ economic profit) was equal to area E. After the tariffs and import quotas are removed, the price falls to $500 per ton of rice. Consumer surplus increases and equals area A + area B + area F + area E + area G. Producer surplus, however, decreases to area C. The government’s tariff revenue (and/or importers’ economic profit) disappears. Consumers benefit because their consumer surplus increases; producers lose because their producer surplus decreases; the government (and/or importers) loses because their tariff revenue (or economic profit) is eliminated.

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E.U. Agrees to Trade Deal with South Korea Italy has dropped its resistance to a E.U. trade agreement with South Korea, which will wipe out $2 billion in annual duties on E.U. exports. Italians argued that the agreement, which eliminates E.U. duties on South Korean cars, would put undue pressure on its own automakers. Source: The Financial Times, September 16, 2010 a. What is a free trade agreement? What is its aim? A free trade agreement is an agreement among nations that they will not impose tariffs, quotas, or other protectionist policies on each other’s imports.

b. Explain how a tariff on E.U. car imports changes E.U. production of cars, purchases of cars, and imports of cars. Illustrate your answer with an appropriate graphical analysis. The tariff that was imposed by the European Union decreased E.U. imports of cars. It raised the price of cars in the European Union, thereby increasing production of cars in the European Union and decreasing purchases of cars in the European Union. In Figure 7.10, the world price is $20,000 per car and the E.U. tariff is $2,500 per car. The price in the European Union is $22,500 per car. The quantity produced in the European Union is 20,000 cars per year and the quantity purchased is 42,333 per year so that 22,333 cars per year are imported. If there was no tariff, so that the price in the European Union was equal to the world price, the quantity produced in the European Union would be 10,000 and the quantity purchased would be 60,000 so that 50,000 cars per year are imported.

c. Show on your graph the changes in consumer surplus and producer surplus that result from free trade in cars. Figure 7.11 shows how the consumer surplus and producer surplus change if the E.U. tariff is eliminated. With the tariff in place, the consumer surplus equals area A and the producer surplus equals area B + area E. If the tariff is eliminated, the price in the European Union falls to $20,000 per car. Consumer surplus increases the area A + area B + area C. Producer surplus decreases to area E.

d. Explain why Italian automakers opposed cuts in car import tariffs. Italian automakers opposed cuts in the tariff because they knew that if the tariff was cut, the price of cars in Italy would fall, thereby decreasing their producer surplus.

C h a p t e r

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Answers to the Review Quizzes Page 218 1.

Explain how a consumer’s income and the prices of goods limit consumption possibilities. A consumer’s consumption possibilities are limited by the consumer’s income and the prices of the goods. The consumer is unable to consume limitless quantities of goods and services because the consumer must pay a price for each good or service consumed and the consumer’s income is limited. If the consumer’s income increases and/or the prices of the goods and services fall, the quantity of goods and services the consumer can afford increases, thereby increasing the consumer’s consumption possibilities.

What is utility and how do we use the concept of utility to describe a consumer’s preferences? Utility is the benefit a person gets from the consumption of goods and services. We use total utility to describe a consumer’s preferences by looking at the (total) utility from the consumption of all the goods and services. We use marginal utility to measure the gain in utility from consuming another unit of a good or service.

What is the distinction between total utility and marginal utility? Total utility is the entire amount of satisfaction an individual obtains from the total amount of goods and services consumed. Marginal utility is the change in total utility from a one-unit increase in the consumption of a good or service.

What is the key assumption about marginal utility? Generally, more consumption gives more utility. A key assumption about marginal utility is that it generally declines as more units of the good are consumed. This assumption is the principle of diminishing marginal utility.

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Why does a consumer spend the entire budget? The more goods and services a person consumes, the higher the person’s utility. By spending his or her entire budget, the person is consuming the maximum quantity of goods and services, which means the utility can be at its maximum.

What is the marginal utility per dollar and how is it calculated?

The marginal utility per dollar equals the marginal utility of the good or service divided by its price. The marginal utility per dollar tells the additional utility gained from spending one more dollar on a good or service.

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What two conditions are met when a consumer is maximizing utility? The two conditions that must be met to ensure that a consumer is maximizing his or her utility are: i) all available income is spent, and ii) the marginal utility per dollar spent is equal for all goods and services consumed.

Explain why equalizing the marginal utility per dollar for all goods maximizes utility. Equating the ratio of marginal utility per dollar for each good and service consumed maximizes utility because it measures the utility gained when an additional dollar of a good or service is consumed. This allows the consumer to weigh the utility gained from additional consumption of a dollar’s worth of one good against the utility lost from the forgone consumption of a dollar’s worth of another good. When the marginal utility per dollar for each good and service is equalized, there is no additional utility available from any other consumption combination.

Page 228 1.

When the price of a good falls and the prices of other goods and a consumer’s income remain the same, explain what happens to the consumption of the good whose price has fallen and to the consumption of other goods. When the price of a good falls, the marginal utility per dollar for that good increases. The marginal utility per dollar for other goods does not change. To maximize total utility, a consumer makes marginal utility per dollar equal for all goods, so the consumer buys more of the good that has experienced the fall in price and less of the goods whose marginal utilities per dollar have not changed.

Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change? After the price of a good falls, the consumer increases consumption of the good to lower the marginal utility per dollar. This action means that more of the good is consumed at the lower price, which implies that the demand curve for the good is downward sloping. The consumer increases the quantity demanded of this good. Additionally, the consumer decreases the quantity of the other goods and services consumed, despite the price of other goods and services remaining unchanged. This change implies that the demand curves for each of the other goods and services shift leftward.

If a consumer’s income increases and if all goods are normal goods, explain how the quantity bought of each good changes. If the consumer’s income increases and all the goods consumed are normal goods, then the consumption of all goods increase. With the increase in income, the initial consumption possibility is now affordable with money left over. If the consumer’s utility for all goods increases with consumption, because the consumer seeks to maximize utility subject to prices and available income, he or she will use the money left over from the initial bundle to increase the quantity consumed for all goods and services. By doing so the consumer increases his or her total utility. This increase occurs while the price of these goods and services remained unchanged, which indicates there is a rightward shift of the demand curve for all goods and services.

What is the paradox of value and how is the paradox resolved? The paradox of value asks: “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?” Consumers have diminishing marginal utility for water. The marginal utility of the last unit of water consumed is low because water is readily available and so the quantity consumed is very high. Consumers also have diminishing marginal utility for diamonds. The marginal utility of the last diamond consumed is high because diamonds are very scarce and so the quantity consumed is very low. Consumers maximize utility by equating the marginal utility per dollar for both goods. The scarcity of diamonds (high marginal utility) and the abundance of water (low marginal utility) indicate people are willing to pay a higher price for an additional unit of diamonds than for an additional unit of water.

What are the similarities between utility and temperature? The scales of both utility and temperature are arbitrary. The units used to measure both can be changed without changing their predictive abilities. For instance, the scale used to “measure” utility can be changed without consequence and the scale used to measure temperature (such as Celsius,

UTILITY AND DEMAND

Fahrenheit, or Kelvin) also can be changed without consequence. Additionally, although neither utility nor temperature can be directly observed, both can be used to make predictions about the observable world.

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Define behavioral economics. Behavioral economics studies the ways that limits on the ability of people’s brains to compute and implement rational decisions influence their economic actions.

What are the three limitations on human rationality that behavioral economics emphasizes? Behavioral economics studies bounded rationality (the point that people’s brain-computing power is limited and this limits people’s ability to make rational decisions), bounded willpower (the point that people’s will power is limited so that at times they make decisions they know they will later regret), and bounded self-interest (the point that at times people make decisions that do not advance their selfinterest).

Define neuroeconomics. Neuroeconomics studies the activity of the human brain when it makes an economic decision.

What do behavioral economics and neuroeconomics seek to achieve? Behavioral economics and neuroeconomics seek to explain why we do not always make rational economic decisions. Behavioral economists study how the bounded limitations they study affect people’s decisions so that not all decisions are the consequence of rational behavior. Neuroeconomists study how the brain works to make decisions so that neuroeconomists have a better understanding of the decisions people make.

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Answers to the Study Plan Problems and Applications Jerry has $12 a week to spend on yogurt and berries. The price of yogurt is $2, and berries are $4 a box. 1.

List the combinations of yogurt and berries that Jerry can afford. Draw a graph of Jerry’s budget line with the quantity of berries plotted on the x-axis. Jerry can buy 6 yogurts and 0 boxes of berries; 4 yogurts and 1 box of berries; 2 yogurts and 2 boxes of berries; and, 0 yogurts and 3 boxes of berries. Figure 8.1 shows Jerry’s budget line.

How do Jerry’s consumption possibilities change if, other things remaining the same, (i) the price of berries falls and (ii) Jerry’s income increases. (i) If the price of a box of berries falls, Jerry’s consumption possibilities increase. His budget line rotates outward around the unchanged vertical intercept, which shows the (unchanged) maximum quantity of yogurt Jerry can buy. (ii) If Jerry’s income increases, Jerry’s consumption possibilities increase. His budget line shifts outward and its slope does not change.

Use the following data to work Problems 3 to 9. Max has $35 a day to spend on windsurfing and snorkeling and he can spend as much time as he likes doing them. The price of renting equipment for windsurfing is $10 an hour and for snorkeling is $5 an hour. The table shows the total utility Max gets from each activity. 3.

Calculate Max’s marginal utility from windsurfing at each number of hours per day. Does Max’s marginal utility from windsurfing obey the principle of diminishing marginal utility?

Hours per day 1 2 3 4 5 6 7

Total utility from windsurfing 120 220 300 360 396 412 422

Total utility from snorkeling 40 76 106 128 140 150 158

Max’s marginal utility from windsurfing 1 hour per day is 120; from windsurfing 2 hours per day is 100; from windsurfing 3 hours per day is 80; from windsurfing 4 hours per day is 60; from windsurfing 5 hours per day is 36; from windsurfing 6 hours per day is 16; and, from windsurfing 7 hours per day is 10. Max’s marginal utility from windsurfing obeys the principle of diminishing marginal utility because it decreases as consumption increases.

UTILITY AND DEMAND

Calculate Max’s marginal utility from snorkeling at each number of hours per day. Does Max’s marginal utility from snorkeling obey the principle of diminishing marginal utility? Max’s marginal utility from snorkeling 1 hour per day is 40; from 2 hours per day is 36; from snorkeling 3 hours per day is 30; from snorkeling 4 hours per day is 22; from snorkeling 5 hours per day is 12; from snorkeling 6 hours per day is 10; and, from snorkeling 7 hours per day is 8. Max’s marginal utility from snorkeling obeys the principle of diminishing marginal utility because it decreases as consumption increases.

Which does Max enjoy more: his 6th hour of windsurfing or his 6th hour of snorkeling? Max’s marginal utility from his 6th hour of windsurfing is 16 and his marginal utility from his 6th hour of snorkeling is 10. Max enjoys his 6th hour of windsurfing more than his 6th hour of snorkeling.

Make a table of the combinations of hours spent windsurfing and snorkeling that Max can afford. The table is to the right. The first and third columns show the combinations of windsurfing and snorkeling Max can afford.

Hours windsurfing 3 2 1 0

Add two columns to your table in Problem 6 and list Max’s marginal utility per dollar from windsurfing and from snorkeling.

Marginal utility per dollar from windsurfing 8.0 10.0 12.0

Hours snorkeling 1 3 5 7

Marginal utility per dollar from snorkeling 8.0 6.0 2.4 1.6

The columns are in the table, in the second and fourth columns.

8. a. To maximize his utility, how many hours a day does Max spend on each activity? To maximize his utility, Max windsurfs for 3 hours and snorkels for 1 hour. Max uses his $35 so that all of the $35 is spent and so that the marginal utility per dollar from each activity is the same. When Max windsurfs for 3 hours and snorkels for 1 hour, he spends $30 renting the windsurfing equipment and $5 renting the snorkeling equipment—a total of $35. The marginal utility from the third hour of windsurfing is 80 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 8. The marginal utility from the first hour of snorkeling is 40 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 8. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling.

b. If Max spent a dollar more on windsurfing and a dollar less on snorkeling than in part (a), how would his total utility change? If Max windsurfs another hour, he pays $10 and gains 60 units of utility (the marginal utility from the 4th hour), which is 6.0 units of utility per dollar. So if he spends a dollar more on windsurfing, his utility from windsurfing increases by 6.0. If he spends an hour less on snorkeling, he saves $5 and loses 40 units of utility (the marginal utility from the 1st hour of snorkeling), which is 8.0 units of utility per dollar. So if he spends a dollar less on snorkeling, he loses 8.0 units of utility. Overall, spending a dollar more on windsurfing and a dollar less on snorkeling lowers Max’s total utility by 2.0 units of utility.

c. If Max spent a dollar less on windsurfing and a dollar more on snorkeling than in part (a), how would his total utility change? If Max snorkels another hour, he pays $5 and gains 36 units of utility (the marginal utility from the 2nd hour), which is 7.2 units of utility per dollar. So if he spends a dollar more on snorkeling, his utility from snorkeling increases by 7.2. If he spends an hour less on windsurfing, he saves $10 and loses 80 units of utility (the marginal utility from the 3rd hour of windsurfing), which is 8.0 units of utility per dollar. So if he spends a dollar less on windsurfing, he loses 8.0 units of utility. Overall, spending a dollar more on snorkeling and a dollar less on windsurfing lowers Max’s total utility by 0.8 units of utility.

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Use the data in Problem 3 to work Problems 9 to 13. 9. If the price of renting windsurfing equipment is cut to $5 an hour, how many hours a day does Max spend on each activity? Max will now maximize his total utility by spending 5 hours windsurfing and 2 hours snorkeling. This combination of windsurfing and snorkeling uses all of Max’s income and sets the marginal utility per dollar from windsurfing equal to the marginal utility per dollar from snorkeling.

10.

Draw Max’s demand curve for rented windsurfing equipment. Over the price range from $5 to $10 an hour, is Max’s demand for windsurfing equipment elastic or inelastic? From Problem 8 (a), when the price of renting windsurfing equipment is $10 per hour, Max rents windsurfing equipment for 3 hours. From Problem 9, when the price of renting windsurfing equipment is $5 per hour, Max rents windsurfing equipment for 5 hours. These points lead to the demand curve in Figure 8.2. Max’s elasticity of demand for renting windsurfing equipment is inelastic because a fall in the price decreases Max’s total expenditure on renting windsurfing equipment.

11.

How does Max’s demand for snorkeling equipment change when the price of windsurfing equipment falls? What is Max’s cross elasticity of demand for snorkeling with respect to the price of windsurfing? Are windsurfing and snorkeling substitutes or complements for Max? When the price of windsurfing falls, Max increases the hours he snorkels from 1 hour to 2 hours. Max’s demand for snorkeling increases when the price of windsurfing falls. Max’s cross elasticity of demand equals (1 hour/1.5 hours)/($5/$7.50) = −1.00. Windsurfing and snorkeling are complements for Max.

12.

If Max’s income increases from $35 to $55 a day, how does his demand for rented windsurfing equipment change? Is windsurfing a normal good? Explain. To maximize his utility, Max windsurfs for 4 hours and snorkels for 3 hours. Max uses his $55 such that all of the $55 is spent and marginal utility per dollar for each activity is the same. When Max windsurfs for 4 hours and snorkels for 3 hours, he spends $40 renting the windsurfing equipment and $15 renting the snorkeling equipment—a total of $55. The marginal utility from the fourth hour of windsurfing is 60 and the rent of the windsurfing equipment is $10 an hour, so the marginal utility per dollar from windsurfing is 6. The marginal utility from the third hour of snorkeling is 30 and the rent of the snorkeling equipment is $5 an hour, so the marginal utility per dollar from snorkeling is 6. The marginal utility per dollar from windsurfing equals the marginal utility per dollar from snorkeling. Max’s demand for rented windsurfing equipment increases. The quantity of windsurfing equipment rented at $10 per hour increases from 3 hours (problem 8 (a)) to 4 hours (this problem). Max’s demand curve for rented windsurfing equipment shifts rightward as shown in Figure 8.3 by the shift from D1 to D2. Windsurfing equipment is a normal good.

UTILITY AND DEMAND

13.

If Max’s income increases from $35 to $55 a day, how does his demand for snorkeling equipment change? Is snorkeling a normal good? Explain. Max’s demand for rented snorkeling equipment increases. The quantity of snorkeling equipment demanded at a price of $5 per hour increases from 1 hour (problem 8 (a)) to 3 hours (this problem). As a result Max’s demand curve for rented snorkeling equipment shifts rightward as illustrated in Figure 8.4 by the shift from D1 to D2. Snorkeling equipment is a normal good.

Use the following news clip to work Problems 14 and 15. Eating Away the Innings in Baseball’s Cheap Seats Baseball and gluttony, two of America’s favorite pastimes, are merging, with Major League Baseball stadiums offering all-you-can-eat seats. Some fans try to “set personal records” during their first game, but by the third time in such seats they eat normally. Source: USA Today, March 6, 2008 14.

What conflict might exist between utility maximization and setting “personal records” for eating? What does the fact that fans eat less at subsequent games indicate about their marginal utility from ballpark food as they consume more? Utility maximization means that the person will eat until the marginal utility per dollar of food equals the marginal utility per dollar of all other goods and services. Setting a personal record, however, implies that the person’s objective is to eat until he or she has eaten more than at past events and not to maximize his or her utility though, of course, “setting a personal record” might bring some utility. The fact that fans eat less implies that the marginal utility from ballpark food decreases as more is consumed.

15.

How can setting personal records for eating be reconciled with marginal utility theory? Which ideas of behavioral economics are consistent with the information in the news clip? The marginal utility of food consumption includes not only the “usual utility” from food but also the utility from setting a food-eating record. Bounded willpower seems very consistent with the information. Undoubtedly the people who “set personal records” in the stadium regret their decisions at later dates when they either have less income to spend than they desire and/or need to lose weight.

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Answers to Additional Problems and Applications 16.

Joy goes bowling once and ice skating twice a month when he has $20 to spend on these activities. A visit to the bowling alley costs $10, and an ice skating ticket costs $5. Draw Joy’s budget line. If the price of an ice skating ticket falls to $4, describe how Joy’s consumption possibilities change. Figure 8.5 shows Joy’s budget line as BL1. The number of visits to the bowling alley per month is on the horizontal axis and the number of ice skating tickets bought per month on the vertical axis. If the price of an ice skating ticket falls to $4, then Joy’s budget line rotates outward, as illustrated in Figure 8.5 by the rotation from BL1 to BL2. Joy’s consumption possibilities expand.

17.

Cindy has $70 a month to spend, and she can spend as much time as she likes playing golf and tennis. The price of an hour of golf is $10, and the price of an hour of tennis is $5. The table shows Cindy’s marginal utility from each sport. Make a table that shows Cindy’s affordable combinations of hours playing golf and tennis. If Cindy increases her expenditure to $100, describe how her consumption possibilities change.

Hours per month 1 2 3 4 5 6 7

Marginal utility from golf

Marginal utility from tennis

80 60 40 30 20 10 6

40 36 30 10 5 2 1

The table showing Cindy’s affordable combinations of hours playing golf and tennis is to the right. If Cindy increases her expenditure, then for each entry of tennis hours in the table, her hours of playing golf increase by 3 hours. Alternatively, for each entry of golf hours in the table her hours of playing tennis increase by 6. In terms of a diagram, Cindy’s budget line shifts to the right and its slope does not change.

Hours playing golf 7 6 5 4 3 2 1 0

Hours playing tennis 0 2 4 6 8 10 12 14

UTILITY AND DEMAND

Use the information in Problem 17 to work Problems 18 to 24. 18. a. How many hours of golf and how many hours of tennis does she play to maximize her utility? Cindy plays golf for 5 hours and tennis for 4 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

b. Compared to part (a), if Cindy spent a dollar more on golf and a dollar less on tennis, by how much would her total utility change? If Cindy played another hour of golf, she pays $10 and gains 10 units of utility (the marginal utility from the 6th hour), which is 1.0 unit of utility per dollar. So if she spends a dollar more on golf, her utility from golf increases by 1.0. If she spends an hour less playing tennis, she saves $5 and loses 10 units of utility (the marginal utility from the 4th hour of tennis), which is 2.0 units of utility per dollar. So if she spends a dollar less on tennis, she loses 2.0 units of utility. Overall, spending a dollar more on golf and a dollar less on tennis lowers Cindy’s total utility by 1.0 unit of utility.

c. Compared to part (a), if Cindy spent a dollar less on golf and a dollar more on tennis, by how much would her total utility change? If Cindy spends an hour less playing golf, she saves $10 and loses 20 units of utility (the marginal utility from the 5th hour), which is 2.0 unit of utility per dollar. So if she spends a dollar less on golf, her utility from golf decreases by 2.0. If she spends an hour more playing tennis, she spends $5 and gains 5 units of utility (the marginal utility from the 5th hour of tennis), which is 1.0 unit of utility per dollar. So if she spends a dollar more on tennis, she gains 1.0 units of utility. Overall, spending a dollar less on golf and a dollar more on tennis lowers Cindy’s total utility by 1.0 unit of utility.

19.

Explain why, if Cindy equalized the marginal utility per hour of golf and tennis, she would not maximize her utility. Cindy would not maximize her utility by equalizing the marginal utility per hour of golf and tennis because golf and tennis have different prices. Golf is twice as expensive as tennis, so effectively every unit of utility that Cindy buys from playing golf costs her twice as much as buying a unit of utility from playing tennis. Equalizing the marginal utilities means that the marginal utility per dollar from tennis is greater than her marginal utility per dollar from golf. This inequality means that Cindy can increase her utility if she spends a dollar less on golf and a dollar more on tennis.

Cindy’s tennis club raises its price of an hour of tennis from $5 to $10, other things remaining the same. 20. a. List the combinations of hours Hours Marginal utility Hours Marginal utility spent playing golf and tennis that playing per dollar from playing per dollar from Cindy can now afford and her golf golf tennis tennis marginal utility per dollar from 7 0.6 0 golf and from tennis. 6 1.0 1 4.0 The lists of affordable combinations 5 2.0 2 3.6 are in the first and third columns in 4 3.0 3 3.0 the table to the right. 3 4.0 4 1.0 The lists of the marginal utilities 2 6.0 5 0.5 per dollar are in the second and 1 8.0 6 0.2 fourth columns in the table. 0 7 0.1 b. How many hours does Cindy now spend playing golf and how many hours does she spend playing tennis? Cindy now plays golf for 4 hours and plays tennis for 3 hours. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis.

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Use the information in Problem 20 to draw Cindy’s demand curve for tennis. Over the price range of $5 to $10 an hour of tennis, is Cindy’s demand for tennis elastic or inelastic? One point on her demand curve is 4 hours of tennis when the price is $5 per hour. Another point is 3 hours of tennis when the price is $10 per hour. Cindy’s demand curve is in Figure 8.6. The price elasticity of demand between these two points on her demand curve is 0.43, so Cindy’s demand is inelastic.

22.

Explain how Cindy’s demand for golf changed when the price of an hour of tennis increased from $5 to $10 in Problem 20. What is Cindy’s cross elasticity of demand for golf with respect to the price of tennis? Are tennis and golf substitutes or complements for Cindy? The quantity of golf Cindy plays falls from 5 hours before the price of tennis increased to 4 hours after the price increased. Cindy’s demand for golf decreases. Her cross elasticity of demand is −0.33. Tennis and golf are complements because the cross elasticity of demand is negative.

23.

Cindy loses her math tutoring job and the amount she has to spend on golf and tennis falls from $70 to $35 a month. With the price of an hour of golf at $10 and of tennis $5, calculate the change in the hours she spends playing golf. For Cindy, is golf a normal good or an inferior good? Is tennis a normal good or an inferior good? With an income of $35, Cindy now plays golf for 2 hours and tennis for 3 hours to maximize her utility. This combination allocates (spends) all her income and sets the marginal utility per dollar from golf equal to the marginal utility per dollar from tennis. Golf is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing golf from 5 hours to 2 hours. Tennis is a normal good because the fall in income leads to a decrease in Cindy’s demand for hours spent playing tennis from 4 hours to 3 hours.

24.

Cindy takes a Club Med vacation, the cost of which includes unlimited sports activities. With no extra charge for golf and tennis, Cindy allocates a total of 4 hours a day to these activities. a. How many hours does Cindy play golf and how many hours does she play tennis? Cindy plays golf for 3 hours and plays tennis for 1 hour.

b. What is Cindy’s marginal utility from golf and from tennis? Cindy’s marginal utility from golf and from tennis both equal 40.

c. Why does Cindy equalize the marginal utilities rather than the marginal utility per dollar from golf and from tennis? Because the equipment is free, Cindy does not have to allocate her income between the two activities; instead, she allocates her time between the two activities because time is now the factor that limits her. Because each activity is in hour increments, Cindy equalizes the marginal utility per hour and thereby sets the marginal utilities equal to each other.

UTILITY AND DEMAND

25.

Katy has made her best affordable choice of noodles and iced tea. She spends all of her income on 15 packets of instant noodles at $3 each and 30 cups of iced tea at $2 each. Now the price of a packet of noodles rises to $3.50 per packet and the price of iced tea falls to $1.75 a cup. a. Will Katy now be able to consume 15 packets of instant noodles and 30 cups of iced tea? Before the changes in price, Katy spent all her income on noodles and iced tea. Therefore, Katy’s income is (15 packets of noodles) x ($3 each) + (30 cups of iced tea) x ($2 each) = $105. After the change in prices, the cost of 15 packets of instant noodles and 30 cups of iced tea is (3.50 x 15) + (1.75 x 30 ) = $105. Therefore, Katy can buy 15 packets of instant noodles and 30 cups of iced tea.

b. If Katy changes the quantities she buys, will she buy more or fewer packets of instant noodles? Explain your answer. If Katy changes the quantities she buys, she will buy fewer packets of instant noodles and more iced tea. She will make these changes because iced tea has fallen in relative price while instant noodles have risen in relative price.

26.

Shelly, a homemaker, spends $70 twice a year on 10 grams of saffron and $140 a year on 28,000 gallons of tap water. a. Out of saffron and water, which is more valuable to Shelly? In total, water is more valuable to Shelly than saffron because water has a much higher total utility. On the margin, the marginal utility derived from an additional gallon of water is lower than that from an additional gram of saffron, as water is available to Shelly in abundance at a cheaper price, whereas saffron is rare and expensive.

b. Explain how Shelly’s expenditure on saffron and water illustrates the paradox of value. Saffron is much more expensive than water, even though water is essential to life. The reason spices, such as saffron, are more expensive is because homemakers, such as Shelly, consume small quantities of saffron than they do water. Because Shelly consumes so much water, its marginal utility is quite low even though its total utility is tremendous. Because only a small quantity of saffron is consumed, its marginal utility is relatively high even though its total utility is small. Prices, though, reflect the marginal utility of the good and so saffron is more expensive than water.

Use the following news clip to work Problems 27 to 29. Putting a Price on Human Life Researchers at Stanford and the University of Pennsylvania estimated that a healthy human life is worth about $129,000. Using Medicare records on treatment costs for kidney dialysis as a benchmark, the authors tried to pinpoint the threshold beyond which ensuring another “quality” year of life was no longer financially worthwhile. The study comes amid debate over whether Medicare should start rationing health care on the basis of cost effectiveness. Source: Time, June 9, 2008 27.

Why might Medicare ration health care according to treatment that is “financially worthwhile” as opposed to providing as much treatment as is needed by a patient, regardless of costs? Increasing the quantity of health care lowers the marginal utility from the last unit of health care. At some amount of health care the point is reached such that the marginal utility per dollar of health care is less than the marginal utility per dollar from other goods and services. At that point the quantity of health care being provided is too much and society would be better off with less health care.

28.

What conflict might exist between a person’s valuation of his or her own life and the rest of society’s valuation of that person’s life? The marginal utility that an individual places on another year of their own life likely approximates infinity. The marginal utility that the rest of society places on another year of the person’s life is not as high. Hence the individual’s valuation of their life is much higher than society’s valuation.

29.

How does the potential conflict between self-interest and the social interest complicate setting a financial threshold for Medicare treatments?

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Each individual has a very high marginal utility from an additional year of life. Hence each individual’s marginal utility per dollar from extending their life is extremely high and so their self-interested demand will be very high. But the rest of society’s marginal utility per dollar from an additional year of the person’s life is much lower and the socially interested demand will be much lower.

Economics in the News 30.

After you have studied Economics in the News (pp. 232–233), answer the following questions. a. If big cups of sugary drinks are banned at restaurants, theaters, and stadiums: (i) How will the price of an ounce of sugary drink change? The data show that the larger the container, the lower the price per ounce. If big cups are banned, then only smaller cups will be available, so the price per ounce will rise.

(ii) How will consumers respond to the change in price? The higher price decreases the marginal utility per dollar from sugary drinks. In the consumer equilibrium, the marginal utility per dollar of all goods consumed is equal. To restore this equality, consumers respond to the higher price by decreasing the quantity of sugary drinks they consume, which raises the marginal utility from a sugary drink.

b. If a tax is imposed on sugary drinks, how does (i) The marginal utility of a sugary drink change? The tax has no direct effect on the marginal utility of a sugary drink. However with the tax imposed, the price of a sugary drink rises and consumers respond by decreasing the quantity of sugary drinks they consume. The decrease in the quantity of sugary drinks consumed increases the marginal utility of the last sugary drink consumed.

(ii) The consumer surplus in the market for sugary drinks change? The consumer surplus, the benefit consumers receive from a good above the price they must pay for it, decreases. It decreases because, first, the price consumers must pay for a sugary drink rises, and second, consumers respond to the higher price by decreasing the quantity of sugary drinks consumed.

31.

Five Signs You Have Too Much Money When a bottle of water costs $38, it’s hard not to agree that bottled water is a fool’s drink. The drink of choice among image-conscious status seekers and high-end tee-totalers in L.A. is Bling H2O. It’s not the water that accounts for the cost of the $38, but the “limited edition” bottle decked out in Swarovski crystals. Source: CNN, January 17, 2006 a. Assuming that the price of a bottle of Bling H2O is $38 in all the major U.S. cities, what might its popularity in Los Angeles reveal about consumers’ incomes or preferences in Los Angeles relative to other U.S. cities? If Bling H2O is a normal good, then the increased popularity in Los Angeles indicates that incomes in Los Angeles are higher than elsewhere. In addition, the increased popularity of the drink in Los Angeles indicates that the marginal utility of Bling H2O is higher in Los Angeles than elsewhere. b.

Why might the marginal utility from a bottle of Bling H2O decrease more rapidly than the marginal utility from ordinary bottled water? One of the major attributes of Bling H2O is the “statement” it makes that the consumer is one of the few who can afford it. But typically a consumer carries around only one bottle of water. And once one bottle of Bling H2O is purchased, it is easily refillable and can be carried once more with no loss of status. For both reasons, the marginal utility of a second bottle of Bling H 20 is quite low compared to the marginal utility of the first bottle. Ordinary bottled water, however, is purchased more for its hydrating properties than a fashion statement, so its marginal utility falls more slowly because its marginal utility is derived from its hydration.

UTILITY AND DEMAND

32.

Money Can Buy Happiness A new study by economists Justin Wolfers and Betsey Stevenson has cast doubt on the credibility of the Easterlin paradox, which claims that higher incomes do not necessarily make people happier. The new study states that people do report more happiness and satisfaction as they grow richer. Moving from rich to richer seems to raise happiness just as much as moving from poor to less poor. Source: The Economist, May 2, 2013 According to the news clip, a. How does moving from rich to richer influence total utility? “Utility” and “happiness” aren’t synonymous because they are different measures. Utility is an arbitrary measure that tells how people value different consumption bundles, at a point in time. Happiness, presumably, is a measure that tells how pleased people are with their lives. As they aren’t the same concepts, no conclusion from the news clip can be drawn regarding how becoming richer has an impact on total utility.

b. How do total utility and marginal utility from consumption change over time? For two reasons, the news clip tells us nothing about how total utility has changed over time. First, total utility is an arbitrary measure: its units and scale can be changed with no effect on its predictions, so it does not make sense to try to determine how it has changed over time. Second, even if its units and scale were kept constant, total utility and happiness are not the same thing. Because the article gives us no information about how total utility changed, it also gives no information about how marginal utility changed. A consumer will consume the combination of goods and services that sets their marginal utility divided by their price equal. To know how marginal utilities have changed, we therefore need to know how the prices and quantities consumed have changed.

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POSSIBILITES, PREFERENCES, AND CHOICES

Answers to the Review Quizzes Page 242 1.

What does a household’s budget line show? The budget line plots combinations of goods that require all a household’s income and describes the limits to its consumption choices.

How does the relative price and a household’s real income influence its budget line? The magnitude of the slope of the budget line equals the relative price of the good or service measured on the horizontal axis. A fall in the price of the good measured on the horizontal (vertical) axis decreases that good’s relative price and decreases (increases) the slope of the budget line. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. An increase (decrease) in household income causes a parallel shift of the budget line rightward (leftward). The slope of the budget line does not change when income changes.

If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household’s budget line? The budget equation states that a household’s spending must equal its income. The budget equation is derived for two goods, bus rides and magazines. The amount spent on bus rides is (Pbus ride)×(Qbus ride), the amount spent on magazines is (Pmagazine)×(Qmagazine), and the consumer’s income is y. We know that (Pmagazine)×(Qmagazine) + (Pbus ride)×(Qbus ride) = y. Rearrange this equality by subtracting the amount spent on bus rides from both sides to give (Pmagazine)×(Qmagazine) = y – (Pbus ride)×(Qbus ride). Finally, divide both sides by the price of magazine to give the budget equation Qmagazine = y/Pmagazine – (Pbus ride /Pmagazine)×(Qbus ride). Substituting in our values, y = $40, P bus ride = $2 and P magazine = $4, gives Qmagazine = $40/$4 – ($2/$4)×(Qbus ride) which is equal to Qmagazine = 10 – 0.5 Qbus ride

If the price of one good changes, what happens to the relative price and the slope of the household’s budget line? A relative price is the price of one good divided by the price of another good. For example, the magnitude of the slope of the budget line (Pmovie/Psoda) is the relative price of a movie in terms of soda. This relative price shows how many sodas must be forgone to see an additional movie. A fall in the price of the good on the horizontal (vertical) axis increases the total affordable quantity of that good, decreases its relative price, and decreases (increases) the magnitude of the slope of the budget line.

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If a household’s money income changes and prices do not change, what happens to the household’s real income and budget line? A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. For example, the vertical intercept for a budget line measuring soda on the vertical axis is (y/Psoda), which is the consumer’s real income in terms of sodas. A change in a household’s money income changes the household’s real income in terms of both goods and causes a parallel shift of the budget line. If a household’s money income increases, its budget line shifts rightward and if a household’s money income decreases, its budget line shifts leftward.

Page 246 1.

What is an indifference curve and how does a preference map show preferences? An indifference curve shows those combinations of goods for which a consumer is indifferent. The consumer has the same level of satisfaction for any combination on a given indifference curve. The family of indifference curves is the preference map. This map shows the person’s preferences because it shows how the person ranks each combination of goods. In particular, the person prefers combinations on higher indifference curves to combinations on lower indifference curves.

Why does an indifference curve slope downward and why is it bowed toward the origin? The downward slope of an indifference curve illustrates the tradeoff between two goods while maintaining the same level of total satisfaction. Since the consumer is indifferent among all points on an indifference curve, when moving along it any increase in satisfaction from gaining one good must be matched by an equal decrease in satisfaction from a loss in the other good. An indifference curve is bowed toward the origin because the more of good x that is consumed the less you are willing to give up of good y to get more of good x and remain indifferent.

What do we call the magnitude of the slope of an indifference curve? The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The MRS measures the rate at which the consumer gives up one good to get more of another good, while remaining on the same indifference curve (keeping the consumer indifferent about the changes). The bowed-in shape of the indifference curve is due to the assumption of diminishing MRS.

What is the key assumption about a consumer’s marginal rate of substitution? The key assumption about the marginal rate of substitution is that it is diminishing as a consumer moves down an indifference curve, creating the bowed-in shape.

Page 251 1.

When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve? The consumer is trying to achieve the highest level of well being possible.

Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.) At the optimal consumption choice, the consumer’s consumption bundle is 1) on the budget line, 2) on the highest attainable indifference curve, 3) such that the slope of the budget line, which is the relative price of the two goods, equals the slope of the indifference curve, which is the MRS.

If the price of a normal good falls, what happens to the quantity demanded of that good? If the price of a normal good falls, the quantity demanded of that good increases because the substitution effect and the income effect both bring an increase in the quantity demanded.

POSSIBILITIES, PREFERENCES, AND CHOICES

Into what two effects can we divide the effect of a price change? A price change can be divided into a substitution effect and an income effect. The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation. The income effect is the effect of a change in income sufficient to get the consumer to the highest indifference curve that is affordable on the new budget line reflecting the price change.

For a normal good, does the income effect reinforce the substitution effect or does it partly offset the substitution effect? For a normal good the substitution effect and the income effect reinforce each other, and a decrease (increase) in the price of a good will always result in an increase (decrease) in the quantity of the good demanded.

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Answers to the Study Plan Problems and Applications Use the following information to work Problems 1 to 2. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of a smoothie is $3. 1.

Calculate Sara’s real income in terms of smoothies. Calculate her real income in terms of popcorn. What is the relative price of smoothies in terms of popcorn? What is the opportunity cost of a smoothie? Sara’s real income is 4 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is $12, and the price of a smoothie is $3. Sara’s real income is $12 divided by $3 a smoothie, which is 4 smoothies. Sara’s real income is 4 bags of popcorn. Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn, which is $12 divided by $3 a bag or 4 bags of popcorn. The relative price of a smoothie is 1 bag of popcorn per smoothie. The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag, which equals 1 bag of popcorn per smoothie. The opportunity cost of a smoothie is 1 bag of popcorn. The opportunity cost of a smoothie is the quantity of popcorn that must be forgone to get a smoothie. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so to buy one smoothie Sara must forgo 1 bag of popcorn.

Calculate the equation for Sara’s budget line (with bags of popcorn on the left side). Draw a graph of Sara’s budget line with the quantity of smoothies on the x-axis. What is the slope of Sara’s budget line? What determines its value? The equation that describes Sara’s budget line is QP = 4 – QS. Call the price of popcorn PP and the quantity of popcorn QP, the price of a smoothie PS and the quantity of smoothies QS, and income y. Sara’s budget equation is PPQP + PSQS = y. If we substitute $3 for the price of popcorn, $3 for the price of a smoothie, and $12 for the income, the budget equation becomes $3QP + $3QS = $12. Dividing both sides by $3 and subtracting QS from both sides gives QP = 4 – QS. To draw a graph of the budget line, plot the quantity of smoothies on the x-axis and the quantity of popcorn on the y-axis. The budget line is a straight line from 4 bags of popcorn on the y-axis to 4 smoothies on the x-axis. The slope of the budget line, when smoothies are plotted on the x-axis, is minus 1. The magnitude of the slope is equal to the relative price of a smoothie. The slope of the budget line is “rise over run.” If the quantity of smoothies decreases from 4 to 0, the quantity of popcorn increases from 0 to 4. The rise is 4 and the run is 4. Therefore the slope equals 4/ 4, which is 1.

POSSIBILITIES, PREFERENCES, AND CHOICES

Use the following data to work Problems 3 and 4. Sara’s income falls from $12 to $9 a week, while the price of popcorn is unchanged at $3 a bag and the price of a smoothie is unchanged at $3. 3. What is the effect of the fall in Sara’s income on her real income in terms of (a) smoothies and (b) popcorn? a.

Sara’s real income falls from 4 smoothies to 3 smoothies. Sara’s real income in terms of smoothies is equal to her money income divided by the price of a smoothie. Sara’s money income is now $9 and the price of a smoothie is $3. Sara’s real income is now $9 divided by $3 a smoothie, which is 3 smoothies. Sara’s real income falls from 4 bags of popcorn to 3 bags of popcorn. Sara’s real income in terms of popcorn is equal to her money income divided by the price of a bag of popcorn. Sara’s money income is now $9 and the price of a bag of popcorn is $3. Sara’s real income is now $9 divided by $3 a bag, which is 3 bags of popcorn.

What is the effect of the fall in Sara’s income on the relative price of a smoothie in terms of popcorn? What is the slope of Sara’s new budget line if it is drawn with smoothies on the x-axis? The relative price of a smoothie is 1 bag of popcorn per smoothie, the same relative price as before her income fell. The relative price does not depend on Sara’s income. Instead the relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The price of a smoothie is $3 and the price of popcorn is $3 a bag, so the relative price of a smoothie is $3 divided by $3 a bag. The relative price equals 1 bag per smoothie. The slope of the budget line, when smoothies are plotted on the x-axis is minus 1, the same slope as before her fall in income. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price does not change when Sara’s income decreases so the slope of the budget line does not change.

Sara’s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and the price of a smoothie is unchanged at $3. Explain how Sara’s budget line changes with smoothies on the xaxis. The budget line rotates inward around the unchanged x intercept. The magnitude of the slope of the budget line is equal to the relative price of a smoothie. The relative price of a smoothie is the price of a smoothie divided by the price of a bag of popcorn. The rise in the price of a bag of popcorn lowers the relative price of a smoothie in terms of popcorn. The relative price has fallen so the magnitude of the slope of the budget line has fallen.

Draw figures that show your indifference curves for the following pairs of goods. For each pair, are the goods perfect substitutes, perfect complements, substitutes, complements, or unrelated? • Right gloves and left gloves Figure 9.2A is to the right. Right gloves/left gloves are perfect complements. Because these are perfect complements, the indifference curves are right angles.

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•

Coca-Cola and Pepsi Figure 9.2B is to the right. These are, for most students, almost perfect substitutes. The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear.

•

Desktop computers and laptop computers Figure 9.2C is to the right. These are substitutes, though not perfect substitutes. The indifference curves are bowed inward toward the origin.

•

Strawberries and ice cream Figure 9.2D is to the right. These are probably complements for many students, though not perfect complements. The indifference curves are not right angles, as they would be for perfect complements, but instead are bowed inward toward the origin.

POSSIBILITIES, PREFERENCES, AND CHOICES

Discuss the shape of the indifference curve for each of the following pairs of goods. Explain the relationship between the shape of the indifference curve and the marginal rate of substitution as the quantities of the two goods change. • Orange juice and smoothies

•

Orange juice and smoothies are substitutes. They are not perfect substitutes, so the indifference curves are bowed in toward the origin. The marginal rate of substitution falls moving down along an indifference curve.

Baseballs and baseball bats These are complements but probably not perfect complements. The indifference curves should be significantly bowed inward. (If a student says these goods are perfect complements, the indifference curves should be right angles, such as those in Figure 9.2A.) If the indifference curves are not right angles, then the marginal rate of substitution falls rapidly moving down along an indifference curve. (If the goods are perfect complements, the marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.)

Left running shoe and right running shoe These are perfect complements so the indifference curves are right angles, as shown in Figure 9.2A. The marginal rate of substitution does not change moving down along the indifference curve except when moving around the 90 degree point where it goes from infinity to zero.

Eyeglasses and contact lenses The indifference curves should either be linear (for perfect substitutes, as shown in Figure 9.2B) or nearly linear as in Figure 9.2C. If the indifference curves are linear, then the marginal rate of substitution does not change moving down along the indifference curve; if the indifference curves are nearly linear, then the marginal rate of substitution falls slightly moving down along an indifference curve.

Use the following data to work Problems 8 and 9. Pam has made her best affordable choice of cookies and granola bars. She spends all of her weekly income on 30 cookies at $1 each and 5 granola bars at $2 each. Next week, she expects the price of a cookie to fall to 50¢ and the price of a granola bar to rise to $5. 8. a. Will Pam be able to buy and want to buy 30 cookies and 5 granola bars next week? Pam can still buy 30 cookies and 5 granola bars. When Pam buys 30 cookies at $1 each and 5 granola bars at $2 each, she spends $40 a week. Now that the price of a cookie is 50 cents and the price of a granola bar is $5, 30 cookies and 5 granola bars will cost $40. So Pam can still buy 30 cookies and 5 granola bars. But Pam will not want to buy 30 cookies and 5 granola bars because the marginal rate of substitution does not equal the relative price of the goods. Pam will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price.

b. Which situation does Pam prefer: cookies at $1 and granola bars at $2 or cookies at 50¢ and granola bars at $5? Pam prefers cookies at 50 cents each and granola bars at $5 each because she can get onto a higher indifference curve than when cookies are $1 each and granola bars are $2 each. To see why Pam can move to a higher indifference curve, note that the new budget line and the old budget line both pass through the point 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. So Pam’s new equilibrium combination of cookies and granola bars must be on an indifference curve at a point steeper than the initial indifference curve. Because the new budget line is steeper and passes through the initial equilibrium combination, the new best affordable point must lie above the initial equilibrium point so it must be on a higher indifference curve.

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9. a. If Pam changes how she spends her weekly income, will she buy more or fewer cookies and more or fewer granola bars? Pam will buy more cookies and fewer granola bars. The new budget line and the old budget line pass through the point at 30 cookies and 5 granola bars. If granola bars are plotted on the x-axis, the marginal rate of substitution at this point on Pam’s indifference curve is equal to the relative price of a granola bar at the original prices, which is 2. The new relative price of a granola bar is $5/50 cents, which is 10. That is, the budget line is steeper than the indifference curve at 30 cookies and 5 granola bars. Pam will buy more cookies and fewer granola bars.

b. When the prices change next week, will there be an income effect, a substitution effect, or both at work? There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant.

Use the following information to work Problems 10 and 11. Boom Time For “Gently Used” Clothes Most retailers are blaming the economy for their poor sales, but one store chain that sells used namebrand children’s clothes, toys, and furniture is boldly declaring that an economic downturn can actually be a boon for its business. Last year, the company took in $20 million in sales, up 5% from the previous year. Source: CNN, April 17, 2008 10. a. According to news clip, is used clothing a normal good or an inferior good? If the price of used clothing falls and income remains the same, explain how the quantity of used clothing bought changes. According to the article, the demand for used clothing increases when the economy is in a downturn and incomes are falling. Because the demand increases when income decreases, used clothing is an inferior good. If the price of used clothing falls and income remains the same, the quantity of used clothing purchased increases.

b. Describe the substitution effect and the income effect that occur.

11.

The price fall creates both a substitution effect and an income effect. The substitution effect leads to an increase in the quantity of used clothing demanded. The price decrease increases consumers’ real incomes. Because used clothing is an inferior good, the income effect leads to a decrease in the quantity of used clothing purchased. The substitution effect is larger so that the quantity of used clothing purchased increases.

Use a graph of a family’s indifference curves for used clothing and other goods. Then draw two budget lines to show the effect of a fall in income on the quantity of used clothing purchased. In Figure 9.3, the fall in income shifts the budget line from BL1 to BL2. The quantity of used clothing purchased increases, in the figure from 4 items per month to 5 items per month.

POSSIBILITIES, PREFERENCES, AND CHOICES

Answers to Additional Problems and Applications Use the following data to work Problems 12 to 15. Natalia has a budget of $24 a month to spend on fruit juice and books. The price of fruit juice is $3 a bottle, and the price of a book is $6. 12.

What is the relative price of a bottle of fruit juice in terms of a book and what is the opportunity cost of a bottle of juice? The relative price of fruit juice is 1/2 book. The relative price of fruit juice is the price of a bottle of fruit juice divided by the price of a book. The price of fruit juice is $3 a bottle and the price of a book is $6, so the relative price of fruit juice is $3 a bottle divided by $6 a book, which equals 1/2 book per bottle. The opportunity cost of a bottle of fruit juice is equal to half a book, which is the quantity of books that must be foregone to obtain a bottle of juice.

13.

Calculate Natalia’s real income in terms fruit juice? What is her real income in terms of books? Natalia’s real income is 8 bottles of fruit juice. Natalia’s real income in terms of bottles of fruit juice is equal to her money income divided by the price of a bottle of fruit juice. Natalia’s money income is $24, and the price of fruit juice is $3 a bottle. Natalia’s real income is $24 divided by $3 a bottle of fruit juice, which is 8 bottles of fruit juice. Natalia’s real income is 4 books. Natalia’s real income in terms of books is equal to her money income divided by the price of a book, which is $24 divided by $6 a book or 4 books.

14.

Calculate the equation for Natalia’s budget line (with the quantity of fruit juice on the left side). The equation that describes Natalia’s budget line is QJ= 8 – 2QB. Call the price of a bottle of fruit juice PJ and the quantity of fruit juice QJ, the price of a book PB and the quantity of books QB, and income is y. Natalia’s budget equation is: PJQJ + PBQB = y. If we substitute $3 for the price of a bottle of fruit juice and $6 for the price of a book, and $24 for income, the budget equation becomes $3QJ + $6QB = $24. Next, divide both sides by $3 to obtain becomes QJ + 2QB = 8. Finally, subtract 2QB from both sides to give QJ = 8 – 2QB.

15.

Draw a graph of Natalia’s budget line with the quantity of books on the x-axis. What is the slope of Natalia’s budget line? What determines its value? The budget line equation is illustrated in Figure 9.4. The slope of the budget line, when books are plotted on the x-axis is –2. The magnitude of the slope is equal to the relative price of a book. The slope of the budget line is “rise over run.” If the quantity of books decreases from 4 to 0, the quantity of fruit juice increases from 0 to 8. The rise is 8 and the run is –4. So the slope equals 8/–4, which is –2.

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Use the following data to work Problems 16 to 19. Amy has $20 a week to spend on coffee and cake. The price of coffee is $4 a cup, and the price of cake is $2 a slice. 16.

Calculate Amy’s real income in terms of cake. Calculate the relative price of cake in terms of coffee. Amy’s real income in terms of cake is $20/($2 per slice), which is 10 slices. The relative price of cake in terms of coffee is ($2 per slice)/($4 per cup) = 0.5 cups of coffee per slice of cake.

17.

Calculate the equation for Amy’s budget line (with cups of coffee on the left side). The equation that describes Amy’s budget line is QCOFFEE = 5 – 0.5QCAKE. Call the price of a cup of coffee PCOFFEE and the quantity of coffee QCOFFEE, the price of a slice of cake PCAKE and the quantity of cake QCAKE, and income y. Amy’s budget equation is PCOFFEEQCOFFEE + PCAKEQCAKE = y. If we substitute $4 for the price of a cup of coffee, $2 for the price of a slice of cake and $20 for income, the budget equation becomes $4QCOFFEE + $2QCAKE = $20. Next, divide both sides by $4 to obtain QCOFFEE + 0.5QCAKE = 5. Finally subtract 0.5QCAKE from both sides to give QCOFFEE = 5 – 0.5QCAKE.

18.

If Amy’s income increases to $24 a week and the prices of coffee and cake remain unchanged, describe the change in her budget line. Amy’s budget line shifts outward and its slope does not change.

19.

If the price of cake doubles while the price of coffee remains at $4 a cup and Amy’s income remains at $20, describe the change in her budget line. Amy’s budget line rotates inward. If the quantity of cake is plotted on the horizontal axis, the budget line rotates inward around the unchanged vertical intercept (which is the maximum number of cups of coffee Amy can purchase) and becomes steeper.

Use the following news clip to work Problems 20 and 21. Gas Prices Straining Budgets With gas prices rising, many people say they are staying in and scaling back spending to try to keep within their budget. They are driving as little as possible, cutting back on shopping and eating out, and reducing other discretionary spending. Source: CNN, February 29, 2008 20. a. Sketch a budget line for a household that spends its income on only two goods: gasoline and restaurant meals. Identify the combinations of gasoline and restaurant meals that are affordable and those that are unaffordable. Figure 9.5 shows a budget line. The combinations of gasoline and restaurant meals that lie on and inside the budget line are affordable. The combinations of gasoline and restaurant meals that lie beyond the budget line are unaffordable.

POSSIBILITIES, PREFERENCES, AND CHOICES

b. Sketch a second budget line to show how a rise in the price of gasoline changes the affordable and unaffordable combinations of gasoline and restaurant meals. Describe how the household’s consumption possibilities change. The rise in the price of gasoline rotates the budget inward, as illustrated in Figure 9.6. The combinations of gasoline and restaurant meals that were previously affordable that have now become unaffordable are shown by the grey triangle. The household’s consumption possibilities have been reduced.

21.

How does a rise in the price of gasoline change the relative price of a restaurant meal? How does a rise in the price of gasoline change real income in terms of restaurant meals? The relative price of restaurant meals equals the price of restaurant meals divided by the price of gasoline. The rise in the price of gasoline reduces the relative price of restaurant meals. The rise in the price of gasoline does not change real income in terms of restaurant meals.

Use the following information to work Problems 22 and 23. Rashid buys only books and CDs and Figure 9.7 shows his preference map. 22. a. If Rashid chooses 3 books and 2 CDs, what is his marginal rate of substitution? Rashid’s marginal rate of substitution is 1 book per CD. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 3 books and 2 CDs, the slope of his indifference curve at this point is minus 1 book per CD.

b. If Rashid chooses 2 books and 6 CDs, what is his marginal rate of substitution? Rashid’s marginal rate of substitution is 1/2. Rashid’s marginal rate of substitution equals the magnitude of the slope of his indifference curve. If Rashid buys 2 books and 6 CDs, the slope of his indifference curve at this point is minus 1/2 book per CD.

23.

Do Rashid’s indifference curves display diminishing marginal rate of substitution? Explain why or why not. Rashid’s indifference curves display diminishing marginal rate of substitution. When moving along either indifference curve the slope becomes smaller as the consumption of CDs increases, which means that Rashid has diminishing marginal rate of substitution of books for CDs.

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You May Be Paid More (or Less) Than You Think It’s so hard to put a price on happiness, isn’t it? But if you’ve ever had to choose between a job you like and a better-paying one that you like less, you probably wished some economist would tell you how much job satisfaction is worth. Trust in management is by far the biggest component to consider. Say you get a new boss and your trust in management goes up a bit (say, up 1 point on a 10-point scale). That’s like getting a 36 percent pay raise. In other words, that increased level of trust will boost your level of overall satisfaction in life by about the same amount as a 36 percent raise would. Source: CNN, March 29, 2006 a. Measure trust in management on a 10–point scale, measure pay on the same 10–point scale, and think of them as two goods. Sketch an indifference curve (with trust on the x-axis) that is consistent with the news clip. The clip implies that a 1 point increase in trust combined with a 3.6 point (which is 36 percent on a 10 point scale) decrease in income leaves the person indifferent. So, as illustrated in Figure 9.8, the indifference curve is linear showing the tradeoff between trust and income.

b. What is the marginal rate of substitution between trust in management and pay according to this news clip? The news clip implies that the indifference curves are linear (as illustrated in Figure 9.82) which means that the marginal rate of substitution is constant and equal to 3.6 in the figure.

c. What does the news clip imply about the principle of diminishing marginal rate of substitution? Is that implication likely to be correct? The news clip implies that the indifference curves are linear, as illustrated in Figure 9.8. Linear indifference curves mean that the marginal rate of substitution is constant, that is, the principle of diminishing marginal rate of substitution does not hold. This assumption is likely to be incorrect. Increasing trust in management from 0 to 1 is likely to be very worthwhile and the person will give up a large amount of income to gain this unit increase. But increasing trust in management from, say, 8 to 9 is probably not nearly so worthwhile because at 8 management is already highly trusted. So to gain this unit increase in trust, the person is likely willing to give up only a small amount of income. Hence, contrary to the article, increasing trust in management is subject to a diminishing rate of substitution.

Use the following information to work Problems 25 and 26. Najib has made his best affordable choice of sparkling water and jelly beans. He spends all of his income on five bottles of sparkling water at $2 each and 10 jelly bean bags at $4 each. Now the price of sparkling water rises to $2.50 a bottle and the price of jelly beans drops to $3.75 a bag. 25. a. Will Najib now be able and want to buy five bottles of sparking water and 10 jelly bean bags? Najib is able to buy five bottles of sparkling water and 10 jelly bean bags because this combination remains affordable. Najib will not want to buy this combination, however, because the relative price of sparkling water and jelly beans has changed. At his consumer equilibrium, Najib’s MRS equals the relative price of jelly beans and sparkling water and because the relative price has changed, Najib’s MRS has changed so Najib will change his consumption point.

POSSIBILITIES, PREFERENCES, AND CHOICES

b. Which situation does Najib prefer: sparkling water at $2 a bottle and jelly beans at $4 a bag or sparkling water at $2.50 a bottle and jelly beans at $3.75 a bag? Najib prefers to buy sparkling water at $2.50 a bottle and jelly beans at $3.75 a bag because he can attain a higher indifference curve. The new budget line goes through the old budget line at the initial consumption point. But, with jelly beans measured along the horizontal axis, the new budget line is flatter than the old budget line and lies beyond the initial budget line at all points below the initial consumption point.

26. a. If Najib changes the quantities that he buys, will he buy more or less sparkling water and more or less jelly beans? Explain your answer. Najib will buy more jelly beans and less sparkling water. This is because the relative price of jelly beans has dropped and the relative price of sparkling water has increased.

b. When the prices change, will there be an income effect, a substitution effect, or both at work? Justify your answer. Price changes can always be divided into an income effect and a substitution effect. As the price of jelly beans falls and the relative price of jelly beans has dropped, Najib will substitute more jelly beans for sparkling water. At the same time, when the price of jelly beans falls, real income in terms of jelly beans increases and Najib can now afford to buy more jelly beans than he was able to before.

Use the following data to work Problems 27 to 29. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of cola is $1.50 a can. Figure 9.9 shows Sara’s preference map for popcorn and cola. 27.

What quantities of popcorn and cola does Sara buy? What is Sara’s marginal rate of substitution at the point at which she consumes? Sara buys 6 cans of cola and 1 bag of popcorn. Sara’s budget line runs from 8 cans of cola on the x-axis to 4 bags of popcorn on the y-axis and is tangent to indifference curve I1 at 6 cans of cola and 1 bag of popcorn. Sara’s marginal rate of substitution is ½. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Sara’s consumption point, which equals the magnitude of the slope of the budget line. The slope of Sara’s budget line is ½ bag of popcorn per can of cola so the marginal rate of substitution is ½ bag of popcorn per can of cola.

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Suppose that the price of cola rises from $1.50 to $3.00 a can while the price of popcorn and Sara’s income remain the same. What quantities of cola and popcorn does Sara now buy? What are two points on Sara’s demand curve for cola? Draw Sara’s demand curve. Sara buys 2 cans of cola and 2 bags of popcorn. Sara buys the quantities of cola and popcorn that moves her onto the highest indifference curve, given her income and the (new) price of cola and price of popcorn. The budget line is tangent to indifference curve I0 at 2 cans of cola and 2 bags of popcorn. Two points on Sara’s demand for cola are the following: At $3 a can of cola, Sara buys 2 cans of cola. At $1.50 a can of cola, Sara buys 6 cans. Her demand curve is downward sloping and, as Figure 9.10 shows, goes through these two points.

29.

Suppose that the price of cola rises to $3.00 a can and the price of popcorn and Sara’s income remain the same. a. What is the substitution effect of this price change and what is the income effect of the price change? The substitution effect is 1 can of cola. To divide the price effect into a substitution effect and an income effect, take enough income away from Sara and gradually move her new budget line back toward the original indifference curve until it just touches Sara’s first indifference curve I1. The point at which this budget line just touches indifference curve I1 is 5 cans of cola. The substitution effect is the decrease in the quantity of cola from 6 cans to 5 cans along the indifference curve I1. The substitution effect is 1 can of cola. The income effect is 3 cans of cola. The income effect is the change in the quantity of cola from the price effect minus the change from the substitution effect. The price effect is 4 cans of cola (2 cans minus the initial 6 cans). The substitution effect is a decrease in the quantity of cola from 6 cans to 5 cans. So the income effect is 3 cans of cola.

b. Is cola a normal good or an inferior good? Explain. Cola is a normal good for Sara because the income effect is positive.

Economics in the News 30.

After you have studied Economics in the News on pp. 252–253, answer the following questions. a. How do you buy books? The answer will depend on how the student buys books.

b. Sketch your budget line for books and other goods. Suppose the student has $800 to spend, the price of a print book is $25, the price of an e-book is $15, and the price of each “other good” is $1. The budget line between paper books and other goods is a downward sloping budget line and is illustrated in Figure 9.11. If the student buys Amazon’s e-books, the student needs to buy a $200 e-book reader. With other goods on the vertical axis and e-books on the horizontal axis, the budget line shown in Figure 9.12 starts at 600 “other goods.” The budget line is flatter than the previous budget line to reflect the lower price of $15 per e-book compared to $25 for a print book.

POSSIBILITIES, PREFERENCES, AND CHOICES

c. Sketch your indifference curves for books and other goods. The indifference curves will be conventional showing some substitutability between books and other goods. This is the situation illustrated in Figure 9.13.

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d. Identify your best affordable point. For the student who consumes print books, the best affordable point is point A in Figure 9.14, with 20books and 300 other goods. For the student who consumes e-books, the best affordable point is point B in Figure 9.15 with 28 e-books and 200 other goods

C h a p t e r

ORGANIZING PRODUCTION

Answers to the Review Quizzes Page 264 1.

What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this goal? A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.

Why do accountants and economists calculate a firm’s cost and profit in different ways? Accountants and economists have different reasons for computing a firm’s costs. An accountant calculates a firm’s cost and profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. An economist calculates a firm’s cost and profit in a way that enables him or her to predict the firm's decisions.

What are the items that make opportunity cost differ from the accountant’s measure of cost? A firm’s opportunity cost includes the cost of using resources bought in the market, owned by the firm and supplied by the firm's owner. Economists and accountants both include the price of resources bought in the market as costs. But accountants omit costs included by economists. For instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity costs not recorded by an accountant.

Why is normal profit an opportunity cost? Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, such as running another firm. This cost is an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm’s opportunity cost of production.

What are the constraints that a firm faces? How does each constraint limit the firm’s profit? The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. Market constraints mean that what each firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them

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are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

Page 266 1.

Is a firm technologically efficient if it uses the latest technology? Why or why not? Technological efficiency occurs when a firm produces a given level of output using the least amount of inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.

Is a firm economically inefficient if it can cut its costs by producing less? Why or why not? Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.

Explain the key distinction between technological efficiency and economic efficiency. The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.

Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor? The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.

Page 270 1.

Explain the distinction between a command system and an incentive system. A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.

What is the principal-agent problem? What are three ways in which firms try to cope with it? The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.

What are the three types of firms? Explain the major advantages and disadvantages of each. The three main ways of organizing a firm have both advantages and disadvantages: Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive. Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES—all the owners’ wealth is at risk because of unlimited liability; if

ORGANIZING PRODUCTION

there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high. Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, largescale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.

Page 275 1.

What are the four market types? Explain the distinguishing characteristics of each. Economists identify four market types: 1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry. 2. Monopolistic competition is a market with many firms that produce similar but slightly different goods. 3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods. 4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.

What are the two measures of concentration? Explain how each measure is calculated. Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl–Hirschman Index (HHI). 1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry. 2. The Herfindahl–Hirschman Index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.

Under what conditions do the measures of concentration give a good indication of the degree of competition in a market? Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct: 1. The industry market is national in scope, rather than local or international. 2. There are no concerns about over-stating or under-stating the extent of barriers to entry. 3. Firms are not misclassified with respect to their markets.

Is the U.S. economy competitive? Is it becoming more competitive or less competitive? The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.

Page 277 1.

What are the two ways in which economic activity can be coordinated? Firms and markets both coordinate resources.

What determines whether a firm or markets coordinate production? Firms coordinate resources when they can do so at lower cost than can a market. 1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.

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2. 3. 4.

Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks.

Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure.

What are the main reasons why firms can often coordinate production at a lower cost than markets can? Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.

ORGANIZING PRODUCTION

Answers to the Study Plan Problems and Applications 1.

One year ago, Jack and Jill set up a vinegar-bottling firm (called JJVB). Use the following data to calculate JJVB’s opportunity cost of production during its first year of operation: • Jack and Jill put $50,000 of their own money into the firm and bought equipment for $30,000. • They hired one worker at $20,000 a year. • Jack quit his old job, which paid $30,000 a year worked full-time for JJVB. • Jill kept her old job, which paid $30 an hour, but gave up 500 hours of leisure a year to work for JJVB. • JJVB bought $10,000 of goods and services. • The market value of the equipment at the end of the year was $28,000. • Jack and Jill have a $100,000 home loan on which they pay interest of 6 percent a year. The wages paid, $20,000, and the goods and services bought from other firms, $10,000, are opportunity costs to JJVB. Other opportunity costs include the interest forgone on the $50,000 put into the firm, which could have been used to pay part of the mortgage, so the interest forgone is $3,000; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure; and the economic depreciation of $2,000 ($30,000 minus $28,000). JJVB’s total opportunity cost is the sum of all these opportunity costs and is $80,000.

Joe, who has no skills, no job experience, and no alternative employment, runs a shoeshine stand. Other operators of shoeshine stands earn $10,000 a year. Joe pays rent of $2,000 a year, and his total revenue is $15,000 a year. Joe spent $1,000 on equipment, which he used his credit card to buy. The interest on a credit card balance is 20 percent a year. At the end of the year, Joe was offered $500 for his business and all its equipment. Calculate Joe’s opportunity cost of production and his economic profit. Joe’s opportunity costs are the $2,000 paid to the airport for the space; the $200 for the interest paid on the $1,000 credit card balance; the $10,000 of normal profit; and, the $500 for the depreciation of his equipment (which equals the $1,000 paid for the chair, polish, and brushes minus the $500 he was offered for this equipment). Joe’s total opportunity cost is the sum of these costs, which is $12,700. Joe’s economic profit is his total revenue, $15,000, minus his total opportunity cost, $12,700, for an economic profit of $2,300.

Four ways of laundering 100 shirts are in the table. a. Which methods are technologically efficient? All the methods are technologically efficient.

b. Which method is economically efficient if the hourly wage rate and the implicit rental rate of capital are: (i) Wage rate $1, rental rate $100?

Method A B C D

Labor (hours) 1 5 20 50

Capital (machines) 10 8 4 1

Method D is economically efficient because the total cost is the least. Method D’s costs are 50  $1 + 1  $100, or $150.

(ii) Wage rate $5, rental rate $50? Method D and Method C are economically efficient because the total cost is the least. Method C’s costs are 20  $5 + 4  $50, or $300 and Method D’s costs are 50  $5 + 1  $50, also $300.

(iii) Wage rate $50, rental rate $5? Method A is economically efficient because the total cost is the least. Method A’s costs are 1  $50 + 10  $5, or $100.

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Executive Pay Executive compensation, based on performance, can theoretically constrain pay, but companies are paying their top executives more and more. The median compensation of a CEO in 2013 was $13.9 million, up 9 percent from 2012. Source: CNBC, April 28, 2014 What is the economic problem that CEO compensation schemes are designed to solve? Would paying executives with stock align their interests with shareholders? CEO compensation schemes are designed to overcome the principal-agent problem. A CEO’s decisions can have large effects on the company’s profitability. The principals, the shareholders of the corporation, want the CEO, the agent, to carefully consider the decisions and make decisions that boost the firm’s profit. The CEO, however, has the incentive to shirk and to make decisions that boost his or her well-being rather than the company’s profit. Paying executives with stock helps align their interests with shareholders. If the profit rises, then the company’s stock price will rise. If the CEO’s pay is largely determined by changes in the stock price, then the CEO’s decisions are directly linked to the company’s fortunes.

Sales of the firms in the tattoo industry are in the table. Calculate the four-firm concentration ratio. What is the structure of the tattoo industry?

Firm

Sales (dollars per year) 450 325 250 200 800

The four-firm concentration ratio is 60.49. The four-firm Bright Spots concentration ratio equals the ratio of the total sales of Freckles the largest four firms to the total industry sales expressed Love Galore as a percentage. The total sales of the largest four firms is Native Birds $450 + $325 + $250 + $200, which equals $1,225. Total Other 15 firms industry sales equal $1,225 + $800, which equals $2,025. The four-firm concentration ratio equals ($1,225/$2,025) 100, which is 60.49 percent. This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent.

GameStop Racks Up the Points No retailer has more cachet among gamers than GameStop. For now, only Wal-Mart has a larger share—21.3% last year. GameStop’s share was 21.1% last year, and may well overtake Wal-Mart this year. But if new women gamers prefer shopping at Target to GameStop,Wal-Mart and Target might erode GameStop’s market share. Source: Fortune, June 9, 2008 Estimate a range for the four-firm concentration ratio and the HHI for the U.S. game market based on the data provided in this news clip. Wal-Mart is described as having the largest market share, 21.3 percent, and GameStop is said to have the second largest market share, 21.1 percent. These two firms have a market share of 42.4 percent. The market share of the next two largest firms must be less than 42.4 percent. As a result the four-firm concentration ratio ranges from 42.4 percent to 84.7 percent. The HHI equals the sum of the squared market shares of the 50 largest firms. Wal-Mart’s contribution 2 2 to the HHI is 21.3 which is 453.7 and GameStop’s contribution to the HHI is 21.1 which is 445.2. Based on the two largest firms, the HHI is at least 898.9. If there are two other firms each with a market share of 21.0 percent and one other firm with a market share of 15.6 percent, the HHI attains its maximum of 2,024.26. So the HHI can range from about 900 to about 2,025.

ORGANIZING PRODUCTION

FedEx contracts with independent truck operators to pick up and deliver its packages and pays them on the volume of packages carried. Why doesn’t FedEx buy more trucks and hire more drivers? What incentive problems might arise from this arrangement? FedEx does not buy more trucks and hire more drivers because FedEx faces a principal-agent problem. In particular, it is not easy to monitor its drivers and insure that they are working hard to efficiently deliver packages. FedEx overcomes this problem by hiring independent contractors and then paying them based on the amount of packages they deliver. Essentially, FedEx uses a piecework method of payment. FedEx pays its drivers based on the volume of packages they deliver. This method of payment creates a few incentive potential problems for FedEx. First, FedEx must worry about the quality of its service. In particular, unless FedEx bases part of the payment on quality, its drivers have an incentive to drop the package and race off to the next delivery with no concern for how the packages are handled. Second, FedEx must take care that drivers do not attempt to select only packages that are close to the FedEx location and avoid packages that have a greater than average driving time. Finally, FedEx also must worry that its drivers do not take undue risks while driving in order to deliver as many packages as possible. If FedEx trucks were involved in too many accidents, FedEx would suffer bad publicity and, presumably, would lose some business.

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Answers to Additional Problems and Applications Use the following data to work Problems 8 and 9. Lee is a computer programmer who earned $35,000 in 2011. But on January 1, 2012, Lee opened a body board manufacturing business. At the end of the first year of operation, he submitted the following information to his accountant: • He stopped renting out his cottage for $3,500 a year and used it as his factory. The market value of the cottage increased from $70,000 to $71,000. • He spent $50,000 on materials, phone, etc. • He leased machines for $10,000 a year. • He paid $15,000 in wages. • He used $10,000 from his savings account, which earns 5 percent a year interest. • He borrowed $40,000 at 10 percent a year. • He sold $160,000 worth of body boards. • Normal profit is $25,000 a year. 8.

Calculate Lee’s opportunity cost of production and his economic profit. Lee has costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; $3,500 of forgone rent for the cottage plus −$1,000 for the “depreciation” of the cottage (the cottage actually appreciated); $500 in forgone interest from the savings account; wages forgone of $35,000; and, $25,000 for normal profit. These give a total opportunity cost of $142,000. Lee’s economic profit is the total revenue, $160,000, minus the total opportunity cost, $142,000, for an economic profit of $18,000.

Lee’s accountant recorded the depreciation on his cottage during 2012 as $7,000. According to the accountant, what profit did Lee make? Lee’s accountant will include costs of $50,000 paid for materials, phone, utilities, etc; $15,000 for wages; $10,000 paid for the machine lease; $4,000 paid for interest expense on the loan; and, $7,000 of depreciation expense for a total opportunity cost of $86,000. The total profit according to the accountant will equal total revenue, $160,000, minus total cost, $86,000, for a profit of $74,000.

10.

In 2014, Homer was a salesperson and had an annual salary of $8,000. He also earned $1,500 by teaching Japanese. On January 1, 2015, he quit his job, stopped teaching, and rented a storefront to run a bookshop. He took $6,000 from his savings account to buy bookshelves and other facilities. During 2015, he paid $13,000 for rent and $7,500 for hiring an employee. He received a total revenue from the bookshop of $43,000 and earned interest at 5 percent a year on his savings account balance. Normal profit is $52,000 a year. At the end of 2015, John could have sold his bookshelves and other facilities for $2,800. Calculate John’s opportunity cost of production and his economic profit in 2015. John has costs of $13,000 for the rent of the storefront; $7,500 for hiring a staff; $52,000 for normal profit; $8,000 of forgone earnings from working as a salesperson; $1,500 of forgone earnings from teaching; $300 of forgone interest from her saving account; and $3,200 for the depreciation of his facilities (which equals the $6,000 paid for it minus the $2,800 for which he could have sold it). These various costs sum to a total opportunity cost of $85,500. John’s economic profit is his total revenue, $43,000, minus his total opportunity cost, $88,500, for an economic loss of $45,500.

ORGANIZING PRODUCTION

11.

The Colvin Interview: Chrysler The key driver of profitability will be that the focus of the company isn’t on profitability. Our focus is on the customer. If we can find a way to give customers what they want better than anybody else, then what can stop us? Source: Fortune, April 14, 2008 a. In spite of what Chrysler’s vice chairman and co-president claims, why is Chrysler’s focus actually on profitability? Chrysler’s actual focus is on its profit because if Chrysler continues to incur losses Chrysler eventually will shut down. This statement is correct even in an era of government bailouts because the government will eventually stop offering bailouts if the company does not return to profitability.

b. What would happen to Chrysler if it didn’t focus on maximizing profit, but instead focused their production and pricing decisions to “give customers what they want”? In general customers want very elaborate, very costly automobiles sold for an exceptionally low price. In particular, customers want to pay the lowest price possible regardless of the company’s profit. If Chrysler focused on only giving customers want they want, Chrysler would continue to incur a loss and ultimately would either close or be purchased by another company.

12.

Must Watches Stocks too volatile? Bonds too boring? Then try an alternative investment—one you can wear on your wrist.… [The] typical return on a watch over five to ten years is roughly 10%. [One could] do better in an index fund, but… what other investment is so wearable? Source: Fortune, April 14, 2008 a. What is the cost of buying a watch? The (opportunity) cost of buying a watch is the loss of whatever else would have been purchased with the funds.

b. What is the opportunity cost of owning a watch? The opportunity cost of owning a watch is the annual forgone return, such as the forgone interest from buying a watch rather than placing the funds in a savings account, and the depreciation of the watch.

c. Does owning a watch create an economic profit opportunity? Yes, owning a watch creates an economic profit opportunity. If the watch appreciates at a rapid clip, so that the gain in the value of the watch over time exceeds the normal profit from the funds used to purchase the watch, then owning the watch has lead to an economic profit.

Use the following data to work Problems 13 and 14. Four methods of completing a tax return and the time taken by each method are: with a PC, 1 hour; with a pocket calculator, 12 hours; with a pocket calculator and paper and pencil, 12 hours; and with a pencil and paper, 16 hours. The PC and its software cost $1,000, the pocket calculator costs $10, and the pencil and paper cost $1. 13.

Which, if any, of the methods is technologically efficient? All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.

14.

Which method is economically efficient if the wage rate is (i) $5 an hour? The economically efficient method is the technologically efficient method that allows the task to be done at least cost. When the wage rate is $5 an hour, total cost with a PC is $1,005, total cost with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least with a pocket calculator.

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(ii) $50 an hour? When the wage rate is $50 an hour, total cost with a PC is $1,050, total cost with a pocket calculator is $610, and the total cost with paper and pencil is $801. The pocket calculator is economically efficient.

(iii) $500 an hour? When the wage rate is $500 an hour, total cost with a PC is $1,500, total cost with a pocket calculator is $6,010, and total cost with pencil and paper is $8,001. The PC is economically efficient.

15.

Farms of the Future Will Utilize Drones, Robots and GPS Precision agriculture will become commonplace on farms. It will include the use of self-driving machinery and flying robots to automatically survey and treat crops. Source: www.theconversation.com, March 18, 2015 a. Assume that using self-driving machinery for agriculture requires fewer farmers and less time. Is using self-driving machinery technologically efficient? Using self-driving machinery for agriculture is technologically efficient because the production technique uses less labor (and more capital) than the non-robotic technique.

b. What additional information would you need to be able to say that switching to self-driving machinery is economically efficient for agriculture? To determine if the production technique is economically efficient, information about the cost of the self-driving machinery, cost of the farmers, and about the number of farmers each production technique uses is needed.

16.

Starbucks has more than 10,000 employees, 6,700 stores, which serve some 50 million customers in 51 countries each week. Geoffrey mwa Ngulumbi runs the family-owned fair trade farm in Tanzania and supplies Starbucks with coffee beans and other raw materials. a. How does Starbucks coordinate its activities? Is it likely to use mainly a command system or an incentive system? Explain. Starbucks is a huge organization. As such, it uses both command and incentive systems. At the lower, store level, command is the system that is most commonly used. (For instance, an associate is told that he or she will help unload a delivery and stack the packages in a warehouse.) At the higher, corporate level, incentive is the system most commonly used. (For instance, regional directors have part of their income tied to their region’s performance.) However, even at the store level some incentive systems are used (associates can enroll in a profit sharing plan) and even at the corporate level some command systems are used (regional directors are told that they must report to their supervisors on a weekly basis).

b. How do you think Geoffrey mwa Ngulumbi coordinates the activities of his farm? Is he likely to use mainly a command system or also to use incentive systems? Explain. Geoffrey mwa Ngulumbi probably uses a command system significantly more often than an incentive system. His farm has few employees and so it is easy to tell each employee what to do, when to do, and where to do it. Possibly the only use of an incentive system might be if he has some higher-ranked family members on a profit-sharing program.

c. Describe, compare, and contrast the principal–agent problems faced by Starbucks and Geoffrey mwa Ngulumbi’s farm. How might these firms cope with their principal–agent problems? Starbucks faces many more principal-agent problems than does Geoffrey mwa Ngulumbi’s farm. For Mr. Ngulumbi’s farm, it is relatively straightforward to monitor each employee, so the employee will find it difficult to shirk. Additionally, Mr. Ngulumbi owns the farm, and so there is no principal-agent problem associated with a difference between the owners and the managers. Starbucks, however, has more than a ten thousand employees. Each of these employees realizes that if he or she shirks, it will make little difference to Starbucks’ overall performance. So Starbucks’ managers must be constantly alert to this problem. Starbucks also faces the principal-agent problem that results because its owners are not its managers. As a result, the owners must try to create incentives for the managers to behave in the best interests of the owners. Starbucks has a number of ways that it can try to overcome the principal-agent problems it faces. Its top management is given stock options. Regional managers, store managers, and

ORGANIZING PRODUCTION

top level store management are given profit-sharing packages that depend on the performance of the region or a particular store. Buyers for Starbucks—people employed by Starbucks to determine which products Starbucks will purchase—are often given profit-sharing packages that increase the buyer’s income depending on how well the products the buyer purchased perform in the stores. All of these are designed to give the recipient the incentive to make decisions that boost Starbucks’ profit and thereby its stock price, which benefit the owners.

17.

Why Facebook is the Best Company to Work For In America At Facebook, the key to innovation and creativity is employee autonomy. Employees are encouraged to take ownership over their spaces, and this could mean coming up with original ideas to improve Facebook services to designing the office walls. The company also offers its employees unrivaled perks and competitive salaries. Source: Business Insider, April 27, 2015 a. Describe Facebook’s method of organizing production with employees. In a larger sense, Facebook is using an incentive system because it “offers” its employees autonomy, perks, and competitive salaries so that they find their jobs meaningful. If the employees love their job, they will contribute significantly more to the productivity of the company, maximizing its profit. Also, if one of the employees comes up with a wildly profitable idea, he or she will benefit by gaining stature and probably income within Facebook.

b. What are the potential gains and opportunity costs associated with this method? The potential gain is that the creative people working for Facebook will apply their creativity to develop ways to make Facebook better. The potential drawback is the principal-agent problem. The employees might use their time for on-the-job leisure rather than for new, cutting edge research.

18.

Market shares of smartphone producers are in the table. Calculate the Herfindahl-Hirschman Index. What is the structure of the smartphone industry? The Herfindahl-Hirschman Index is 3,054. The HerfindahlHirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 382 + 382 + 42 + 52 + 52 + 102, which equals 3,054. This industry is highly concentrated and dominated by a few firms as in an oligopoly because the Herfindahl-Hirschman Index is higher than 2,500.

Firm Apple Samsung Sony HTC Lenovo LG

Market share (percent) 38 38 4 5 5 10

Use the following information to work Problems 19 to 21. Two leading design firms, Astro Studios of San Francisco and Hers Experimental Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game console. IBM, ATI, and SiS designed the Xbox 360’s hardware. Three firms—Flextronics, Wistron, and Celestica—manufacture the Xbox 360 at their plants in China and Taiwan. 19.

Describe the roles of market coordination and coordination by firms in the design, manufacture, and marketing of the Xbox 360. Microsoft entered the market to hire various firms, Astro Studios and Hers Experimental Design Laboratory to design the Xbox 360 and then entered the market again to hire IBM, ATI, and SiS to design the hardware of the Xbox 360. Finally, Microsoft once again entered the market to hire Flextronics and Wistron, and Celestica to produce the Xbox 360. Once Microsoft had contracted with these firms, the design, manufacture, etc. takes place within the firm.

20. a. Why do you think Microsoft works with a large number of other firms, rather than performing all the required tasks itself? Microsoft works with a large number of firms rather than doing everything in-house because it is less expensive for Microsoft to work with other firms. These other firms have specialized in various tasks and so have gained economies of scale that Microsoft does not possess. Therefore it is cheaper for

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Microsoft to enter the market and hire the expertise it needs than to do it all itself.

b. What are the roles of transactions costs, economies of scale, economies of scope, and economies of team production in the design, manufacture, and marketing of the Xbox? Microsoft needed to determine what part of designing, building, and marketing the Xbox would take place inside of Microsoft and what would take place in other companies that Microsoft hired. Hiring other companies means that Microsoft incurs the transactions costs of using markets. However, other companies that specialized in different tasks have economies of scale, economies of scope, and/or economies of team production that lower the cost to Microsoft of hiring them. So Microsoft had to determine which parts of the Xbox 360 would be cheaper to undertake inside of Microsoft and which parts would be cheaper to enter the market to contract with other firms.

21.

Why do you think the Xbox is designed in the United States and Japan but built in China? The Xbox is designed in America and Japan because America and Japan have a large number of highlyskilled workers who can successfully design the Xbox. With a large number of technically adept workers, it is less expensive to design the Xbox in these countries. Manufacturing the Xbox, however, takes place in China because China has a large number of lower-skilled workers and so it is less expensive to build the Xbox in China.

Economics in the News 22.

After you have studied Economics in the News on pp. 278–279, answer the following questions. a. What products do Facebook and Google sell? Facebook sells social networking services; that is, it allows its users to keep up with their friends. Google sells search services; that is, it helps its users search the Internet for the topics in which they are interested.

b. In what types of markets do Facebook and Google compete? Both markets have many other providers of similar services. But in each case there are a few that are much larger than the many competitors. So both markets are oligopolies.

c. How do social networks and Internet search providers generate revenue? Both social network Internet sites and Internet search providers generate revenue from sale of advertisements.

d. What is special about social network sites that make them attractive to advertisers? Social network sites have millions of users. Users typically provide the social network site information about the user’s interests. Therefore these sites are attractive to advertisers because an advertiser gains a large audience of people who have a tendency to be interested in the advertiser’s product.

e. What is special about Internet search providers that make them attractive to advertisers? Users of Internet search providers often are searching for either a particular product or else a product to fill a particular need. Often users are searching with an intention to buy. Advertisers are attracted to these web sites because they allow the advertiser to target an audience that is frequently going to purchase the product the advertiser has for sale.

What technological changes might increase the profitability of social networks compared to Internet search providers? Technological change that enables the social networking site to more precisely target the preferences of individual consumers—such as past buying history from the social networking website or better information about preferences via the consumer’s past web browsing on the social network site or on other web sites—would make Internet advertising on the social website more profitable because the ads would more precisely reflect the potential buyer's interests. This change would enable the social networking website to set a higher price for each advertisement, thereby increasing its profitability compared to Internet search providers.

23.

Long Reviled, Merit Pay Gains Among Teachers School districts in many states experiment with plans that compensate teachers partly based on classroom performance, rather than their years on the job and coursework completed. Working with mentors to improve their instruction and getting bonuses for raising student achievement

ORGANIZING PRODUCTION

encourages efforts to raise teaching quality.

Source: The New York Times, June 18, 2007 How does “merit pay” attempt to cope with the principal-agent problem in public education? The principal-agent problem with teachers in public education is the concern that teachers will not work hard in the classroom. Teachers’ efforts are difficult to monitor and so teachers have the incentive to shirk by working less diligently and teaching their students less. Merit pay links the teachers’ pay to their students’ achievement, presumably performance on standardized exams. With this linkage teachers will be paid more the better their students’ performance which gives the teachers the self-interested incentive to work diligently to instruct their students.

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OUTPUT AND COSTS

Answers to the Review Quizzes Page 286 1.

Distinguish between the short run and the long run. The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.

Why is a sunk cost irrelevant to a firm’s current decisions? Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must be paid. The only costs that concern the firm are costs that the firm can change with its current decisions.

Page 290 1.

Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually. Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase. Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.

What is the law of diminishing returns? Why does marginal product eventually diminish? The law of diminishing returns states that as a firm uses more of a variable factor of production with a given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.

Explain the relationship between marginal product and average product. As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal

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product of labor falls below the average product, the average product decreases as the quantity of labor increases.

Page 297 1.

What relationships do a firm’s short-run cost curves show? The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run: When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest point. When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point. As output increases, the ATC curve becomes vertically closer to the AVC curve.

How does marginal cost change as output increases (a) initially and (b) eventually? At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.

What does the law of diminishing returns imply for the shape of the marginal cost curve? The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward.

What is the shape of the AFC curve and why does it have this shape? Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes downward as the quantity produced increases.

What are the shapes of the AVC curve and the ATC curve and why do they have these shapes? The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped. The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping. ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.

Page 301 1.

What does a firm’s production function show and how is it related to a total product curve? A firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.

Does the law of diminishing returns apply to capital as well as labor? Explain why or why not. The law of diminishing returns applies to capital as well as labor. The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring.

OUTPUT AND COSTS

What does a firm’s LRAC curve show? How is it related to the firm’s short-run ATC curves? The long-run average cost curve (LRAC) shows the relationship between the lowest attainable ATC and output when both plant size and labor are varied. The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output. For any level of output the firm might choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size. Once the firm has chosen that plant size, it will incur costs corresponding to the ATC curve associated with that plant size.

What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of the LRAC curve? Economies of scale are features of a firm’s technology that lead to falling long-run average cost (LRAC) as output increases. As plant size increases, the minimum attainable average total cost (ATC) for each plant size falls with output. Diseconomies of scale are features of a firm’s technology that lead to rising LRAC as output increases. As plant size increases, the minimum attainable ATC for each plant size rises with output. A firm initially experiences economies of scale up to some output level and over this range of output the LRAC curve is downward sloping as output increases. Beyond that output level, it may move toward diseconomies of scale. When there are diseconomies of scale, the LRAC slopes upward as output increases, resulting in a U-shaped LRAC curve.

What is a firm’s minimum efficient scale? Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. If the long-run average cost curve has the typical U shape, the minimum point of the LRAC identifies the level of output that represents the firm’s minimum efficient scale.

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Answers to the Study Plan Problems and Applications 1.

Which of the following news items involves a short-run decision and which involves a long-run decision? Explain. January 31, 2008: Starbucks will open 75 more stores abroad than originally predicted, for a total of 975. This decision is a long-run decision. It increases the quantity of all of Starbucks’ factors of production, labor and the size of Starbucks’ plant.

February 25, 2008: For three hours on Tuesday, Starbucks will shut down every single one of its 7,100 stores so that baristas can receive a refresher course. This decision is a short-run decision. It involves increasing the quality of Starbucks’ labor and so only one factor of production—labor—changes and all the other factors remain fixed.

June 2, 2008: Starbucks replaces baristas with vending machines. This decision is a short-run decision. It involves changing two of Starbucks’ factors of production, labor and one type of capital. But other factors of production, such as Starbucks’ land and other capital inputs such as the store itself, remain fixed.

July 18, 2008: Starbucks is closing 616 stores by the end of March. This decision is a long-run decision. It decreases the quantity of all of Starbucks’ factors of production, labor and the size of Starbucks’ plant.

Use the table to work Problems 2 to 6. The table sets out Sue’s Surfboards’ total product schedule. 2.

Draw the total product curve. To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping and is illustrated in Figure 11.1.

Calculate the average product of labor and draw the average product curve. The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 120 surfboards a week, so average product is 40 surfboards per worker. As Figure 11.2 (on the next page) shows, the average product curve is upward sloping when up to 3 workers are hired and then is downward sloping when more than 4 workers are hired.

Labor (workers per week) 1 2 3 4 5 6 7

Output (surfboards per week) 30 70 120 160 190 210 220

Calculate the marginal product of labor and draw the marginal product curve. The marginal product of labor is equal to the increase in total product that results from a oneunit increase in the quantity of labor employed. For example, when 3 workers are employed, total product is 120 surfboards a week. When a fourth worker is employed, total product increases to 160 surfboards a week. The marginal product of increasing the number of workers from 3 to 4 is 40 surfboards. We plot the marginal product at the halfway point, so at a quantity of 3.5 workers, the marginal product is 40 surfboards per worker per week. As Figure 11.2 shows, the marginal product curve is upward sloping when up to 2.5 workers a week are employed and it is downward sloping when more than 2.5 workers a week are employed.

OUTPUT AND COSTS

5. a. Over what output range does Sue’s Surfboards enjoy the benefits of increased specialization and division of labor? The firm enjoys the benefits of increased specialization and division of labor over the range of output for which the marginal cost decreases. This range of output is the same range over which the marginal product of labor rises. For Sue’s Surfboards, the benefits of increased specialization and division of labor occur until 2.5 workers are employed.

b. Over what output range does the firm experience diminishing marginal product of labor? The marginal product of labor decreases after the 3rd worker is employed.

c. Over what output range does the firm experience an increasing average product of labor but a diminishing marginal product of labor? The marginal product of labor decreases and the average product of labor increases between 2.5 and 3.5 workers.

Explain how it is possible for a firm to experience simultaneously an increasing average product but a diminishing marginal product. As long as the marginal product of labor exceeds the average product of labor, the average product of labor rises. For a range of output the marginal product of labor, while decreasing, remains greater than the average product of labor, so the average product of labor rises. Each additional worker, while producing less than the previous worker hired is still producing more than the average worker.

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Use the following data to work Problems 7 to 11. Sue’s Surfboards, in Problem 2, hires workers at $500 a week and its total fixed cost is $1,000 a week. 7.

Calculate total cost, total variable cost, and total fixed cost of each output in the table. Plot these points and sketch the short-run total cost curves passing through them. Total cost is the sum of the costs of all the factors of production that Sue’s Surfboards uses. Total variable cost is the total cost of the variable factors. Total fixed cost is the total cost of the fixed factors. For example, the total variable cost of producing 120 surfboards a week is the total cost of the workers employed, which is 3 workers at $500 a week, which equals $1,500. Total fixed cost is $1,000, so the total cost of producing 120 surfboards a week is $2,500. Figure 11.4 (on the previous page) shows these total cost curves.

Calculate average total cost, average fixed cost, average variable cost, and marginal cost of each output in the table. Plot these points and sketch the short-run average and marginal cost curves passing through them. Output (surfboards)

AFC (dollars per surfboard)

AVC (dollars per surfboard)

33.33

16.67

ATC (dollars per surfboard) 50.00

14.29

28.58

120

8.33

12.50

20.83

160

6.25

12.50

18.75

190

5.26

13.16

18.42

210

4.76

14.29

19.05

220

4.55

15.91

20.46

MC (dollars per surfboard) 12.50 10.00 12.50 16.67 25.00 50.00

OUTPUT AND COSTS

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output. For example, take the case in which the firm makes 160 surfboards a week. Total fixed cost is $1,000, so average fixed cost is $6.25 per surfboard; total variable cost is $2,000, so average variable cost is $12.50 per surfboard; and, total cost is $3,000, so average total cost is $18.75 per surfboard. Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 120 to 160 surfboards a week, total cost increases from $2,500 to $3,000, an increase of $500. This $500 increase in total cost means that the increase in output of 40 surfboards increases total cost by $500. Marginal cost is equal to $500 divided by 40 surfboards, which is $12.50 a surfboard. The table shows these data schedules and the curves are plotted in Figure 11.4. 9.

Illustrate the connection between Sue’s AP, MP, AVC, and MC curves in graphs like those in Fig. 11.7.

Labor (workers)

Output (surfboards)

AP (surfboards per worker) 30.0

35.0

120

40.0

160

40.0

190

38.0

210

35.0

220

31.4

MP (surfboards per worker) 40.0 50.0 40.0 30.0 20.0 10.0

AVC (dollars per surfboard) 16.67 14.29 12.50 12.50 13.16 14.29 15.91

MC (dollars per surfboard) 12.50 10.00 12.50 16.67 25.00 50.00

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The table sets out the data used to draw the curves. Figure 11.5 shows the curves and the relationships. When the AP curve rises the AVC curve falls and vice versa. When the MP curve rises the MC curve falls and vice versa.

10.

Sue’s Surfboards rents a factory. If the rent rises by $200 a week and other things remain the same, how do Sue’s Surfboards’ short-run average cost curves and marginal cost curve change? The rent is a fixed cost, so total fixed cost increases. The increase in total fixed cost increases total cost but does not change total variable cost. Average fixed cost is total fixed cost per unit of output. The average fixed cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve and average variable cost curve do not change.

11.

Workers at Sue’s Surfboards negotiate a wage increase of $100 a week per worker. If other things remain the same, explain how Sue’s Surfboards’ short-run average cost curves and marginal cost curve change. The increase in the wage rate is a variable cost, so total variable cost increases. The increase in total variable cost increases total cost but total fixed cost does not change. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward while the average fixed cost curve does not change.

OUTPUT AND COSTS

Use the following data to work Problems 12 to 14. Jackie’s Canoe Rides rents canoes at $100 per day and pays $50 per day for each canoe operator it hires. The table shows the firm’s production function. 12.

Graph the ATC curves for Plant 1 and Plant 2. Explain why these ATC curves differ.

Labor (workers per day) 10 20 30 40 Canoes

Plant 1 20 40 65 75 10

Output (rides per day) Plant 2 Plant 3 40 55 60 75 75 90 85 100 20 30

Plant 4 65 85 100 110 40

To find the average total cost for each plant, at the different levels of output add the cost of the workers, $50 per worker, and the fixed cost, the cost of the canoes, $100 per canoe. So for plant 1, the total cost for 20 rides is $1,500; for 40 rides is $2,000; and, for 65 rides is $2,500. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.6. (The average total cost curve for one plant, ATC1, is the same as the thicker curve through the first 4 points.) The curves differ because the number of plants differs.

13.

Graph the ATC curves for Plant 3 and Plant 4. Explain why these ATC curves differ. These are drawn in Figure 11.6. The curves differ because the number of plants differs.

14. a. On Jackie’s LRAC curve, what is the average cost of producing 40, 75, and 85 rides a week? The long-run average total cost curve is illustrated in Figure 11.6 as the thicker curve. It is comprised of the parts of the short-run average total cost curves that are the minimum average total cost for the different levels of output. From this curve, the average cost of producing 40 rides is $50; of producing 75 rides is $40; and the average cost of producing 85 rides is $47.06.

b. What is Jackie’s minimum efficient scale? Jackie’s minimum efficient scale is the smallest quantity at which the long-run average cost is the lowest. Jackie’s minimum efficient scale is 65 canoe rides where, with one plant, the average total cost is $38.46.

c. Does Jackie’s production function feature economies of scale or diseconomies of scale? Jackie’s has both economies of scale for up to 65 canoe rides and then diseconomies of scale for more than 65 canoe rides.

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Answers to Additional Problems and Applications 15.

Jobs Boost as Lidl Unveils Plans for £20m Warehouse Expansion The German supermarket giant Lidl has plans to expand its distribution centre in County Antrim and open additional stores across Northern Ireland. The company is already recruiting new employees to facilitate its growth and expansion plan. Throughout the build, it could be employing more than 100 construction workers as well. Source: Belfast Telegraph, June 12, 2015 a. Which of Lidl’s decisions described in the news clip is a short-run decision and which is a longrun decision? Employing more than 100 construction workers is a short-run decision; expanding its distribution center and opening additional stores are long-run decisions.

b. Why is Lidl’s long-run decision riskier than its short-run decision? Lidl’s long-run decision is riskier than its short-run decision because it is more difficult to change the long-run decision. In particular, if Lidl decides to reverse its short-run decision to hire more workers, it is straightforward to fire the workers. However to reverse the long-run decision of expanding its distribution center and opening additional stores is more difficult and takes much longer to do.

16.

The Sunk-Cost Fallacy You have good tickets to a basketball game an hour’s drive away. There’s a blizzard raging outside, and the game is being televised. You can sit warm and safe at home and watch it on TV, or you can bundle up, dig out your car, and go to the game. What do you do? Source: Slate, September 9, 2005 a. What type of cost is your expenditure on tickets? At the time of the game, the cost of the ticket is a sunk cost.

b. Why is the cost of the ticket irrelevant to your current decision about whether to stay at home or go to the game? The cost of the ticket is a sunk cost; that is, the cost of the ticket has already been incurred. Because the cost of the ticket is the same regardless if you attend the game or stay at home, the cost of the ticket is irrelevant to your decision whether to attend or stay at home.

17.

Jason runs a corn farm. One worker produces 100 tons of corn a year; hiring a second worker, doubles his total product; hiring a third worker doubles his output again; hiring a fourth worker increased his total product but by only 80 tons of corn. Construct Jason’s marginal product and average product schedules. Over what range of workers do marginal returns increase? The easiest way to construct the marginal product and average product schedules is to use the total product schedule. Then the Labor Output Average Marginal average product of labor is (workers (tons of product product equal to the output divided by per week corn per (tons of corn (tons of corn the quantity of labor and the year) per year) per year) marginal product of labor is 1 100 100 100 equal to the change in output divided by the change in the 2 200 100 100 quantity of labor. Marginal returns increase over the range 3 400 133 200 of 3 workers. After the third worker, the marginal product decreases as more workers are 4 480 120 80 hired.

OUTPUT AND COSTS

18.

155

Use the events described in the news clip in Problem 15. By how much will Avalon’s short-run decision increase its total variable cost? By how much will Avalon’s long-run decision increase its monthly total fixed cost? Sketch Avalon’s short-run ATC curve before and after the events described in the news clip. Avalon’s short-run decision to increase its workforce increases its total variable cost (its payroll) by 30 percent to 40 percent, the increase in its wages. Avalon’s long-run decision to increase the size of its plant (its space) increases its total fixed cost by $6,500. Figure 11.7 shows Avalon’s short-run ATC curve before and after. The old cost curve is labeled with a “1” and the new cost curve, after the expansion, is labeled with a “2.” At lower levels of output Avalon’s new average total cost curve lies above its old average total cost curve and at higher levels of output Avalon’s new average total cost curve lies below its old average cost total curve. (In the figure the new minimum average total cost equals the old minimum, so Avalon has constant returns to scale.)

19.

Bill’s Bakery has a fire and Bill loses some of his cost data. The bits of paper that he recovers after the fire provide the information in the following table (all the cost numbers are dollars). Bill asks you to come to his rescue and provide the missing data in the five spaces identified as A, B, C, D, and E.

TP 10

AFC 120

AVC 100

ATC 220

150

130

MC 80 90 130

A is the average fixed cost, AFC, when the output is 40 30 C D 20. Average fixed cost equals total fixed cost divided E by output, or AFC = TFC ÷ Q. Rearranging gives TFC = 50 24 108 132 AFC × Q. So the total fixed cost for the problem equals $120 × 10, which is $1,200. A equals $1,200, TFC, divided by 20, Q, which is $60. B is the average variable cost, AVC, when output is 20. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC − AFC, so average variable cost equals $150 − $60, which is $90. D is the average total cost, ATC, when output, Q, equals 40. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 30 units are produced is $130 × 30, which is $3,900. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. Rearranging gives TC = MC × Q, so the change in total cost between Q = 30 and Q = 40 is $130 × 10, or $1,300. Therefore the total cost when Q equals 40 is $3,900 + $1,300, or $5,200. The average total cost when Q is 40 is $5,200 ÷ 40, or $130. C is the average variable cost, AVC, when output, Q, equals 40. Use the result that AFC + AVC = ATC by rearranging to give AVC = ATC − AFC. As a result, average variable cost equals $130 − $30, or $100. E is the marginal cost, MC, when output increases from 40 units to 50 units. Marginal cost, MC, equals the change in total cost divided by the change in quantity, or MC = TC ÷ Q. To calculate marginal cost, the total cost when output is 40 and the total cost when output is 50 are needed. Average total cost equals total cost divided by output, or ATC = TC ÷ Q. Rearranging gives TC = ATC × Q. So the total cost when 40 units are produced is $130 × 40, which is $5,200 and total cost when 50 units are produced is $132 × 50, which is $6,600. So the marginal cost equals ($6,600 − $5,200) ÷ 10, which equals $140.

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Use the following table to work Problems 20 and 21. ProPainters hires students at $250 a week to paint houses. It leases equipment at $500 a week. The table sets out its total product schedule. 20.

If ProPainters paints 12 houses a week, calculate its total cost, average total cost, and marginal cost. At what output is average total cost a minimum?

Labor (students) 1 2 3 4 5 6

Output (houses painted per week) 2 5 9 12 14 15

To paint 12 houses, ProPainters hires 4 students. The total variable cost is $1,000 (paid to the students) and the total fixed cost is $500 (the leased equipment). Therefore the total cost is $1,500. The average total cost equals $1,500/12, which is $125 per house. The marginal cost of 10½ houses is $83.33 and the marginal cost of 13 houses is $125.00. These mean that the marginal cost of 12 houses is $104.17. Using the data in the table, the average total cost is at its minimum of $125 per house when 13 houses are painted.

21.

Explain why the gap between ProPainters’ total cost and total variable cost is the same no matter how many houses are painted. The gap between total cost and total variable cost is total fixed cost. Because the fixed cost is the same at all levels of output, the difference between the total cost and total variable cost is constant.

22.

A Pepsi, a Business Decision PepsiCo has done a deal with 300 small Mexican farmers close to their two factories to buy corn at a guaranteed price. PepsiCo saves transportation costs and the use of local farms assures it access to the type of corn best suited to its products and processes. “That gives us great leverage because corn prices don’t fluctuate so much, but transportation costs do,” said Pedro Padierna, president of PepsiCo in Mexico. Source: The New York Times, February 21, 2011 a. How do fluctuations in the price of corn and in transportation costs influence PepsiCo’s shortrun cost curves? Fluctuations in the price of corn and transportation costs shift Pepsi’s short-run cost curves. The cost of corn and transportation are variable costs, so when the price of corn and/or the cost of transportation rise, Pepsi’s short-run variable cost and short-run total cost curves shift upward.

b. How does the deal with the farmers to avoid fluctuations in costs benefit PepsiCo? Pepsi lowers its costs because it will receive the type of corn that is best for its products and because Pepsi will not incur costs to transport the corn from far away. Use the table in Problem 20 and the following information to work Problems 23 and 24.

If ProPainters doubles the number of students it hires and doubles the amount of equipment it leases, it experiences diseconomies of scale. 23.

Explain how the ATC curve with one unit of equipment differs from that when ProPainters uses double the amount of equipment. Because ProPainters experiences diseconomies of scale, when ProPainters doubles its inputs the minimum average cost is higher than when it uses the lesser quantities of inputs. Even so, at high levels of output the average total cost of producing the large level of output with the greater quantities of inputs is lower than the average total cost of producing this large level of output with the smaller quantities of inputs.

24.

Explain what might be the source of the diseconomies of scale that ProPainters experiences. ProPainters might experience diseconomies of scale because when it gets larger the complexity of operating the business increases, which increases the costs of running the business and making decisions.

OUTPUT AND COSTS

Use the following information to work Problems 25 to 27. The table shows the production function of Bonnie’s Balloon Rides. Bonnie’s pays $500 a day for each balloon it rents and $25 a day for each balloon operator it hires. 25.

Labor (workers per day) 10 20 30 40 50 Balloons

Graph the ATC curves for Plant 1 and Plant 2. Explain why these ATC curves differ.

Plant 1 6 10 13 15 16 1

Output (rides per day) Plant 2 Plant 3 10 13 15 18 18 22 20 24 21 25 2 3

Plant 4 15 20 24 26 27 4

To find the average total cost for each plant, at the different levels of output add the variable cost, which is the cost of the workers or $25 per worker, to the fixed cost, which is the cost of the balloons or $500 per balloon. For Plant 1, the total cost for 6 rides is $750; for 10 rides is $1,000; for 13 rides is $1,250; for 15 rides is $1,500; and, for 16 rides is $1,750. The average total cost is calculated by dividing the total cost by the quantity of rides. These average total costs are plotted in Figure 11.8. The curves differ because the number of plants differs.

26.

Graph the ATC curves for Plant 3 and Plant 4. Explain why these ATC curves differ. Figure 11.8 shows these ATC curves. These curves differ because the number of plants differs.

27. a. On Bonnie’s LRAC curve, what is the average cost of producing 15 rides and 18 rides a day? The long-run average total cost curve is illustrated in Figure 11.8 as the darker line. The long-run average cost curve is comprised of the segments of the different short-run average total cost curves that have the minimum average total cost for the different levels of output. For 15 rides a day the average cost is $100 and for 18 rides a day the average cost is $97.22.

b. Explain how Bonnie’s uses its long-run average cost curve to decide how many balloons to rent. Bonnie’s will use its long-run average total cost curve by building the size of the plant that minimizes its long-run average cost at the number of balloon rides that Bonnie’s expects to produce.

Economics in the News 28.

After you have studied Economics in the News on pp. 302-303, answer the following questions. a. Explain the distinction between the short run and the long run and identify when Starbucks would want to make each type of change. The short run is a time frame during which the quantity of at least one factor of production is fixed. The long run is a time frame in which the quantities of all factors of production can be varied. Starbucks will make changes that lower its costs. It will make a short-run change when it wants to make an immediate change or when it wants to make a change that it will reverse in the near future. Starbucks will make a long-run change when it wants to make a change that will be permanent.

b. Explain economies of scale. Does Starbucks reap economies of scale in the example on p. 303? Economies of scale occur when a firm’s average total cost falls as the firm’s output increases. As its output increases, the firm will employ more labor and capital. Increased specialization of labor and capital leads to economies of scale. Figure 2 shows that Starbucks has economies of scale up to 2,000 coffees per day.

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c. Draw a graph to illustrate Starbucks cost as it opens more and more cafés in Target stores. Figure 11.9 shows Starbucks long-run average total cost, LRAC, as it opens more cafés in Target. The short-run average total cost curve with no cafes is ATC0 and with the cafes in the Target stores is ATC1. By opening the cafes rather than expanding its current stores, Starbucks has lower average total costs because it has moved along the LRAC curve to point b rather than along the ATC0 curve to point a.

d. Explain why Starbucks is opening cafés in Target stores rather than stand alone cafés. Starbucks is opening in Target stores rather than stand alone cafés because Starbucks believes its profit will be higher. If Starbucks opens in Target stores, it avoids the cost of constructing new cafés, the utility cost of operating the café, and the other costs of having a separate building. Starbucks pays rent to Target but the rent must be less than the cost of running a standalone Starbucks also gains customers for its coffee from among Target’s customer.

29.

Airport To Have Self Check-in Kempegowda International Airport has signed a contract with global aviation IT firm SITA for it’s passenger processing platform, baggage reconciliation system and self-service check-in kiosks that allow passengers to print their own boarding passes as well as baggage tags. Source: The Hindu, May 15, 2015 a. What is SITA’s total fixed cost of operating one self-service check-in kiosk? What are its variable costs of checking in a passenger at a self-service kiosk? The fixed costs are the cost of the machine itself. The variable costs include the cost of the boarding passes as well as baggage tags and, presuming that the self-service check-in kiosks need more maintenance the heavier their use, the cost of maintaining the kiosks.

b. Assume that manual check-in system costs less than the self-service check-in kiosk. Explain how the fixed costs, variable costs, and total costs of manual check-in system and self-service checkin kiosk differ. The fixed cost of the self-service check-in kiosk exceeds that of the manual check-in system. The variable cost of the manual check-in system exceeds that of the self-service check-in kiosk. The total cost of the self-service check-in kiosk is probably higher than that of the manual check-in system at lower levels of output and is probably lower at higher level of outputs.

c. Sketch the marginal cost and average cost curves implied by your answer to part (b). Figure 11.10 shows the different marginal costs and average total cost curves. The costs with the manual check-in system are labeled “1” and the costs with the self-service check-in kiosk are labeled “2”. The average total cost of the self-service check-in kiosk is higher than that of the manual check-in system at low levels of output and is lower than the average total cost of the manual check-in system at high levels of output. The marginal cost of the self-service check-in kiosk is lower than the marginal cost of the manual check-in system.

Use the following news clip to work Problems 30 and 31. THAI to Downsize and Reduce Routes In the face of severe losses, Thai Airways International has drawn up a rehabilitation plan. The plan includes reduction of the airline's staffing from 25,000 to 20,000 and cancellation of its non-performing routes. It will also sell 22 old aircraft and decommission 14 Boeing 747-400 and Airbus A 340-600 craft.

OUTPUT AND COSTS

Source: Vietnam Breaking News, May 30, 2015 30.

Thinking of an airline as a production plant, explain why Thai Airways is making a decision to sell 22 old aircraft? Is Thai Airways’s decision a long-run decision or a short-run decision? Thai Airways is making losses and it is operating where it has diseconomies of scale. By reducing the size of its plant (by selling 22 old aircraft), Thai Airways can slide down its LRAC curve and decrease its average cost. Thai Airways’s decision is a long-run decision because it involves the size of the firm’s plant.

31.

How might Thai Airways take advantage of economies of scale by revising its fleet and slashing its workforce ? At 22 old aircraft and 25,000 employees, Thai Airways was incurring diseconomies of scale. When Thai Airways revises its fleet and slashes its workforce, it will use fewer resources, particularly less capital and less labor. Thai Airways’s costs will be less as a result. Additionally, Thai Airways’s revenue will be less but the proportionate decrease in cost will exceed the decrease in Thai Airways’s revenue. In this case, Thai Airways’s average costs will decrease so that it can reap economies of scale it currently is not enjoying.

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PERFECT COMPETITION

Answers to the Review Quizzes Page 311 1.

Why is a firm in perfect competition a price taker? One firm’s output is a perfect substitute for another firm’s output and each firm is a small part of the market. These points imply that each firm cannot unilaterally influence the market price at which it can sell its good or service. It must accept, or “take” the market equilibrium price—hence the term, price taker.

In perfect competition, what is the relationship between the demand for the firm’s output and the market demand? The market demand curve for the goods and services in a perfectly competitive market is downward sloping. However, no single firm in this market can influence the price at which it sells its output. This point means a firm that is a price taker must take the equilibrium market price as given, and the firm faces a perfectly elastic demand.

In perfect competition, why is a firm’s marginal revenue curve also the demand curve for the firm’s output? A perfectly competitive firm’s demand curve is a horizontal line at the market price. This result means that the price it receives is the same for every unit sold. The marginal revenue received by the firm is the change in total revenue from selling one more unit, which is the constant market price. So a perfectly competitive firm’s demand curve is the same as its marginal revenue curve.

What decisions must a firm make to maximize profit? The firm has three decisions it must make. First it must determine how to produce at the minimum cost. Then it must determine how much to produce. Finally it must decide whether to enter or exit a market.

Page 315 1.

Why does a firm in perfect competition produce the quantity at which marginal cost equals price? A firm’s total profit is maximized by producing the level of output at which marginal revenue for the last unit produced equals its marginal cost, or MR = MC. In a perfectly competitive market, MR is equal to the market price P for all levels of output. These points imply that a perfectly competitive firm will maximize profit by producing the quantity at P = MC.

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What is the lowest price at which a firm produces an output? Explain why. The lowest price at which a firm will produce output is the price that equals the firm’s minimum AVC. At this price the firm has just enough total revenue to cover its total variable costs. The firm’s loss is equal to its fixed costs. At any lower market price the firm’s loss would be greater than its fixed costs. In this case the firm can avoid losses that are greater than its fixed cost by shutting down.

PERFECT COMPETITION

What is the relationship between a firm’s supply curve, its marginal cost curve, and its average variable cost curve? The firm will produce output as long as the price is greater than the minimum AVC. It will choose the level of output where MC = P, which means the firm’s supply curve is the firm’s MC curve above minimum AVC and along the vertical axis, producing zero, below the minimum AVC.

Page 319 1.

How do we derive the short-run market supply curve in perfect competition? The short-run market supply curve is the horizontal sum of each individual firm’s supply curve. That is, the amount supplied by the total market equals the sum of what each firm in the industry supplies at a given price.

In perfect competition, when market demand increases, explain how the price of the good and the output and profit of each firm changes in the short run. When market demand increases, the market price of the good rises, and the market quantity increases. Because price equals marginal revenue, the rise in the price means marginal revenue rises. As a result, each firm moves up its marginal cost curve and increases the quantity it produces. The firm’s economic profit rises (or its economic loss decreases). If the firm had been making a normal profit before the increase in demand, after the increase the firm makes an economic profit.

In perfect competition, when market demand decreases, explain how the price of the good and the output and profit of each firm changes in the short run. When market demand decreases, the market price of the good falls and the market quantity decreases. Because the price equals marginal revenue, the fall in the price means marginal revenue falls. As a result, each firm moves down its marginal cost curve so each firm decreases the quantity it produces. The firm’s economic profit falls (or its economic loss increases). If the firm had been making a normal profit before the decrease in demand, after the decrease the firm incurs an economic loss.

Page 321 1.

What triggers entry in a competitive market? Describe the process that ends further entry. When firms in a competitive market make an economic profit, the economic profit serves as an inducement to other firms to enter the market. As the other firms enter, the supply increases and the price falls. The fall in the price eventually eliminates the economic profit, at which time entry stops.

What triggers exit in a competitive market? Describe the process that ends further exit. When firms in a competitive market are incurring an economic loss, some of the firms will exit the market. As these firms exit, the supply decreases and the price rises. The rise in the price eventually eliminates the economic loss, at which time exit stops.

Page 325 Describe what happens to output, price, and economic profit in the short run and in the long run in a competitive market following: 1.

An increase in demand. An increase in demand increases the market quantity, and the market price rises above ATC for each firm. In the short run, firms in the market make an economic profit, attracting firms from outside the market to enter the market in the long run. This entry shifts the market supply curve rightward, lowering the price as the market quantity continues to increase. The fall in the price shrinks the firms’ economic profit until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and entry stops. In the long run, the price returns to the original level, market output is larger than the original amount, the number of firms is larger, and economic profit for each firm returns to zero.

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A decrease in demand. Starting from an initial point of long-run equilibrium, a permanent decrease in demand decreases the market quantity, and the price falls below the minimum ATC for each firm. In the short run, firms in the market incur an economic loss, which leads some firms to exit the market in the long run. This exit shifts the market supply curve leftward, raising the price and continuing to decrease the market quantity. The increase in the price shrinks the economic loss for each remaining firm. Exit continues until the price again equals the minimum point on each firm’s ATC curve. At this point, firms return to zero economic profit and exit stops. In the long run, the market price returns to the original level, market output is less than the original amount, the number of firms is less, and economic profit for each firm returns to zero.

The adoption of a new technology that lowers production costs. Technological advances result in lower costs for the firm that adopts them and initially these firms make an economic profit. Two actions occur in the market: i) firms from outside the market enter the market; ii) firms with old technology either exit the market or adopt the new technology. These two actions shift the market supply rightward, decreasing market price and increasing market quantity. In the long run, all firms in the industry will be new technology firms, economic profit for each firm will return to zero, market quantity will increase, and market price will fall to the new minimum ATC for each firm.

Page 327 1.

State the conditions that must be met for resources to be allocated efficiently. Resource use is efficient when the economy produces the goods and services that people value most highly. This situation requires that consumers are on their demand curves, thereby allocating their budgets to get the most possible value from their income. If the people who consume a good or service are the only ones who benefit from it, then the market demand curve measures the benefit to the entire society and is the marginal social benefit curve. Efficient resource use also requires that firms are on their supply curves, thereby getting the most value out of their resources. If the firms that produce a good or service bear all the costs of producing it, then the market supply curve measures the marginal cost to the entire society and the market supply curve is the marginal social cost curve. And resources are used efficiently when marginal social benefit equals marginal social cost.

Describe the choices that consumers make and explain why consumers are efficient on the market demand curve. Consumers allocate their budgets so they get the most value from their budgets. When consumers are on their demand curves, they are getting the most value out of their resources and are efficient.

Describe the choices that producers make and explain why producers are efficient on the market supply curve. Competitive firms maximize profit. We derive the firm’s supply curve by finding the profit-maximizing quantity at each price, which means that firms are efficient and get the most value out of their resources at all points along their supply curve.

Explain why resources are used efficiently in a competitive market. Resources are used efficiently in a competitive market because the market demand curve is the same as the marginal social benefit curve and the market supply curve is the same as the marginal social cost curve. The equilibrium quantity, determined by where the demand and supply curves intersect, is the same quantity where the marginal social benefit and marginal social cost curves intersect, which is the efficient quantity.

PERFECT COMPETITION

Answers to the Study Plan Problems and Applications 1.

Lin’s makes fortune cookies. Anyone can make and sell fortune cookies, so there are dozens of producers. All fortune cookies are the same and buyers and sellers know this fact. In what type of market does Lin’s operate? What determines the price of fortune cookies? What determines Lin’s marginal revenue? Lin is operating in a perfectly competitive market. The equilibrium price is determined at the intersection of the market demand curve and the market supply curve. Lin’s marginal revenue equals the market price of a box of cookies.

Use the following table to work Problems 2 to 4. Pat’s Pizza Kitchen is a price taker and the table shows its costs of production. 2. Calculate Pat’s profit-maximizing output and economic profit if the market price is (i) $14 a pizza, (ii) $12 a pizza, (iii) $10 a pizza. (i)

(ii)

(iii)

Output (pizzas per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 10 21 30 41 54 69

At $14 a pizza, Pat’s profit-maximizing output is 4 pizzas an hour and economic profit is $2 an hour. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $14 a pizza. The marginal cost is the change in total cost when output is increased by 1 pizza an hour. The marginal cost of increasing output from 3 to 4 pizzas an hour is $13 ($54 minus $41). The marginal cost of increasing output from 4 to 5 pizzas an hour is $15 ($69 minus $54). So the marginal cost of the fourth pizza is half-way between $13 and $15, which is $14. Marginal cost equals marginal revenue when Pat produces 4 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $56 ($14 multiplied by 4). Total cost is $54, so economic profit is $2. At $12 a pizza, Pat’s profit-maximizing output is 3 pizzas an hour and economic profit is $5. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. Marginal revenue equals price, which is $12 a pizza. The marginal cost of increasing output from 2 to 3 pizzas an hour is $11 ($41 minus $30). The marginal cost of increasing output from 3 to 4 pizzas an hour is $13. So the marginal cost of the third pizza is half-way between $11 and $13, which is $12. Marginal cost equals marginal revenue when Pat produces 3 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $36 ($12 multiplied by 3). Total cost is $41, so economic profit is $5. At $10 a pizza, Pat’s profit-maximizing output is 2 pizzas an hour and economic profit is $10. Pat’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. Marginal revenue equals price, which is $10 a pizza. The marginal cost of increasing output from 1 to 2 pizzas an hour is $9 ($30 minus $21). The marginal cost of increasing output from 2 to 3 pizzas an hour is $11. So the marginal cost of the second pizza is half-way between $9 and $11, which is $10. Marginal cost equals marginal revenue when Pat produces 2 pizzas an hour. Economic profit equals total revenue minus total cost. Total revenue equals $20 ($10 multiplied by 2). Total cost is $30, so economic profit is $10.

What is Pat’s shutdown point and what is Pat’s economic profit if it shuts down temporarily? The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($10—when output is zero, total variable cost is $0, so total cost at zero output equals total fixed cost) from total cost. Average variable cost equals total variable cost divided by the quantity produced. The average variable cost of producing 2 pizzas is $10 a pizza. Average variable cost is a minimum when marginal cost equals average variable cost. The marginal cost of producing 2 pizzas is $10. So Pat’s shutdown point is a price of $10 a pizza. When Pat shuts down the economic “profit” is actually an economic loss equal to Pat’s fixed cost. In particular Pat’s economic loss is $10.

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Derive Pat’s supply curve. Pat’s supply curve is the same as the marginal cost curve at prices equal to or above $10 a pizza. The supply curve is the y-axis (0 pizzas) at prices below $10 a pizza.

The market for paper is perfectly competitive and 1,000 firms produce paper. The first table sets out the market demand schedule for paper. The Price Quantity demanded second table sets out the costs of each (dollars per box) (thousands of boxes per producer of paper. Calculate the market price, week) the market output, the quantity produced by 3.65 500 each firm, and the firm’s economic profit or 5.20 450 loss. 6.80 400 The market price is $8.40 per box of paper. 8.40 350 The market price is the price at which the 10.00 300 quantity demanded equals the quantity 11.60 250 supplied. The firm’s supply curve is the same as its marginal cost curve at prices above 13.20 200 minimum average variable cost. Average Output Marginal cost Average Average variable cost is at its minimum when (boxes (dollars per variable cost total marginal cost equals average variable per additional box) cost cost. Marginal cost equals average variable cost at the quantity 250 boxes a week) (dollars per box) week. So the firm’s supply curve is the 200 6.40 7.80 12.80 same as the marginal cost curve for the 250 7.00 7.00 11.00 outputs equal to 250 boxes or more. 300 7.65 7.10 10.43 When the price is $8.40 a box, each 350 8.40 7.20 10.06 firm produces 350 boxes and the 400 10.00 7.50 10.00 quantity supplied by the 1,000 firms is 450 12.40 8.00 10.22 350,000 boxes a week. The quantity 500 20.70 9.00 11.00 demanded at $8.40 is 350,000 a week. The market output is 350,000 boxes a week. Each firm produces 350 boxes a week. Each firm incurs an economic loss of $581 a week. Each firm produces 350 boxes at an average total cost of $10.06 a box. The firm sells the 350 boxes for $8.40 a box. The firm incurs a loss on each box of $1.66 and incurs a total economic loss of $581 a week.

In Problem 5, the market demand and the demand schedule becomes the schedule shown in the table. If firms have the same costs set out in Problem 5, what is the market price and the firm’s economic profit or loss in the short run?

Price (dollars per box) 2.95 4.13 5.30 6.48 7.65 8.83 10.00 11.18

Quantity demanded (thousands of boxes per week) 500 450 400 350 300 250 200 150

The market price is $7.65 a box, the equilibrium market quantity is 300,000 boxes a week, and each firm incurs an economic loss of $834 a week. When the price is $7.65 a box, each firm produces 300 boxes and the total quantity supplied by the 1,000 firms is 300,000 boxes a week. The market quantity demanded at $7.65 is 300,000 boxes a week. Each firm produces 300 boxes at an average total cost of $10.43 a box. The firm sells the 300 boxes for $7.65 a box. At this price and quantity the firm incurs a loss on each box of $2.78 and incurs an economic loss of $834 a week.

PERFECT COMPETITION

In Problem 5, in the long run, what is the market price and the quantity of paper produced? What is the number of firms in the market? In the long run, the price equals the minimum average total cost, $10 a box. The number of firms in the long run is 750. In the long run, as firms exit the industry, the price rises. In the long-run equilibrium the price will equal the minimum average total cost. When output is 400 boxes a week, marginal cost equals average total cost and average total cost is a minimum at $10 a box. In the long run, the price is $10 a box. Each firm remaining in the industry produces 400 boxes a week. The quantity demanded at $10 a box is 300,000 boxes a week. The number of firms is 300,000 boxes divided by 400 boxes per firm, which is 750 firms. In the long run, the 750 firms together produce the equilibrium quantity of 300,000 boxes.

If the market demand for paper remains the same as in Problem 6, calculate the market price, market output, and the economic profit or loss of each firm. In the long run, the price equals the minimum average total cost, which is $10.00 a box, the equilibrium industry quantity is 200,000 boxes a week, and each firm makes zero economic profit.

In perfect competition in the long-run equilibrium, can consumer surplus or producer surplus be increased? Explain your answer. Once at the competitive equilibrium quantity, which is the same as the efficient quantity, the sum of consumer surplus plus producer surplus is as large as possible. If the price is lowered, consumer surplus increases but only at the expense of a larger decrease in producer surplus. And the lower price is not the long-run equilibrium price. If the price is raised, producer surplus increases but only at the expense of a larger decrease in consumer surplus. And the higher price is not the long-run equilibrium price.

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Answers to Additional Problems and Applications Use the following news clip to work Problems 10 to 12. Money in the Tank Two gas stations stand on opposite sides of the road: Rutter’s Farm Store and Sheetz gas station. Rutter’s doesn’t even have to look across the highway to know when Sheetz changes its price for a gallon of gas. When Sheetz raises the price, Rutter’s pumps are busy. When Sheetz lowers prices, there’s not a car in sight. Both gas stations survive but each has no control over the price. Source: The Mining Journal, May 24, 2008 10.

In what type of market do these gas stations operate? What determines the price of gasoline and the marginal revenue from gasoline? These stations operate in a perfectly competitive market. The equilibrium price is determined at the equilibrium between the market demand and the market supply. The marginal revenue from a gallon of gasoline equals the market price of a gallon.

11.

Describe the elasticity of demand that each of these gas stations faces. Each station’s elasticity of demand is very high. When one station raises its price even a bit, it loses a lot of customers to its competitors. And when one of the stations lowers its price, it gains a lot of customers from its competitor.

12.

Why does each of these gas stations have so little control over the price of the gasoline they sell? These stations face a large amount of competition, not only from each other but also from all nearby gas stations. If a firm raises its price it loses a vast number of customers so each firm is severely limited in raising its price. And there is no need for a firm to lower its price much below the going price because the firm can already increase its sales drastically with only a slight lowering of its price.

13.

Figure 12.1 shows the costs of Quick Copy, one of many copy shops near campus. If the market price of copying is 10¢ a page, calculate Quick Copy’s a. Profit-maximizing output. Quick Copy’s profit-maximizing quantity is 80 pages an hour. Quick Copy maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is 10 cents a page. Marginal cost is 10 cents a page when Quick Copy produces 80 pages an hour.

b. Economic profit. Quick Copy’s economic profit is $2.40 an hour. Economic profit equals total revenue minus total cost. Total revenue equals $8.00 an hour (10 cents a page multiplied by 80 pages). The average total cost of producing 80 pages is 7 cents a page, so total cost equals $5.60 an hour (7 cents multiplied by 80 pages). So economic profit equals $8.00 minus $5.60, which is $2.40 an hour.

PERFECT COMPETITION

14.

The market for smoothies is perfectly competitive and the market demand schedule is in the first table. Each of the 100 producers of smoothies has the costs given in the second table when it uses its least-cost plant. a. What is the market price of a smoothie?

Price (dollars per smoothie) 1.90 2.00 2.20 2.91 4.25 5.25 5.50

Quantity demanded (smoothies per hour) 1,000 950 800 700 550 400 300

The market price is the price at which the market quantity demanded equals the market quantity supplied. The firm’s supply curve is the same as its marginal cost curve at prices above minimum average variable cost. Average variable cost is a minimum when Output Marginal cost Average Average marginal cost equals average (smoothie (dollars per variable total variable cost. Marginal cost equals s additional smoothie) cost cost average variable cost at the per hour) quantity 7 smoothies an hour. So (dollars per smoothie) the firm’s supply curve is the same 3 2.50 4.00 7.33 as the marginal cost curve for 4 2.20 3.53 6.03 outputs greater than and equal to 5 1.90 3.24 5.24 7 smoothies. When the price is 6 2.00 3.00 4.67 $2.91 a smoothie, each firm 7 2.91 2.91 4.34 produces 7 smoothies and the 8 4.25 3.00 4.25 market quantity supplied by the 9 8.00 3.33 4.44 100 firms is 700 smoothies an hour. The market quantity demanded at $2.91 is 700 smoothies an hour so the market price is $2.91

b. What is the market quantity of smoothies? The market quantity of smoothies is 700 smoothies an hour.

c. How many smoothies does each firm sell? Each firm sells 7 smoothies an hour.

d. What is the economic profit made or economic loss incurred by each firm? Each firm incurs an economic loss. Each firm produces 7 smoothies at an average total cost of $4.34 a smoothie. The firm sells the 7 smoothies for $2.91 each. The firm incurs a loss on each smoothie of $1.43 and incurs a total economic loss of $10.01 an hour.

15.

Chevy Volt Production Temporarily Shut Down GM will temporarily lay off 1,300 employees as the company stops production of the electric car, Chevy Volt, for five weeks. GM had hoped to sell 10,000 Volts last year, but ended up selling just 7,671. It plans to maintain inventory levels by adjusting production to match demand. Source: Politico, March 2, 2012 a. Explain how the shutdown decision will affect GM Chevy Volt’s TFC, TVC, and TC. The shutdown decision has no effect on GM’s TFC. It will lower GM’s TVC and TC.

b. Under what conditions would this shutdown decision maximize Chevy Volt’s economic profit (or minimize its loss)? Explain your answer. GM will shut down its plant when the price of a Volt is less than its average variable cost, that is, when P < AVC. By shutting down, GM incurs an economic loss equal to its total fixed cost, which is the minimum loss that it can incur in this situation.

c. Under what conditions will GM start producing the Chevy Volt again? Explain your answer. GM will start producing the Chevy Volt again when the price of Volt exceeds its average variable cost, that is, when P > AVC. In this case, even if GM is still incurring an economic loss, its loss will be less if it produces than if it shuts down.

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Oil Prices Climb on Supply Outlook, Weaker Dollar Oil prices have risen 38 percent from mid-March due to expectations of a sixth straight weekly decline in U.S. crude supplies, sharp spending cuts, and a weak dollar. Source: The Wall Street Journal, June 9, 2015 Why did oil prices increase in 2015? Draw a graph to show the short-run effect on an individual gas station’s economic profit. Oil prices increased in 2015 because the supply of oil decreased. The decrease in the supply of oil drives the prices of oil higher. The figure shows the effect of the higher price on the economic profit of an individual gas station. The price of a barrel of oil increases from $58 per barrel to $62 per barrel. The gas station’s marginal revenue curve therefore rises from MR0 to MR1. When the price was $58 per barrel, the gas station produced 100 barrels per day and incurs an economic loss (because P < ATC). After the price increases to $62 per barrel, the gas station produces 120 barrels per day and made an economic profit (because P > ATC).

17.

In Problem 14, do firms enter or exit the market in the long run? What is the market price and the equilibrium quantity in the long run? The firms are incurring economic losses, so some firms exit the market. As firms exit the market, the market supply decreases so that in the long run the price rises to equal the minimum average total cost, $4.25 per smoothie. When the price is $4.25 for a smoothie, the equilibrium quantity is 550 smoothies per hour.

18.

In Problem 15, under what conditions would GM stop producing the Chevy Volt and exit the market for electric cars. Explain your answer. GM will permanently shut down and exit the market in the long run if the price of a Volt is less than GM’s average total cost. In this situation, if it remained open GM would incur an economic loss but if it exited the market it would no longer incur an economic loss.

19.

Exxon Mobil Selling All Its Retail Gas Stations Exxon Mobil is not alone among Big Oil exiting the retail gas business, a market where profits have gotten tougher as crude oil prices have risen. Gas station owners say they’re struggling to turn a profit because while wholesale gasoline prices have risen sharply, they’ve been unable to raise pump prices fast enough to keep pace. Source: Houston Chronicle, June 12, 2008 a. Is Exxon Mobil making a shutdown or exit decision in the retail gasoline market? Exxon Mobil is making an exit decision. It is permanently leaving the market.

b. Under what conditions will this decision maximize Exxon Mobil’s economic profit? This decision maximizes Exxon Mobil’s economic profit if Exxon Mobil’s retail gasoline operation is incurring an economic loss. In this case by closing its retail gasoline stations, Exxon Mobil increases its economic profit.

c. How might Exxon Mobil’s decision affect the economic profit of other gasoline retailers? Exxon Mobil’s exit will decrease the number of retail firms selling gasoline. The decrease in the number of firms decreases the supply and raises the market price of retail gasoline. As a result of the higher market price the surviving firms’ profits rise.

PERFECT COMPETITION

20.

Another DVD Format, but It’s Cheaper New Medium Enterprises claims the quality of its new system, HD VMD, is equal to Blu-ray’s but at $199 it’s cheaper than the $300 Blu-ray player. The Blu-ray Disc Association says New Medium will fail because it believes that Blu-ray technology will always be more expensive. But mass production will cut the cost of a Blu-ray player to $90. Source: The New York Times, March 10, 2008 a. Explain how technological change in Blu-ray production might support the prediction of lower prices in the long run. Illustrate your explanation with a graph. Technological change will decrease the firm’s average total cost and marginal cost. As more firms adopt the new technology, the market supply will increase, which drives down the price. Figure 12.3 shows the effect of the increase in technology. The firm’s average total cost curve and marginal cost curve shift downward from ATC0 and MC0 to ATC1 and MC1. In the long run, competition lowers the price from $300 per player to $90 per player and so the marginal revenue curve falls from MR0 to MR1.

b. Even if Blu-ray prices do drop to $90 in the long run, why might the HD VMD still end up being less expensive at that time? Quite likely there will be technological advances in the HD VMD laser player which decrease its costs of production, increase its market supply, and lower its price. Additionally if there are only a few firms initially producing the HD VMD laser player and these firms are making an economic profit, entry of new firms will increase market supply and also lower the price of a red-laser HD VMD.

21.

In a perfectly competitive market, each firm maximizes its profit by choosing only the quantity to produce. Regardless of whether the firm makes an economic profit or incurs an economic loss, the short-run equilibrium is efficient. Is the statement true? Explain why or why not. The statement is true. A perfectly competitive firm is a price taker and so it has no choice about what price it will charge. If there are no external benefits or external costs, then when a competitive market is in equilibrium, it is efficient. Regardless of the firms’ profits, as long as they are producing along their supply curves they are producing efficiently and obtaining the most value for their resources.

Economics in the News 22.

After you have studied Economics in the News on pp. 328–329, answer the following questions. a. What are the features of the market for apps that make it competitive? The market for apps is highly competitive because there are many producers and buyers of apps, there are no restrictions on entry, established app sellers have no advantages over new sellers, and sellers and buyers of apps are well informed about prices.

b. Does the information provided in the news article suggest that the app market is in long-run equilibrium? Explain why or why not. The market is not in long-run equilibrium. Developers are constantly entering the market, which indicates the presence of economic profit.

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c. How would an advance in development technology that lowered a developer’s costs change the market supply and the developer’s marginal revenue, marginal cost, average total cost, and economic profit? An advance in development technology that lowers developers’ costs increases the market supply, which lowers the market price. Developers’ marginal revenue is equal to the market price, so the fall in the price lowers the marginal revenue. The new technology lowers developers’ marginal cost and average total cost and the marginal cost and average total cost curves shift downward. Because firms maximize their profit by producing so that marginal revenue equals marginal cost, the marginal cost decreases. In the short run, the firms that adopt the new technology make an economic profit. But in the long run, all developers will use the new technology and some new developers will enter the market. In the long run, the price falls so that the firms make zero economic profit.

d. Illustrate your answer to part (c) with an appropriate graphical analysis.

Figure 12.4a shows the market for apps; Figure 12.4b shows an individual app developer. Before the advancement in development technology, the market supply curve is S0 and the price is $5 per app and 100 million apps are bought and sold in a year. The app developer illustrated in Figure 12.4b initially produces 15,000 apps per year and makes zero economic profit. After the development of the new technology, the developer’s average total cost curve and marginal cost curve shift downward from ATC0 and MC0 to ATC1 and MC1. The market supply increases and the market supply curve shifts rightward. Eventually after all the app developers have adopted the new technology and new developers have entered the market, the supply curve shifts to S1. The price of an app falls to $1.50 and at this price the app developers now make zero economic profit.

23.

Electric Car Demand Growing, Global Market Hits 740,000 Units Around the world, demand for electric vehicles (EV) is growing according to the Centre for Solar Energy and Hydrogen Research. There have been more than 320,000 new EV registrations in 2014, bringing the total global market up to 740,000 vehicles. Source: www.cleantechnica.com, March 28, 2015 a. Explain the effects of the increase in global demand for electric vehicles on the market for electric vehicles and on an individual electric vehicle producer in the short run. In the short run the market demand for electric vehicles increases. The price of an electric vehicle rises and the market equilibrium quantity increases. Because the market price rises, individual electric vehicle producers increase the quantity they produce and make an economic profit.

PERFECT COMPETITION

b. Draw a graph to illustrate your explanation in part (a).

Figure 12.5 shows the short-run outcome. Figure 12.5a shows the market equilibrium. In the market, demand increases and the demand curve shifts rightward from D0 to D1. In the short run the supply curve remains S. As a result of the increase in demand the market price rises to $6000 an electric vehicle and the market quantity increases to 30,000. Figure b shows the situation at a representative firm. The rise in the market price raises the firm’s demand and marginal revenue curve from MR0 to MR1. The firm responds by increasing the quantity it produces from 1,000 electric vehicles a month to 1,500 electric vehicles a month. It makes an economic profit because the price exceeds the firm’s average total cost.

c. Explain the long-run effects of the increase in global demand for electric vehicles on the market for electric vehicles. In the long run the economic profit attracts entry into the market. The market supply increases which drives the price down. The market equilibrium quantity increases. The fall in the price decreases and, in the long run, totally eliminates the firms’ economic profit so the firm makes zero economic profit.

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MONOPOLY

Answers to the Review Quizzes Page 337 1.

How does monopoly arise? Monopoly arises if a firm is selling a good that has no close substitutes and if the firm is protected from competition by a barrier to entry. As a result, a monopoly is the only firm in its market.

How does a natural monopoly differ from a legal monopoly? The barrier to entry protecting a natural monopoly is the firm’s cost. For a natural monopoly, the costs are such that one firm can supply the entire market at lower cost than could two or more firms. The barrier to entry protecting a legal monopoly is a legal prohibition preventing competitors from entering the market. Copyrights, patents, government licenses, and public franchises are legal barriers to entry.

Distinguish between a price-discriminating monopoly and a single-price monopoly. A single-price monopoly charges every consumer the same price for each unit of the good or service the consumer buys. A price-discriminating monopolist might charge different consumers different prices for the same good or service or charge the same consumer different prices for different units of the good or service. When a firm practices price discrimination, it sells different units of a good or service for different prices.

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What is the relationship between marginal cost and marginal revenue when a single-price monopoly maximizes profit? A single-price monopoly firm maximizes profit by producing an amount of output so that marginal cost equals marginal revenue (MR = MC).

How does a single-price monopoly determine the price it will charge its customers? The market demand curve is the monopolist’s demand curve. The demand curve shows the maximum price at which the monopoly can sell its profit-maximizing level of output. So the monopoly finds the quantity it will produce and then uses its demand curve—the market demand curve—to determine the price it will charge.

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What is the relationship between price, marginal revenue, and marginal cost when a single-price monopoly is maximizing profit? MR < P for every level of output. A profit-maximizing monopoly firm produces the amount of output that sets MR = MC. As a result, MC must be below price: MC = MR < P.

Why can a monopoly make a positive economic profit even in the long run? Barriers to entry prevent the monopoly firm from enduring the pressure of competition, and allow it to choose the quantity of output that is associated with the profit-maximizing market price. This allows a monopoly firm to potentially enjoy positive economic profit, even in the long run.

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Why does a single-price monopoly produce a smaller output and charge more than the price that would prevail if the market were perfectly competitive? The market supply curve for a competitive market is the horizontal sum of the individual firm’s marginal cost curves. Equilibrium output in this competitive market is determined where the market supply curve intersects the market demand curve, and at this point price equals marginal cost, that is P = MC. Equilibrium output for a single-price monopoly is determined at the intersection of its marginal cost curve and its marginal revenue curve. Marginal revenue is less than price, which means that MR = MC at less output than that for which P=MC, so the monopoly produces less than a perfectly completive market. For a monopoly price exceeds marginal revenue which, in turn, equals marginal cost. Therefore for a monopoly, P > MC which means the monopoly price exceeds the price in a perfectly competitive market.

How does a monopoly transfer consumer surplus to itself? The monopoly raises price by lowering the quantity offered for sale. This raises the price consumers must pay for the good compared to the competitive market price. This difference in price multiplied by the quantity the monopolist sells represents the amount of consumer surplus that is transferred to producer surplus.

Why is a single-price monopoly inefficient? In a competitive market, the supply curve is the marginal social cost curve for society, and the demand curve is the marginal social benefit curve to society. The perfectly competitive market is efficient because production occurs where the quantity supplied equals the quantity demanded so that MSB = MSC. The monopolist is inefficient because price exceeds marginal cost at the quantity of output the monopoly produces. When the monopoly equates MC = MR to choose the profit-maximizing level of output, it charges a price from the demand curve that is greater than marginal cost, which means MSB > MSC. Consumer and producer surplus are not maximized and society suffers a deadweight loss.

What is rent seeking and how does it influence the inefficiency of monopoly? Rent seeking is the pursuit of wealth by capturing economic rent. Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent. There are two forms of rent seeking activity to pursue a monopoly status: i) Buying a monopoly, where a person expends resources seeking to purchase monopoly rights for a price slightly less than the monopoly profit, or ii) Creating a monopoly, where a person expends resources seeking political influence, such as lobbying legislators to provide preferential market status by restricting domestic or international competition. The resources expended in rent seeking can be equal to the economic profit that a monopoly status would create for the owner.

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What is price discrimination and how is it used to increase a monopoly’s profit? Price discrimination is the practice of selling different units of a good or service for different prices. To practice price discrimination, a monopoly must be able to: i) identify and separate different buyer types, and ii) sell a product that cannot be resold. The key idea to price discrimination is to charge different

MONOPOLY

consumers different prices, according to their willingness to pay for the good. This transfers potential consumer surplus under the single-price scenario into producer surplus, raising the monopoly’s profit.

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Explain how consumer surplus changes when a monopoly price discriminates. When a monopoly price discriminates, it charges different prices for different units of the product or it charges different prices to different consumers. Consumer surplus is the value (or marginal benefit) of a good minus the price paid for it, summed over the quantity bought. When the monopoly price discriminates, it decreases the consumer surplus on the units for which it charges a higher price to its initial customers. But it increases the consumer surplus on units for which it charges a lower price to new customers. If a monopoly is able to perfectly price discriminate, it totally eliminates consumer surplus because it charges every consumer the highest price the consumer is willing to pay.

Explain how consumer surplus, economic profit, and output change when a monopoly perfectly price discriminates. Perfect price discrimination occurs when a monopoly charges each consumer the maximum price he or she is willing to pay. The closer the price paid is to the value placed on the good, the smaller is the consumer surplus. This transfers the entire consumer surplus to producer surplus. Consumer surplus is eliminated. Producer surplus increases because it gains an amount equal to the lost consumer surplus. Producer surplus also increases because the quantity produced increases to the output at which price equals marginal cost. The monopoly increases its economic profit compared to charging a single-price to all customers. This outcome achieves efficiency by eliminating the deadweight loss.

What are some of the ways that real-world airlines price discriminate? Vacation travelers are willing to pay less than business travelers, so airlines need to sort vacation travelers from business travelers. Vacation travelers generally know well in advance when their vacation will occur and so they are able to purchase their tickets in advance. In addition vacation travelers are often willing to spend a weekend at their destination. Travelers who either buy their tickets in advance and/or are willing to spend a weekend at the destination are identifying themselves as vacation travelers and airlines charge them a lower price. The airline companies make airline tickets non-transferable, preventing the vacation travelers with the lower willingness to pay from reselling their less expensive tickets to the business travelers with the higher willingness to pay.

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What is the pricing rule that achieves an efficient outcome for a regulated monopoly? What is the problem with this rule? Regulating the actions of a natural monopoly to achieve an efficient outcome implies setting the level of output at the quantity where MB = MC, and the monopoly must set its price equal to marginal cost. This type of regulation is called the marginal cost pricing rule. A marginal cost pricing rule maximizes total surplus. However, when the monopoly price equals marginal cost, average total cost exceeds price and the monopoly incurs an economic loss. A monopoly that is required to use a marginal cost pricing rule will not stay in business because it is not covering its costs. Two possible ways of enabling the firm to cover its costs are by price discrimination and by using a two-part price (called a two-part tariff). The government might also grant the firm a subsidy. But this subsidy must be raised through imposing taxes on other economic activity, which creates deadweight loss and prevents efficient resource allocation in the markets affected by the tax.

What is the average cost pricing rule? Why is it not an efficient way of regulating monopoly? An average cost pricing rule requires that the firm set its price equal to its average total cost and produce the quantity at which the LRAC curve intersects the demand curve. This pricing rule leads to an inefficient quantity of output. Allocative efficiency requires that the quantity produced be the amount for which the marginal social benefit, shown on the demand curve, equal marginal social cost, which is shown on the marginal cost curve. Efficiency requires that P = MC. When a natural monopoly is regulated using an average cost pricing rule, P = LRAC and at the quantity produced LRAC > MC. Combining these results shows that P > MC, which means that the firm is producing an inefficient amount of output.

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What is a price cap? Why might it be a more effective way of regulating monopoly than rate of return regulation? A price cap is a price ceiling, a regulation that sets the maximum price the regulated firm can charge. This type of regulation might be a more effective method of regulation than rate of return regulation because rate of return regulation gives managers the incentive to inflate their costs. Price cap regulation, however, gives the regulated firm the incentive to operate efficiently and not inflate its costs.

Compare the consumer surplus, producer surplus, and deadweight loss that arise from average cost pricing with those that arise from profit-maximization pricing and marginal cost pricing. For a natural monopoly, marginal cost is less than average total cost at all levels of output in the market. Compared to an average cost pricing rule a marginal cost pricing rule generates greater consumer surplus and less producer surplus because P = MC (which determines production with the marginal cost pricing rule) at a larger level of output than when P = LRAC (which determines production with an average cost pricing rule). With a marginal cost pricing rule the monopoly market will be efficient (MSB = MSC) and not experience a deadweight loss. However, the firm’s average total cost exceeds its price and the monopoly suffers an economic loss. The monopoly will stay in business only if it receives a subsidy to make up for the economic loss, returning it to a normal profit. Yet this subsidy must be provided through taxing other markets, causing inefficient resource allocations in those markets. So with a marginal cost pricing rule the other markets affected by the tax will experience an increase in deadweight loss. The average cost pricing rule generates a deadweight loss in the monopoly market because MSB no longer equals MSC. This result occurs because the monopoly produces where P = LRAC and LRAC exceeds MSC at this level of output. Finally, compared to a profit-maximizing firm, a firm regulated with an average cost pricing rule has greater consumer surplus, smaller producer surplus, and smaller deadweight loss.

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Answers to the Study Plan Problems and Applications 1.

The U.S. Postal Service has a monopoly on non-urgent First Class Mail. Pfizer Inc. makes LIPITOR, a prescription drug that lowers cholesterol. Cox Communications is the sole provider of cable television service in some parts of San Diego. Are any of these firms protected by a barrier to entry? Do any of these firms produce a good or service that has a substitute? Might any of them be able to profit from price discrimination? Explain your answers. The U.S. Postal Service and Pfizer are protected by legal barriers to entry. The Postal Service has the legal right given to it by the Private Express Statutes to be the only first class non-urgent mail service and Pfizer has a patent on Lipitor. Cox Communications has a natural barrier to entry because it is a natural monopoly. It also has a legal barrier to entry because it has been given the public franchise to be the only cable provider in its area. Substitutes for the U.S. Postal Service include email, fax, and private delivery services, such as FedEx or UPS. Substitutes for Lipitor are generic Lipitor, other statin drugs, such as Zocor, non-statin drugs that also lower cholesterol, and exercise. Substitutes for Cox Communications include satellite television services, Hulu, and other Internet provided television service. All three of the firms practice price discrimination. The second ounce in a first class letter is less expensive to mail than the first ounce. Lipitor’s price varies according to the insurance policy a customer has. Cox Communications bundles packages of services that have a lower price than each item taken separately so that additional units of service are less expensive than the initial units.

Use the following table to work Problems 2 to 4. Minnie’s Mineral Springs is a singleprice monopoly. Columns 1 and 2 of the table set out the market demand schedule for Minnie’s water and columns 2 and 3 set out Minnie’s total cost schedule. 2.

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

Quantity demanded (bottles per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 1 3 7 13 21 31

Calculate Minnie’s marginal revenue schedule and draw a graph of the market demand curve and Minnie’s marginal revenue curve. Explain why Minnie’s marginal revenue is less than the price. To calculate Minnie’s marginal revenue, we first need to calculate the total revenue. Minnie’s total revenue schedule lists the total revenue at each quantity sold. For example, Minnie’s can sell 1 bottle for $8 a bottle, which is $8 of total revenue at the quantity 1 bottle. Minnie’s entire total revenue schedule is in the table on the next page. The marginal revenue schedule lists the marginal revenue that results from increasing the quantity sold by 1 bottle. For example, Minnie’s can sell 1 bottle for total revenue of $8. Minnie’s can sell 2 bottles for $6 each, for total revenue of $12. So by increasing the quantity sold from 1 bottle to 2 bottles, marginal revenue is $4 a bottle ($12 minus $8). In the table on the next page, this marginal revenue is placed midway between the quantities 1 bottle and 2 bottles. Minnie’s demand curve and marginal revenue curve are in Figure 13.1 The demand curve intersects the vertical axis at a price of $10 and intersects the horizontal axis at a quantity of 5. The marginal revenue curve intersects the vertical axis at a price of $10 and intersects the horizontal axis at a quantity of 2.5.

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Price (dollars per bottle) 10

Quantity demanded (bottles per hour) 0

Total revenue (dollars)

Marginal revenue (dollars per bottle)

8 4 0 −4

−8 Minnie’s marginal revenue is less than her price because to sell an additional unit of output, Minnie must lower her price on all units sold. So when Minnie sells an additional unit of output, her revenue consists of the price she receives for this extra unit minus what she loses on all previous units she sells now at the new, lower price.

At what price is Minnie’s total revenue maximized and over what range of prices is the demand for water elastic? Why will Minnie not produce a quantity at which the market demand is inelastic? Interpolating along the demand curve, Minnie’s total revenue is maximized at a price of $5. At this price she sells 2.5 bottles an hour for total revenue of $12.50. The demand for Minnie’s Mineral Springs water is elastic between $5 per bottle and $10 per bottle. Minnie will not produce a quantity at which the demand for her water is inelastic because producing at such a price does not maximize her profit. If Minnie is producing where her demand is inelastic, she can decrease the quantity she produces and 1) increase her total revenue, and 2) decrease her total cost. Because her total revenue increases and her total cost decreases, Minnie’s total profit increases. Anytime Minnie’s production is at a quantity at which demand is inelastic, she can always increase her total profit by decreasing her production.

Calculate Minnie’s profit-maximizing output and price and economic profit. Minnie’s profit-maximizing output is 1.5 bottles and her profit-maximizing price is $7a bottle. To maximize profit Minnie’s needs to produce the quantity at which marginal revenue equals marginal cost. The marginal cost of increasing the quantity from 1 bottle to 2 bottles is $4 a bottle ($7 minus $3). That is, the marginal cost at 1.5 bottles of water is $4 a bottle. The marginal revenue of increasing the quantity sold from 1 bottle to 2 bottles is $4 ($12 minus $8). So the marginal revenue from 1.5 bottles is $4 a bottle. The profit-maximizing output is 1.5 bottles. The profit-maximizing price is the highest price that Minnie’s can sell the profit-maximizing output of 1.5 bottles. Minnie’s can sell 1 bottle for $8 and 2 bottles for $6, so it can sell 1.5 bottles for $7 a bottle. Economic profit equals total revenue minus total cost. Total revenue equals price ($7 a bottle) multiplied by quantity (1.5 bottles), which is $10.50. Total cost of producing 1 bottle is $3 and the total cost of producing 2 bottles is $7, so the total cost of producing 1.5 bottles is $5. Minnie’s economic profit equals $10.50 minus $5, which is $5.50.

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Use the data in Problem 2 to work Problem 5. a. Use a graph to illustrate the producer surplus generated from Minnie’s Mineral Springs’ water production and consumption. Figure 13.2 shows Minnie’s producer surplus. The producer surplus equals the area of the grey polygon on the figure.

b. Is Minnie’s an efficient producer of water? Explain your answer. Minnie’s is not an efficient producer of water. Efficiency requires that the amount of production sets the marginal cost of water equal to its marginal benefit. The marginal benefit is measured by the demand curve, so in Figure 13.2 the efficient quantity of water to produce is the quantity where the marginal cost curve intersects the demand curve, which is 2 1/9 bottles per hour.

c. Suppose that new wells were discovered nearby to Minnie’s and Minnie’s faced competition from new producers. Explain what would happen to Minnie’s output, price, and profit. Competition would force Minnie’s to lower its price. Minnie’s output would decrease as would its economic profit.

LaBella Pizza can produce a pizza for a marginal cost of $2. Its price of a pizza is $15. a. Could La Bella Pizza make a larger economic profit by offering a second pizza for $5? Use a graph to illustrate your answer. La Bella Pizza is price discriminating, which increases its profit. It is charging consumers a second price for the second pizza they buy. This sort of price discrimination essentially is moving downward along a consumer’s demand curve and increasing the quantity the consumer purchases. On both counts, La Bella is increasing its sales and, because its marginal revenue from these additional sales, $5 per pizza, exceeds its marginal cost of $2, the additional sales increase La Bella’s profit. Figure 13.3 illustrates La Bella Pizza’s situation. With no price discrimination La Bella produces 300 pizzas and sells them at a price of $15 a pizza. With the price discrimination, La Bella still sells 300 pizzas at a price of $15 and also sells an additional 200 pizzas at a price of $5. The economic profit when La Bella sells at one price is equal to the large, light grey area. When La Bella price discriminates, it makes additional economic profit equal to the darker grey rectangle.

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b. How might La Bella Pizza make even more economic profit? Would La Bella Pizza then be more efficient than it would be if it charged $15 for each pizza? La Bella could further price discriminate. For instance, it might sell a third pizza for $4, which, given the marginal cost of $2, would still increase economic profit. A firm that can price discriminate increases its production relative to what it would produce if it could not price discriminate. So the quantity of pizza La Bella produces is closer to the efficient quantity with the price discrimination that it would be if La Bella did not price discriminate.

Use the following figure to work Problems 7 to 9. The figure shows Calypso, a U.S. natural gas distributor. It is a natural monopoly that cannot price discriminate. What quantity will Calypso produce, what price will it charge, and what will be the total surplus and deadweight loss if Calypso is: 7.

An unregulated profit-maximizing firm? As shown in Figure 13.5, Calypso will produce 2 million cubic feet a day and sell it for 6 cents a cubic foot. The marginal revenue curve will run from 10 cents on the y-axis to 2.5 cubic feet on the x-axis. The profit-maximizing output is 2 million cubic feet at which marginal revenue equals marginal cost. The price charged is the highest that people will pay for 2 million cubic feet a day, which is 6 cents a cubic foot. The consumer surplus is $40,000, the producer surplus is $80,000, and the deadweight loss is $40,000. The consumer surplus is the triangular area under the demand curve and above the price. The price is 6 cents, so consumer surplus equals (10 cents minus 6 cents) multiplied by 2 million cubic feet/2, which is $40,000. The producer surplus is the rectangular area under the price and above the MC curve. The price is 6 cents, so producer surplus equals (6 cents minus 2 cents) multiplied by 2 million cubic feet a day, which is $80,000. The efficient output is 4 cubic feet, at which marginal cost equals price (marginal benefit). The deadweight loss is the triangular area between the demand (or marginal social benefit) curve and the marginal cost curve between the equilibrium quantity and the efficient quantity. So the deadweight loss equals (4 million cubic feet minus 2 million cubic feet) multiplied by (6 cents minus 2 cents)/2, which is $40,000 a day.

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Regulated to make zero economic profit? If Calypso is regulated to make zero economic profit, it produces the output at which price equals average total cost—at the intersection of the demand curve and the LRAC curve. Calypso will produce 3 million cubic feet a day and charge 4 cents a cubic foot. The consumer surplus is $90,000, the producer surplus is $60,000, and the deadweight loss is $10,000. The consumer surplus is the triangular area under the demand curve and above the price. The price is 4 cents, so consumer surplus equals (10 cents minus 4 cents) multiplied by 3 million cubic feet/2, which is $90,000. The producer surplus is the rectangular area under the price and above the MC curve. The price is 4 cents, so producer surplus equals (4 cents minus 2 cents) multiplied by 3 million cubic feet, which is $60,000. The efficient output is 4 million cubic feet, at which marginal cost equals price (marginal benefit). The deadweight loss is the triangular area between the demand (or marginal social benefit) curve and the marginal cost curve between the equilibrium quantity and the efficient quantity. So the deadweight loss equals (4 million cubic feet minus 3 million cubic feet) multiplied by (4 cents minus 2 cents)/2, which is $10,000 a day.

Regulated to be efficient? If the firm is regulated to be efficient, it will produce the quantity at which price (marginal social benefit) equals marginal social cost—at the intersection of the demand curve and the marginal cost curve. Calypso will produce 4 million cubic feet a day and charge 2 cents a cubic foot. The consumer surplus is $160,000, the producer surplus is $0, and the deadweight loss is $0. The consumer surplus is the triangular area under the demand curve and above the price. The price is 2 cents, so consumer surplus equals (10 cents minus 2 cents) multiplied by 4 million cubic feet/2, which is $160,000. There is no producer surplus because the price equals the marginal cost. And there is no deadweight loss because the quantity produced is the efficient quantity.

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Answers to Additional Problems and Applications Use the following list, which gives some information about seven firms, to answer Problems 10 and 11. • An airline company cuts ticket price to increase its market share. • A single firm, has a significant portion of a key resource needed to manufacture a medicine that has no close substitutes. • A barrier to entry exists, but the good has some close substitutes. • A firm offers discounts on every Saturday. • A firm will lose most of its customers if it increases the price of its product. • The government issues a state-owned firm an exclusive license to produce oil. • A power station experiences economies of scale even when it supplies electricity to all the residents in a city. 10. In which of the seven cases might monopoly arise?? The second, sixth, and seventh cases suggest that a monopoly might be a possibility.

11.

Which of the seven cases are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why? The second case has an ownership barrier to entry. The sixth case describes a legal barrier to entry because the firm has been given an “exclusive license” by the government. The seventh case is a natural monopoly because it describes the firm as having economies of scale over the entire market demand. The airline company in the first case cannot price discriminate because there are no separate groups of customers with different willingness to pay. Different classes such as economy class and business class on an airplane is not price discrimination, since customers receive different services. The fifth case, the firm that loses most of the customers while increasing price, is a perfect competitor and cannot price discriminate. The fourth case, the firm offering discounts on a certain day, is price discriminating. The other situations describe firms that might be able to price discriminate if there are different classes of customers and if the firm can determine into which class a customer falls.

Use the following information to work Problems 12 to 16. Hot Air Balloon Rides is a single-price monopoly. Columns 1 and 2 of the table set out the market demand schedule and columns 2 and 3 set out the total cost schedule. 12.

Construct Hot Air’s total revenue and marginal revenue schedules.

Price (dollars per ride) 220 200 180 160 140 120

Quantity demanded (rides per month) 0 1 2 3 4 5

Total cost (dollars per month) 80 160 260 380 520 680

The table showing Hot Air’s total revenue schedule and marginal revenue schedule is on the next page. Total revenue equals price multiplied by quantity. Marginal revenue equals the change in total revenue divided by the change in quantity. For example, between 1 ride and 2 rides the total revenue increases by $160 and the quantity increases by 1 ride, so the marginal revenue equals $160/1, which is $160. This marginal revenue is placed midway between the 1 ride and 2 rides rows.

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Price (dollars per ride)

Quantity demanded (rides per month)

Total revenue (dollars per month)

220

200

180

360

160

480

140

560

120

600

Marginal revenue (dollars per ride) 200 160 120 80 40

Draw a graph of the market demand curve and Hot Air’s marginal revenue curve. Figure 13.6 illustrates Hot Air’s demand curve and marginal revenue curve.

14.

Find Hot Air’s profit-maximizing output and price and calculate the firm’s economic profit. Hot Air’s marginal cost equals marginal revenue at 2 1/2 rides a month, where both equal $120. From the demand curve, the price is $170 a ride. Economic profit equals total revenue minus total cost. The total cost of 2 1/2 rides a month is $320. Hot Air’s total revenue equals the number of rides multiplied by the price per ride, which is (2 1/2 rides per month)  ($170) = $425. So the economic profit is total revenue minus total cost, which is $425 − $320 = $105.

15.

If the government imposes a tax on Hot Air’s profit, how do its output and price change? As a result of the tax, Hot Air’s fixed cost changes, but its marginal cost does not. The profitmaximizing level of output is still 2 1/2 rides a month and the price still equals $170. The tax decreases Hot Air’s economic profit but does not change its output or price.

16.

If instead of taxing Hot Air’s profit, the government imposes a sales tax on balloon rides of $30 a ride, what are the new profit-maximizing quantity, price, and economic profit? A $30-a-ride tax increases Hot Air’s marginal cost by $30 at every level of output. With the increase in the marginal cost, Hot Air now sells 2 rides a month because this is the level at which the new marginal cost equals the marginal revenue (both equal $140). From the demand curve, Hot Air sets a price of $180 a ride. Economic profit equals total revenue minus total cost. The total revenue is 2 rides  $180 which is $360. The total cost is $260 plus the tax of $60, which is $320. So the new economic profit is $360 − $320 = $40.

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17.

Figure 13.7 illustrates the situation facing the publisher of the only newspaper containing local news in an isolated community. a. On the graph, mark the profit-maximizing quantity and price and the publisher’s total revenue per day. Profit is maximized when the firm produces the output at which marginal cost equals marginal revenue. As Figure 13.8 shows, the marginal revenue curve runs from 100 on the y-axis to 500 on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 267 newspapers a day. The highest price for which the publisher can sell 267 newspapers a day is read from the demand curve. So the profit-maximizing quantity is 267 newspapers a day and price is 73 cents a paper. The daily total revenue is $194.91 (267 papers at 73 cents each). This amount is equal to the rectangular area C in Figure 13.8.

b. At the price charged, is the demand for this newspaper elastic or inelastic? Why? Demand is elastic. Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the demand curve. The price at the midpoint is 50 cents. So at 73 cents a paper, demand is elastic.

18.

Show on the graph in Problem 17 the consumer surplus from newspapers and the deadweight loss created by the monopoly. Explain why this market might encourage rent seeking. Figure 13.8 shows the consumer surplus, area A, and the deadweight loss, area B. The consumer surplus is $36.05 a day and the deadweight loss is $8.65 a day. The consumer surplus is the area marked A in Figure 13.8 and the deadweight loss is the darker area marked B in the figure. The consumer surplus is the area under the demand curve and above the price. The price is 73 cents, so consumer surplus equals (100 cents minus 73 cents) multiplied by 267/2 papers a day, which is $36.05 a day. Deadweight loss arises because the publisher does not produce the efficient quantity. Output is restricted to 267 newspapers rather than 400, and the price is increased to 73 cents rather than 60 cents. The deadweight loss equals (73 cents minus 46.6 cents) multiplied by 133/2, $17.56. This market would encourage rent seeking because the producer is making an economic profit. Other entrepreneurs would like to make this economic profit and will rent seek in an attempt to do so.

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If the newspaper market in Problem 17 were perfectly competitive, what would be the quantity, price, consumer surplus, and producer surplus? Mark each on the graph. The quantity would be 400 newspapers a day and the price would be 60 cents a newspaper. The consumer surplus is the triangular area under the demand curve and above the price, marked as area A in Figure 13.9. The price is 60 cents, so consumer surplus equals (100 cents minus 60 cents) multiplied by 400/2 papers a day, which is $80 a day. The producer surplus is the triangular area under the price and above the supply curve, marked as area B in Figure 13.9. The price is 60 cents, so producer surplus equals (60 cents minus 20 cents) multiplied by 400/2 papers a day, or $80 a day.

20.

What the Apple-Samsung Verdict Means for Your Smartphone A California jury found Samsung guilty of violating the majority of the patents in question, including software features like double-tap zooming and scrolling. It recommended that Apple be awarded more than $1 billion in damages. This verdict could significantly affect both smartphone users and producers. Source: CNN Money, August 26, 2012 a. If Apple became a monopoly in the smartphone market, who would benefit and who would lose? If Apple became a monopoly, Apple would gain. Consumers would lose. Society would lose because the total surplus is smaller in a monopoly market than in a perfectly competitive market.

b. Compared to smartphone monopoly, who would benefit and who would lose if the smartphone market became perfectly competitive? If the smartphone market became perfectly competitive, consumers would gain and producer(s) would loss. Overall, society gains because the total surplus is larger in a perfectly competitive market than in a monopoly market.

c. Explain which market would be efficient: a perfectly competitive one or a monopoly. A perfectly competitive market is efficient. A monopoly produces less output than does a perfectly competitive market, thereby creating a deadweight loss. There is no deadweight loss in a perfectly competitive market.

21.

Domestic Water Supplies in Hong Kong The following tariff structure is applicable to water consumed in billing periods which commence on or after February 16, 1995: the first tier of 12 m3 is free of charge; the second tier of 31m3 is charged at $4.16 per m3; the third tier of 19 m3 is charged at $6.45 per m3, and the fourth tier for any consumption above the level of 62 m3 is charged at $9.05 per m3. Source: www.wsd.gov.hk a. Explain why Hong Kong Water Supplies Department’s tariff structure might be price discrimination. The Water Supplies Department’s tariff structure is price discrimination because users pay a different price per m3 (cubic meter) of water depending on the quantity of water they use. The department’s marginal cost is the same, regardless of how much water is used, so the price difference does not reflect a difference in cost.

b. Draw graphs to illustrate the first and the third tier in comparison to a flat rate of $5 per m3

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regardless of the amount of water consumption.

In Figures 13.10a, with the flat rate of $5 per m3, people consume 120,000 m3 of water per billing period and the revenue for the Water Supplies Department is $5 multiplied by 120,000 m 3. However, when we apply the tariff structure, the first tier of 12 m3 is free of charge. People spend 300, 000 m3 of water per billing period and the revenue for the department is zero. In the third tier of 19 m3, $6.45 is charged per cubic meter. It is higher than the flat rate. Figure 13.10b shows that when we apply the tariff structure, people spend 280,000 m 3 of water per billing period. The orange rectangle is the revenue for the department. However, with the flat rate of $5 per m 3, people would totally spend 320,000 m3 per billing period. The revenue the department received has been outlined by the red rectangle.

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Ofcom Blows Whistl: It Will No Longer Compete with Royal Mail Whistl, the company which had fulfilled the regulatory role of a competitor to Royal Mail, will suspend its operatives in the direct delivery market due to heavy losses. Clearly, the last mile of the postal network is a natural monopoly and having rival postmen tour the same streets makes no economic sense. But Ofcom boss Sharon White has declared it wishes to mimic the effect of the competition that Whistl had posed to Royal Mail. Source: The Guardian, June 16, 2015 a. How has the withdrawal of Whistl from the direct delivery market enabled Royal Mail to influence the UK direct delivery market? When Royal Mail becomes the exclusive provider of direct delivery service in the UK, the amount of competition within the market will be limited. This may cause the price of direct delivery service to increase than what could otherwise be in the presence of competition; the quantity of service would be lower than what could have been otherwise.

b. Explain why “the last mile of the postal network is a natural monopoly.” Why might this justify allowing a regulated monopoly to exist in this market? In the direct delivery market, there may be one firm that possesses a cost advantage over its competitors by increasing the quantity it produces. The firm then uses that cost advantage to drive its competitors out of business. Ultimately, only the firm with cost advantage survives and thus becomes the natural monopoly. It will be economically unviable for another firm without cost advantages to compete with the monopoly. Because of this, granting the firm the public franchise to be a monopoly in exchange for regulating its price and quantity could be a reasonable public policy to decrease the deadweight loss that would arise from an unregulated monopoly.

Economics in the News 23.

After you have studied Economics in the News on pp. 354–355, answer the following questions. a. Why did the European regulators say that Google was misusing its monopoly power? Do you agree? Explain why or why not. The European regulators asserted that Google was abusing its power in search to extend its reach to other markets, such as commercial searches for digital cameras or hotels, because Google’s search engine highlights links to Google services that search for these (and other) products. The European regulators said that Google gave less prominent space to rivals for these sorts of commercial searches.

b. Explain why it would be inefficient to regulate Google to make it charge the same price per keyword click to all advertisers. Efficiency requires that Google sell the number of clicks so that the marginal social cost of a click equals the marginal social benefit of a click. The marginal social cost of a click equals the marginal cost and the marginal social benefit equals the price. Only if the price per click equals the marginal cost of a click would Google sell the efficient number of clicks. At any other price Google would sell an inefficient quantity of clicks. So only if the marginal social cost of all clicks is the same and Google is regulated to charge precisely that price would this regulation be efficient.

c. Explain why selling keywords to the highest bidder can lead to an efficient allocation of advertising resources. Selling keywords to the highest bidder allocates the words to those bidders who value them most highly, which means the words and hence advertising resources, are allocated efficiently. By selling each click at a separate price to the highest bidder, Google is trying to perfectly price discriminate. If Google perfectly price discriminates, then the market achieves the efficient outcome, albeit with no consumer surplus

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24.

Hong Kong Electric Joins Chorus against a Cut in Permitted Return Rate HK Electric Investments, the sole power supplier to Hong Kong Island and Lamma Island, has joined its larger rival CLP Holdings, which supplies power to 80 percent of Hong Kong’s population, in opposing the Hong Kong government’s proposal to cut their permitted return and bring in competition to their regional electricity supply monopolies in the long term. Source: South China Morning Post, May 14, 2015 a. What barriers to entry exist in the electricity supply market in Hong Kong Island and Lamma Island? The major barrier to entry is that the electricity supply market in Hong Kong Island and Lamma Island is a natural monopoly. Firms entering the market will have higher average total costs if the amount they produce and sell is less than that of the existing firm.

b. Are high power tariffs evidence of monopoly power? High prices are not necessarily evidence of monopoly. Prices can be high in competitive markets if the costs are high. For instance, the luxury car market is competitive but these cars are quite expensive.

c. Draw a graph to illustrate the effects of introducing new competitors in the electricity supply market in Hong Kong Island and Lamma Island on the price, quantity, total surplus, and deadweight loss. Presuming that the power industry was an unregulated monopoly before introducing new competitors and that the market becomes competitive after the actions, Figure 13.11 shows what would happen. With the power industry a monopoly, 30 billion kilowatts electricity is provided and the price is $0.9 a kilowatt. The consumer surplus is equal to area a, the producer surplus is equal to area b+ area e, and the deadweight loss is equal to area c+ area f. Once the market is competitive, 35billion kilowatts electricity is provided and the price is $0.8 a kilowatt. Consumer surplus increases to area a+ area b+ area c. Producer surplus decreases to area e+ area f. There is no deadweight loss because the market is allocatively efficient.

25.

Break Up of State Oil Monopoly? Experts have suggested that China should establish an independent company to operate the oil wholesale business and manage the supply to retailers, to break up the de facto monopoly of the three State-owned oil companies, especially the two onshore oil giants. Source: China Daily, September 26, 2013 a. Is China’s oil industry a monopoly? China’s oil industry is not a monopoly because there are three competitors in the market. If the industry was a monopoly it would have no competitors.

b. Will introducing competition decrease the oil price in China? In the short term, the oil price in China will decrease with the introduction of competitors, since the supply will increase. However, in the long term, the price of oil will depend on the fluctuating global demand and supply of oil.

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Answers to the Review Quizzes Page 363 1.

What are the distinguishing characteristics of monopolistic competition? The distinguishing characteristics of monopolistic competition are: i) a large number of firms, each producing a differentiated product than its competitors, ii) firms compete on quality, price, and marketing, and iii) there are no barriers to entry into the industry.

How do firms in monopolistic competition compete? Firms in monopolistic competition compete in three areas: Quality—the physical attributes of a product, including the product’s design and reliability, the service provided with the product, and the ease of access to the product; price—because the firms produce differentiated products, each firm faces a downward-sloping demand curve for its own product; and marketing—firms must make consumers aware of the quality of their differentiated products through advertising and packaging.

Provide some examples of industries near your school that operate in monopolistic competition (excluding those given on the text page in the figure). Hamburger restaurants, coffee shops, and juice bars are examples of firms competing in their own respective industry, each industry being a market described by monopolistic competition.

Page 367 1.

How does a firm in monopolistic competition decide how much to produce and at what price to offer its product for sale? A firm that has already decided the quality of its product and its marketing program produces the output at which its marginal revenue equals its marginal cost (MR = MC) because this output maximizes profit. The price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

Why can a firm in monopolistic competition make an economic profit only in the short run? A firm in monopolistic competition can make an economic profit only in the short-run because economic profit induces entry, which decreases the demand for the firm’s product, lowers its profitmaximizing output, price, and economic profit. In long-run equilibrium, when entry ends, each firm makes zero economic profit.

Why do firms in monopolistic competition operate with excess capacity? A firm’s capacity output is the output at which average total cost is at its minimum. In monopolistic competition in the long run, MR = MC and P = ATC. At the long run equilibrium, it is the case that MC < ATC, which means that ATC is falling in this range and so production occurs at an output level that is less than capacity output.

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Why is there a price markup over marginal cost in monopolistic competition? A firm’s markup is the amount by which price exceeds marginal cost. There is a markup in monopolistic competition because P > MR at all levels of output. Since the firm produces the quantity at which MR = MC, the fact that P > MR means that P > MC, so that there is a markup.

Is monopolistic competition efficient? Monopolistic competition is not efficient by the requirement for allocative efficiency MSB = MSC. The price equals the consumer’s willingness to pay, which is the marginal social benefit and the firm’s marginal cost is the marginal social cost. Product differentiation in monopolistic competition means that P > MR, which implies that P > MC at the quantity where MR = MC. Because P = MSB and MC = MSC, the result is that MSB > MSC, which signals inefficiency. However, when compared to the perfectly competitive alternative that all goods are identical, the variety offered by monopolistic competition makes monopolistic competition potentially efficient.

Page 371 1.

How, other than by adjusting price, do firms in monopolistic competition compete? The two main ways firms in monopolistic competition compete other than by adjusting price is through product development and advertising.

Why might product development be efficient and why might it be inefficient? Product development might be efficient if the development represents actual improvements to the product and not simply the perception of improvement. The value of these new innovations to the consumer is the marginal benefit or the extra amount consumers are willing to pay to have the new product. If the marginal benefit to the consumer is equal to the marginal cost of product development, then development is efficient.

Explain how selling costs influence a firm’s cost curves and its average total cost. Selling costs increase a firm’s fixed cost, which increase the firm’s total cost. This means that an increase in selling costs shifts the average fixed cost (AFC) curve and the average total cost (ATC) curve upward. Variable costs do not change, so the marginal cost (MC) and average variable cost (AVC) curves remain unchanged.

Explain how advertising influences the demand for a firm’s product. If a firm’s advertising program is successful, it will shift the firm’s demand curve rightward in the short run. But if this shift in demand increases economic profit, it will attract firms to enter the industry, shifting each existing firm’s demand curve back leftward as they each lose some market share. In the long run, each firm makes zero economic profit, and demand for the firm’s product will not increase through advertising.

Are advertising and brand names efficient? Advertising and brand names can increase consumer information about product differences and quality. This information increases consumers’ wellbeing and increases efficiency. But advertising and creating a brand name also are costly endeavors. If the MSB from the advertising and brand names is greater than the MSC of the advertising and brand names, then advertising and brand names increase efficiency. But if the MSB from the advertising and brand names is less than the MSC of the advertising and brand names, then advertising and brand names decrease efficiency. Basically, if the additional benefit that consumer’s gain from advertising and brand names exceed the costs, then advertising and brand names have a surplus for society and should be increased until their marginal social benefit equals their marginal social cost.

MONOPOLISTIC COMPETITION

Answers to the Study Plan Problems and Applications 1.

Which of the following items are sold by firms in monopolistic competition? Explain your selections. • Cable television service • • • • •

The cable television market is not an example of monopolistic competition because at any locale, there are not a lot of firms competing.

Wheat The wheat market is not an example of monopolistic competition because the many competing firms each produce an identical product.

Athletic shoes The athletic shoe market is an example of monopolistic competition. There are several producers of athletic shoes, with extensive product differentiation and competition on quality, price, and marketing.

Soda The soda market is not an example of monopolistic competition because there are only two producers who together have a very large market share.

Toothbrushes The toothbrush market is an example of monopolistic competition. There are many producers of toothbrushes, with extensive product differentiation and competition on quality, price, and marketing.

Ready-mix concrete The ready-mix concrete market is not an example of monopolistic competition.

The four-firm concentration ratio for audio equipment makers is 30 and for electric lamp makers it is 89. The HHI for audio equipment makers is 415 and for electric lamp makers is 2,850. Which of these markets is an example of monopolistic competition? The audio equipment market is an example of monopolistic competition.

Use the following information to work Problems 3 and 4. Sara is a dot.com entrepreneur who has established a Web site at which people can design and buy sweatshirts. Sara pays $1,000 a week for her Web server and Internet connection. The sweatshirts that her customers design are made to order by another firm, and Sara pays this firm $20 a sweatshirt. Sara has no other costs. The table sets out the demand schedule for Sara’s sweatshirts. 3.

Calculate Sara’s profit-maximizing output, price, and economic profit.

Price (dollars per sweatshirt) 0 20 40 60 80 100

Quantity demanded (sweatshirts per week) 100 80 60 40 20 0

Sara produces the quantity that sets her marginal cost equal to her marginal revenue. Sara’s marginal cost is $20. Between the quantity of 20 and 40 sweatshirts, Sara’s marginal revenue is $40. Between 40 and 60 sweatshirts, Sara’s marginal revenue is $0. So at the quantity of 40 sweatshirts Sara’s marginal revenue is $20. To maximize her profit, Sara produces 40 sweatshirts. When Sara produces 40 sweatshirts, the price from the demand schedule is $60 per sweatshirt. Sara’s total revenue is $2,400. Her total cost is $1,000 (fixed cost) plus $800 (variable cost), or $1,800. Sara’s economic profit equals $2,400 − $1,800 or $600.

4. a. Do you expect other firms to enter the Web sweatshirt business and compete with Sara? b.

Sara is making an economic profit so other firms will enter the Web sweatshirt business and compete with Sara. What happens to the demand for Sara’s sweatshirts in the long run? What happens to Sara’s economic profit in the long run? As new firms enter the Web sweatshirt industry, the demand for Sara’s sweatshirts will decrease. In the long run Sara’s economic profit is zero—a normal profit.

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Use Figure 14.1, which shows the situation facing Flight Inc., a producer of running shoes, to work Problems 5 to 8. 5. What quantity does Flight produce, what price does it charge, and what is its economic profit? To maximize profit, Flight produces the quantity at which marginal revenue equals marginal cost, so it produces 100 pairs a week. Flight charges the highest price that enables it to sell the 100 pairs of shoes. As read from the demand curve, Flight charges $80 a pair. Economic profit equals total revenue minus total cost. The price is $80 a pair and the quantity sold is 100 pairs, so total revenue is $8,000. Average total cost is $60 a pair, so total cost equals $6,000. Economic profit equals $8,000 minus $6,000, so Flight makes an economic profit of $2,000 a week.

In the long run, how does Flight change its price and the quantity it produces? What happens to the market output of running shoes? The price of a pair of Flight’s running shoes falls and the quantity decreases in the long run. Flight is making an economic profit and this profit attracts entry into the market so the number of firms increases. As new firms enter the market, the demand for Flight’s shoes decreases. The decrease in demand leads to the price of Flight’s running shoes falling and the quantity of running shoes decreasing. The quantity of running shoes in the market as a whole increases in the long run. As new firms enter, each existing firm decreases its output a bit. But the new firms produce more shoes and, on net, the quantity of shoes in the entire market increases.

Does Flight have excess capacity in the long run? If it has excess capacity in the long run, why doesn’t it decrease its capacity? In the long run, monopolistically competitive firms produce less output than the amount which minimizes the average total cost, which means that in the long run they have excess capacity. Flight produces at the average total cost that is the minimum average total cost for the quantity it produces. If Flight decreased its capacity it would shift its average total cost curve upward. This shift would increase its average total cost for its profit-maximizing quantity and Flight would incur an economic loss.

Is the market for running shoes efficient or inefficient in the long run? Explain your answer. Based on the allocative efficiency criterion of producing the quantity at which MSB = MSC, the market for running shoes is not efficient. Producing at the allocatively efficient quantity P (which equals MSB) equals MC (which equals the MSC). But a monopolistically competitive industry produces so that P > MC and therefore is not allocatively efficient. However based on a broader measure of efficiency the market might be efficient. In particular due to the monopolistically competitive nature of the market there are a variety of running shoes produced. People value variety and if consumers’ benefit from the product variety equals the cost of producing this variety then, in this broader sense, the market is efficient.

Suppose that Tommy Hilfiger’s marginal cost of a jacket is a constant $100 and the total fixed cost at one of its stores is $2,000 a day. This store sells 20 jackets a day, which is its profit-maximizing number of jackets. Then the stores nearby start to advertise their jackets. The Tommy Hilfiger store now spends $2,000 a day advertising its jackets, and its profit-maximizing number of jackets sold jumps to 50 a day. a. What is this store’s average total cost of a jacket sold (i) before the advertising begins and (ii) after the advertising begins? Before the advertising begins, the average total cost of a jacket is $200. The average total cost equals the total cost divided by the quantity. The fixed cost is $2,000. Because the marginal cost is $100 per

MONOPOLISTIC COMPETITION

jacket, the total variable cost is $2,000. So the total cost is the $2,000 fixed cost plus the $2,000 variable cost, which is $4,000. So the average total cost is $4,000/20, which is $200. After the advertising begins, the average total cost of a jacket is $180. The average total cost equals the total cost divided by the quantity. The fixed cost is $4,000. Because the marginal cost is $100 per jacket, the total variable cost is $5,000. So the total cost is the $4,000 fixed cost plus the $5,000 variable cost, which is $9,000. The average total cost is $9,000/50, which is $180.

b. Can you say what happens to the price of a Tommy Hilfiger jacket, Tommy’s markup, and Tommy’s economic profit? Why or why not? If the advertising has decreased the demand and made it more elastic, which is likely the case if all firms advertise, then the price will fall. However, if the advertising has increased the demand and made the demand less elastic, then the price will rise. If the price falls, then the makeup falls; if the price rises, then the markup rises. It is not possible to determine the effect on the profit in the short run. In the long run, however, the economic profit will equal zero as it does for all monopolistically competitive firms in the long run.

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Answers to Additional Problems and Applications 10.

Which of the following items are sold by firms in monopolistic competition in a developed economy such as the U.S? Explain your selection. • Potato chips • • • • •

There are many firms that produce potato chips and they produce many different varieties. Potato chips is an example of monopolistic competition.

Air conditioner While there are many different varieties of air conditioners, a few very large firms have a very large market share. Air conditioner is an example of an oligopoly.

Television There are many firms that produce televisions and they produce many different varieties. Televisions are an example of monopolistic competition.

Airplane While there are many different varieties of airplanes, two firms—Boeing and Airbus—dominate the industry. Airplane is an example of an oligopoly.

Battery While there are many different varieties of batteries, some of the battery firms have very high market share. Battery is an example of an oligopoly.

Rice There are many producers of rice, but each producer produces an identical product. Because rice is not a differentiated product, the market for rice is perfect competition.

11.

The HHI for automobiles is 2,350, for sporting goods it is 161, for batteries it is 2,883, and for jewelry it is 81. Which of these markets is an example of monopolistic competition? Sporting goods and jewelry are examples of monopolistically competitive markets.

Use the following information to work Problems 12 and 13. Lorie teaches singing. Her fixed costs are $1,000 a month, and it costs her $50 of labor to give one class. The table shows the demand schedule for Lorie’s singing lessons. 12.

Calculate Lorie’s profit-maximizing output, price, and economic profit.

Price (dollars per lesson) 0 50 100 150 200 250

Quantity demanded (lessons per month) 250 200 150 100 50 0

Lorie produces the quantity of singing lessons that sets her marginal cost equal to her marginal revenue. Lorie’s marginal cost is $50. Between the quantity of 50 and 100 lessons, Lorie’s marginal revenue is $100. Between 100 and 150 lessons, Lorie’s marginal revenue is $0. So at the quantity of 100 lessons Lorie’s marginal revenue is $50. To maximize her profit, Lorie sells 100 lessons. When Lorie sells 100 lessons, the price from her demand schedule is $150 per lesson. Lorie’s total revenue is $15,000. Her total cost is $1,000 (her fixed cost) plus $5,000 (her variable cost), which is $6,000. Lorie’s economic profit equals $15,000 − $6,000, which is $9,000.

13. a. Do you expect other firms to enter the singing lesson business and compete with Lorie? Lorie is making an economic profit so other firms will enter the singing-lesson industry to compete with Lorie.

b. What happens to the demand for Lorie’s lessons in the long run? What happens to Lorie’s economic profit in the long run? As new firms enter the singing-lesson industry, the demand for Lorie’s lessons will decrease. In the long run Lorie’s economic profit is eliminated and Lorie makes zero economic profit—a normal profit.

MONOPOLISTIC COMPETITION

Use Figure 14.2, which shows the situation facing Mike’s Bikes, a producer of mountain bikes, to work Problems 14 to 18. The demand and costs of other mountain bike producers are similar to those of Mike’s Bikes. 14.

What quantity does the firm produce and what is its price? Calculate the firm’s economic profit or economic loss. Mike’s Bikes produces 100 mountain bikes per week because this is the quantity at which MR = MC. The price of a mountain bike is $250 per bike because this is the highest price that people are willing to pay at the profit-maximizing quantity of 100 bikes. Mike’s Bikes incurs an economic loss. The average total cost of a bike is $300 and the price of a bike is $250. So Mike’s Bikes’ economic loss is equal to ($300 − $250)  100 bikes, which is an economic loss of $5,000.

15.

What will happen to the number of firms producing mountain bikes in the long run? The firms are incurring an economic loss, so some firms exit the market. In the long run, the number of firms producing mountain bikes decreases.

16. a. How will the price of a mountain bike and the number of bikes produced by Mike’s Bikes change in the long run? As long as Mike’s Bikes is a survivor, the demand for Mike’s Bikes increases. When demand increases, the marginal revenue also increases so Mike’s Bikes increases the quantity of bikes it produces.

b. How will the quantity of mountain bikes produced by all firms change in the long run? In the long run the price of a mountain bike rises, so in the long run the quantity of mountain bikes demanded (and the quantity produced) in the entire market decreases.

17.

Is there any way for Mike’s Bikes to avoid having excess capacity in the long run? If Mike’s Bikes maximizes its profit, it will have excess capacity. If Mike’s Bikes increases its production so that it produces at the minimum of its average total cost, it will incur an economic loss.

18.

Is the market for mountain bikes efficient or inefficient in the long run? Explain your answer. Based on the strict requirement for allocative efficiency, MSB=MSC, the market is definitely not efficient. In monopolistic competition the price of a mountain bike, which is the MSB of a mountain bike, is greater than the marginal cost of a mountain bike, which is the MSC of a mountain bike. However, viewed more widely the mountain bike market might be efficient. There are a variety of mountain bike producers, each producing a differentiated mountain bike. This large variety of different mountain bikes benefits consumers because it is more likely that each consumer will be able to find a mountain bike he or she likes.

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Use the following news clip to work Problems 19 and20. Yum! China: From Rebranding to Reinventing KFC China’s menu has evolved and become highly localized. It eliminated “super-size” items altogether, and added oven-roasted chicken, sandwiches, wraps, and different proteins such as fish, shrimp, and beef. Since 2002, KFC China has been opening for breakfast. They introduced Chinese favorite breakfast congee, which is now the number one seller at breakfast. KFC China is also positioned to appeal to Chinese families. Many restaurants have a play area, and hostesses organize activities. Source: Forbes, September 3, 2012 19. a. Explain how KFC has differentiated its fast food to compete with other restaurants in terms of quality, variety and marketing. KFC differentiated its fast food by localizing the menu and enriching the combination of meals. It has also worked on building a family-friendly and happy atmosphere at its outlets.

b. Predict whether KFC produces at, above, or below the efficient scale in the short run. In the short run KFC might produce at, above, or below its efficient scale; it is not possible to predict which.

20. a. Predict whether the price setting of KFC is at, above, or below marginal cost: (i) In the short run.

In the short run the price exceeds the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC.

(ii) In the long run. In the long run the price will exceed the marginal cost. For a monopolistically competitive firm, P > MR. And to maximize its profit, the firm produces so that MR = MC. Combining these results shows P > MC.

b. Assuming KFC charges its customers more for a localized menu and a family-friendly atmosphere, do you think that it makes the market for fast food inefficient? If KFC charges its customers more for a localized menu and a family-friendly atmosphere, it will possibly make the fast food market inefficient. On the one hand, allocative efficiency requires that MSB = MSC. The increased price for a localized KFC burger, which is its MSB, is greater than its marginal cost, which is the MSC. So production at KFC is not allocatively efficient. On the other hand, viewed more widely the fast food market might be more efficient with KFC. KFC adds to the variety of fast food available so that it is more likely that some consumers will be able to find a restaurant, such as KFC, that they like.

MONOPOLISTIC COMPETITION

Use the following news clip to work Problems 21 and 22. Apple Watch unveiled alongside new larger iPhones Apple has unveiled a smartwatch - the Apple Watch - its first new product line since the first iPad and the death of its co-founder Steve Jobs. The device runs apps, acts as a health and fitness tracker and communicates with the iPhone. Source: BBC News, March 9, 2015 21. a. How is Apple attempting to maintain economic profit? Apple is innovating by creating a new smartwatch. It expects that the demand for its smartwatch will be high and so it will be able to (temporarily) make an economic profit.

b. Draw a graph to illustrate the cost curves and revenue curves of Apple in the market for smartwatch. Figure 14.3 shows the situation at Apple. The firm produces 30 million smartwatches per year and sets a price of $350 per watch.

c. Show on your graph in part (b) the short-run economic profit. The economic profit equals the area of the yellow rectangle labeled A in Figure 14.3. 22. a.

Explain why the economic profit that Apple makes on its smartwatch is likely to be temporary. The economic profit is temporary because there are no barriers to entry. If Apple is indeed able to make an economic profit other firms will enter the market by producing smartwatches. As more firms produce the smartwatches the demand for Apple iwatch will decrease. As a result the quantity and price of Apple iwatch will decrease, which lowers their economic profit. In the long run, entry will eliminate the economic profit. (In reality, apple may keep its economic profit by developing new models and maintaining customer loyalty.)

b. Draw a graph to illustrate the cost curves and revenue curves of Apple in the market for smartwatches in the long run. Mark the firm’s excess capacity. Figure 14.4 shows the long-run equilibrium for Apple. The firm produces 25 million smartwatches and sets a price of $300 per watch. The firm makes zero economic profit (a normal profit) because its price equals its average total cost. The firm’s excess capacity is 7 million smartwatches, shown in the figure by the length of the red arrow between the quantity the firm produces and the quantity that minimizes the firm’s average total cost.

Use the following information to work Problems 23 to

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25. Bianca bakes delicious cookies. Her total fixed cost is $40 a day, and her average variable cost is $1 a bag. Few people know about Bianca’s Cookies, and she is maximizing her profit by selling 10 bags a day for $5 a bag. Bianca thinks that if she spends $50 a day on advertising, she can increase her market share and sell 25 bags a day for $5 a bag. 23.

If Bianca’s advertising works as she expects, can she increase her economic profit by advertising? If additional advertising enables sales to increase so that total revenue increases more than total cost, she can increase economic profit. In the case at hand, her total revenue will increase by $75 and her total cost will increase by $50 plus whatever is the increase in her variable cost of producing the cookies. Because her AVC when she produces 10 bags is only $1, it is likely that her variable costs will increase by less than $25, which means that advertising will be profitable.

24.

If Bianca advertises, will her average total cost increase or decrease at the quantity produced? Before she advertised, Bianca’s total variable cost was $10 and her total fixed cost was $40, so her total cost was $50. With this total cost and production of 10 bags of cookies, Bianca’s average total cost was $5 a bag. After she advertises, if her average variable cost remains $1 a bag, her total variable costs become $25, her total fixed costs are $90 (the initial fixed costs of $40 plus her advertising costs of $50) so her total cost is $115. With this total cost and production of 25 bags a day, Bianca’s average total cost is $4.60 a bag.

25. If Bianca advertises, will she continue to sell her cookies for $5 a bag or will she change her price? In the short run, presuming that advertising raises her demand, Bianca will raise the price of her cookies. In the long run Bianca’s price will equal her average total cost. If her average total cost remains below $5 a bag, in the long run her price will be forced down below $5 a bag.

Use the following news clip to work Problems 26 and 27. A Thirst for More Champagne Champagne exports have tripled in the past 20 years. That poses a problem for northern France, where the bubbly hails from—not enough grapes. So French authorities have unveiled a plan to extend the official Champagne grape-growing zone to cover 40 new villages. This revision has provoked debate. The change will take several years to become effective. In the meantime the vineyard owners whose land values will jump markedly if the changes are finalized certainly have reason to raise a glass. Source: Fortune, May 12, 2008 26. a. Why is France so strict about designating the vineyards that can use the Champagne label? France wants to protect the brand name for Champagne that has been created over the years. Consumers know that a wine labeled “Champagne” is high quality and France wants to avoid losing this perception since that belief increases the demand for the wine.

b. Explain who most likely opposes this plan. The vineyards that are presently part of the Champagne growing area likely will oppose this plan. If the growing area is expanded, the supply of close substitutes—wines labeled “Champagne”—will increase, which will decrease the demand for and the economic profit of the original wine producers.

27.

Assuming that vineyards in these 40 villages are producing the same quality of grapes with or without this plan, why will their land values “jump markedly” if this plan is approved? If the vineyards can label their wine as “Champagne,” then the demand for their wine is likely to “jump markedly” because consumers value the brand name. Essentially at very low cost the vineyards will be able to convey to consumers the information that their wine is high quality. With this information the demand for their wine will increase, which will increase their economic profit.

MONOPOLISTIC COMPETITION

28.

Under Armour’s Big Step Up Under Armour, the red-hot athletic-apparel brand, has joined Nike, Adidas, and New Balance as a major player in the market for athletic footwear. Under Armour plans to revive the long-dead cross-training category. But will young athletes really spend $100 for a cross training shoe to lift weights in? Source: Time, May 26, 2008 What factors influence Under Armour’s ability to make an economic profit in the cross-training shoe market? According to the news clip, Under Armour is "the red-hot athletic-apparel brand." Consumers are already purchasing its T-shirts, so they believe its products are high quality. After Under Armour enters the shoe market, its perceived high quality will able it to make an economic profit. When other firms see that Under Armour is making an economic profit, they will enter the market for cross training shoes. The greater the amount of competition in the market for athletic footwear, the smaller will be Under Armour's sales of its cross training shoe. And the smaller the sales, the smaller the economic profit.

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Economics in the News 29.

After you have studied Economics in the News on pp. 372–373, answer the following questions. a. Why do you think Babolat worked with the firm that helped Nintendo develop the Wii remote? Babolat’s designers have expertise in designing tennis rackets, not remote sensors. The company that helped develop the Wii remote has expertise in remote sensing and therefore is able to design and produce the remote sensors at lower cost than could Babolat. Consequently Babolat worked with that company so that each company concentrated on its competitive advantage.

b. How would Babolat’s cost curves (MC and ATC) have been different if they had not worked with the Wii developer? Babolat’s average total cost and marginal cost would have been higher if it had attempted to create the smart racquet by itself. Consequently, its ATC and MC curves would have been above the ATC and MC curves when it partners with the other company.

c. How do you think the launch of Babolat’s new-technology racquet has influenced the demand for other firms’ racquets? The creation of the smart racquet decreases the demand for older generation racquets.

d. Explain the effects of the introduction of the new-technology racquet on Prince and other firms in the market for tennis racquets. The introduction of the smart racquet decreased the demand for existing racquets made by Prince and other companies. This change lowered the price and quantity of their racquets and decreased the firms’ profit.

e. Draw a graph to illustrate your answer to part (c). Explain your answer. Figure 14.5 shows how the smart racquet affected the demand for other firm’s racquets. The demand for existing, say, Prince racquets decreased and the demand curve shifted leftward from D0 to D1. The price of a Prince racquet falls (in the figure from $225 per racquet to $100 per racquet) and the quantity decreased (in the figure from 400,000 racquets per year to 200,000 per year). Prince’s economic profit decreases. In the figure, after Babolat’s introduction of its smart racquet, Prince is incurring an economic loss because Prince’s price is less than its average total cost.

What do you predict will happen to the markup in the market for smart racquets? In the long run, there will be entry into the market for smart racquets. As more firms enter, the demand for the incumbent firms’ smart racquets decreases. As the demand decreases, the markup between marginal cost and price also decreases.

g. What do you predict will happen to excess capacity in the market for smart racquets? Explain your answer. In the long run, similar to all firms in monopolistic competition, the producers of smart racquets will have excess capacity. In the short run, however, the firms might not have excess capacity. Indeed, in the short run it is possible for the manufacturers to produce at a point beyond their capacity output.

C h a p t e r

OLIGOPOLY

Answers to the Review Quizzes Page 381 1.

What are the two distinguishing characteristics of oligopoly? Oligopoly has two distinguishing characteristics: Natural or legal barriers prevent the entry of new firms, and a small number of firms compete in the industry.

Why are firms in oligopoly interdependent? Firms in oligopoly are interdependent because each firm has a large market share and so each firm’s decisions have a major influence on its competitors’ profits.

Why do firms in oligopoly face a temptation to collude? Firms in oligopoly face the temptation to collude because if they can successfully collude, they can boost their economic profit.

Can you think of some examples of oligopolies that you buy from? The market for graphic accelerator cards is close to an oligopoly; the market for long-distance landbased telephone service is close to an oligopoly; the market for soft drinks is an oligopoly; and, the market for beer is an oligopoly.

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What are the common features of all games? All games share four common features: rules, strategies, payoffs, and outcome.

Describe the prisoners’ dilemma game and explain why the Nash equilibrium delivers a bad outcome for both players. In the prisoners’ dilemma game, each prisoner faces two strategies: confess or deny. There are four outcomes: i) Both prisoners confess and each receives more years in prison than if they both did not confess, ii) both prisoners deny, iii) prisoner A confesses and prisoner B denies, and iv) prisoner B confesses and prisoner A denies. In these last two outcomes, the confessing prisoner gets a lower sentence than if both confessed and lower than if they both denied. The dominant strategy for both prisoners is to confess. Regardless of what the other prisoner does, the best strategy for each prisoner is to confess, and both prisoners confess. This outcome is worse for both prisoners than if they each denied the crime, which creates the dilemma.

Why does a collusive agreement to restrict output and raise price create a game like the prisoners’ dilemma? Each firm has the possibility of sharing monopoly profits with other members of the cartel if each firm complies with the agreement. But each firm has an incentive to cheat on the collusive agreement in a cartel. If they all cheat, the outcome for each firm is worse than if they had all held to the agreement.

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What creates an incentive for firms in a collusive agreement to cheat and increase output? All firms in a collusive agreement face the same optimal strategies: their payoff is high if they all comply, but the payoff to any one firm that cheats is even higher if all the other firms comply. This motivates each firm to cheat on the agreement.

What is the equilibrium strategy for each firm in a duopolists’ dilemma and why do the firms not succeed in colluding to raise the price and profits? Each firm sees that its own profit is higher if it cheats on the agreement, and this strategy is best regardless of how any of the other firms act. This motivates all firms to cheat, and they all suffer an outcome that is far less profitable than if they all had complied with the agreement.

Describe the payoffs for an R&D game of chicken and contrast them with the payoffs in a prisoners’ dilemma. In the R&D game of chicken, a firm can use the R&D if either it conducts the R&D or if its competitor conducts the R&D. So if one firm conducts the R&D, it bears the cost and reaps the reward but the other firm reaps only the reward because it pays none of the costs. In a game of chicken, neither firm “wants” to do the R&D—both firms would prefer that the other conduct the R&D. In the prisoners’ dilemma R&D game, a firm can use the R&D only if it conducts R&D. If one firm conducts R&D, the firm incurs the costs of the R&D but then it alone reaps the rewards of the R&D. In this situation, both firms have the incentive to cheat on any agreement to restrict R&D because each firm knows that if it, and it alone cheats, its profit will increase.

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If a prisoners’ dilemma game is played repeatedly, what punishment strategies might the players employ and how does playing the game repeatedly change the equilibrium? Two strategies for motivating compliance in a repeated prisoner’s dilemma game are: i) a tit-for-tat strategy, where cheating by one firm in the current period is punished by the other firm cheating in the next period, but compliance by one firm in the current period is rewarded by compliance in the next period, ii) a trigger strategy, where cheating by one firm in the current period is punished by cheating by the other firm in all subsequent periods. Both strategies may create a cooperative equilibrium where all players share in the maximum possible benefit.

If a market is contestable, how does the equilibrium differ from that of a monopoly? A contestable market occurs when the firms in a market face potential entry from other firms due to low barriers to entry. While a monopoly free from the threat of entry will charge a high price and maximize economic profit, the firm or firms in a contestable market will keep price low and quantity produced high to deter potential entry by other firms outside the market. This benefits consumers, who enjoy near-competitive levels of output and a competitive market price.

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What are the two main antitrust laws and when were they enacted? The two acts of Congress that make up our main antitrust law and the years of their enactment are: a. The Sherman Act of 1890 b. The Clayton Act of 1914

When is price fixing not a violation of the antitrust laws? Price fixing among competitors always is a violation of antitrust law, whether or not the act was found to be harmful to consumers. If the Justice Department can prove the existence of price fixing, a defendant can offer no acceptable excuse. Price fixing between a supplier and a reseller is not illegal as long as it is not anticompetitive.

What is an attempt to monopolize an industry? In theory, attempts to monopolize an industry mean a firm is trying to become a monopoly. In practice, attempts to monopolize an industry are more difficult to define and are a matter of interpretation by the courts. The “rule of reason” seemed to say that size alone doesn’t constitute an attempt to monopolize as in the 1920 U.S. Steel case. But the “rule of reason” was overturned when size did

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matter as in the 1945 Alcoa case. Even in more recent cases, it is difficult to predict what the court will define as an attempt to monopolize. Decisions continue to be divided in this area of the law.

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What are resale price maintenance, tying arrangements, and predatory pricing? Resale price maintenance occurs when a manufacturer agrees with a distributor about the minimum price at which the product will be resold. Resale price maintenance agreements are illegal only if they are anticompetitive. Resale price maintenance can create inefficiency if it allows the manufacturer to set the monopoly price for its product. However it can create efficiency when it enables manufacturers to induce retail sellers to give the efficient level of sales service for the product. Tying arrangements occur when the seller agrees to sell one product to a buyer only if the buyer also buys another, different product. Tying can sometimes allow the producer to price discriminate and increase its profit. Tying arrangements can be illegal under the Clayton Act. Predatory pricing is setting a low price to drive competitors out of business to then set a high, monopoly price when the competition has gone. If predatory pricing occurs, it can lead to monopoly but economists are skeptical that it occurs often because the firm trades off a sure loss for an uncertain future profit.

Under what circumstances is a merger unlikely to be approved? A merger is likely to be approved by the Justice Department as long as the pre-merger HHI is less than 1,500. If the pre-merger HHI is between 1,500 and 2,500, the merger would be challenged if it raises the HHI by 100 or more points. If the pre-merger HHI is greater than 2,500, the merger generally would be blocked if it raises the HHI index by 200 or more points.

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Answers to the Study Plan Problems and Applications 1.

Intel and Advanced Micro Devices make most of the chips that power a PC. What makes the market for PC chips a duopoly? Sketch the market demand and cost curves that describe the situation in this market and that prevent other firms from entering. The market for PC chips, in particular the processor, is a natural oligopoly, most likely a natural duopoly. There are only two firms in the market, Intel and AMD, and there are no legal barriers to entry which limit the number of firms to two. Because other firms could enter the market but do not do so supports the idea that this industry is a natural duopoly. The cost curves and demand curve for this market would be similar to those in Figure 15.1, which shows the situation for a market in which two firms can satisfy the market demand. In this situation if a new firm entered the market it would be at a significant cost disadvantage compared to Intel and AMD and would likely incur an economic loss. Such a prospect deters entry by new competitors.

Sparks Fly for Energizer Energizer is gaining market share against competitor Duracell and its profit is rising despite the sharp rise in the price of zinc, a key battery ingredient. Source: www.businessweek.com, August 2007 In what type of market are batteries sold? Explain your answer. Batteries are sold in an oligopolistic market. There are two major sellers of batteries: Duracell and Energizer. The 4-firm concentration ratio is approximately 90%.

Oil City In the late 1990s, Reliance spent $6 billion to build a world-class oil refinery at Jamnagar, India. Now Reliance’s expansion will make it the world’s biggest producer of gasoline—1.2 million gallons of gasoline per day, or about 5% of global capacity. Reliance plans to sell the gasoline in the United States and Europe where it’s too expensive and politically difficult to build new refineries. The bulked-up Jamnagar will be able to move the market and Singapore traders expect a drop in fuel prices as soon as it’s going at full steam. Source: Fortune, April 28, 2008 a. Explain why the news clip implies that the global market for gasoline is not perfectly competitive. The news clip asserts that there is not free entry into the refining market. In particular, in the United States and Europe political reasons make it extremely costly for new refiners to enter the market. Therefore the few large refiners, such as that at Jamnagar, produce a significant share of the world market and hence one firm—Jamnagar—can influence the market price.

b. What barriers to entry might limit competition and allow Reliance to influence the price? Political barriers to entry limit entry into the refinery market. The public in the United States and Europe apparently considers refineries as undesirable neighbors because of pollution and, as such, do not want refineries situated nearby. Politicians respond to this pressure by enacting laws and regulations that make new refineries extremely costly to build in the United States and Europe.

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Consider a game with two players who cannot communicate, and in which each player is asked a question. The players can answer the question honestly or lie. If both answer honestly, each receives $100. If one player answers honestly and the other lies, the liar receives $500 and the honest player gets nothing. If both lie, then each receives $50. a. Describe the strategies and payoffs of this game. The game has 2 players (A and B), and each player has 2 strategies: to answer honestly or to lie. There are 4 payoffs: Both answer honestly and both receive $100; both lie and both receive $50; A lies, and B answers honestly and A receives $500 and B receives $0; and B lies, and A answers honestly and A receives $0 and B receives $500.

b. Construct the payoff matrix. The payoff matrix has the following cells: Both answer honestly: A gets $100, and B gets $100; both lie: A gets $50, and B gets $50; A lies and B answers honestly: A gets $500, and B gets $0; B lies and A answers honestly: A gets $0, and B gets $500. The payoff matrix is to the right.

c. What is the equilibrium of this game? The equilibrium is that each player lies and gets $50. If B answers honestly, the best strategy for A is to lie because he would get $500 rather than $100. If B lies, the best strategy for A is to lie because he would get $50 rather than $0. So A’s best strategy is to lie, no matter what B does. Repeat the exercise for B. B’s best strategy is to lie, no matter what A does.

d. Compare this game to the prisoners’ dilemma. Are the two games similar or different? Explain. The game is the same as a prisoners’ dilemma. In this game, as in the prisoners’ dilemma game, both players get the jointly worse equilibrium outcome because they cannot trust the other player to cooperate. If the players could cooperate, they would achieve a better result.

Soapy Inc. and Suddies Inc., the only soap-powder producers, collude and agree to share the market equally. If neither firm cheats, each makes $1 million profit. If one firm cheats, it makes $1.5 million, while the complier incurs a loss of $0.5 million. If both cheat, they break even. Neither firm can monitor the other’s actions. a. What are the strategies in this game? Construct the payoff matrix for this game. Each firm has two strategies: to comply with the agreement or to cheat on the agreement. The payoff matrix has the following cells: Both comply by the agreement: Soapy makes $1 million profit, and Suddies makes $1 million profit; both cheat: Soapy makes $0 profit, and Suddies makes $0 profit; Soapy cheats and Suddies complies with the agreement: Soapy makes $1.5 million profit, and Suddies incurs a $0.5 million loss; Suddies cheats and Soapy complies with the agreement: Suddies makes $1.5 million profit, and Soapy incurs $0.5 million loss. These payoffs are shown, in millions of dollars, in the matrix to the right.

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b. If the game is played only once what is the equilibrium? Is it a dominant-strategy equilibrium? Explain. The equilibrium is that both firms cheat and each makes normal profit. The equilibrium is a dominant strategy equilibrium because for each firm, regardless of the opponent’s choice, the best strategy is to cheat. If Suddies complies with the agreement, the best strategy for Soapy is to cheat because it would make a profit of $1.5 million rather than $1 million. If Suddies cheats, the best strategy for Soapy is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $0.5 million. So Soapy’s best strategy is to cheat, no matter what Suddies does. Repeating the exercise for Suddies shows that Suddies’s best strategy also is to cheat, no matter what Soapy does.

The World’s Largest Airline United Airlines and Continental Airlines announced a $3 billion merger to create the world’s biggest airline. The new airline will be able to better compete with low-cost domestic and foreign airlines. Travelers could face higher fares, although the merged airline has no such plans. But one rationale for any merger is to cut capacity. Source: The New York Times, June 7, 2010 Explain how this airline merger might (i) increase air travel prices or (ii) lower air travel production costs. (i) If the airline is competitive, the rationale that the firms can cut capacity will decrease supply and raise the price of air travel. However, some routes are served by only a handful of airlines and are definitely oligopolistic in nature. On those routes, the merger decreases the number of firms and makes a price-boosting cartel more likely to emerge and persist. (ii) The merged firms might be able to enjoy economies of scale from the increased production. For instance, they might be able to eliminate duplicate services (such as advertising agencies and accounting departments). It might also be able to gain some economies of scale, perhaps because the larger air fleet allows its mechanics to specialize in servicing particular types of planes.

b. Explain how cost savings arising from a cut in capacity might be passed on to travelers or boost producers’ profits. Which might happen from this airline merger and why? If, after the merger and cut in capacity, the market remains competitive, the competition forces the price down toward the (lower) average total cost. Hence competition can lead to the cost savings being passed along to consumers. On the other hand, if the merger and cut in capacity makes the market significantly less competitive, it becomes more likely that the airlines will be able to form a cartel (or reach an implicit agreement) to keep their prices high and thereby increase their profits. It is most likely that the outcome will be to keep the prices high and to increase the airlines’ profits.

If Soapy Inc. and Suddies Inc. play the game in Problem 5 repeatedly, on each round of play: a. What strategies might each firm might adopt? Each firm can adopt a tit-for-tat strategy or a trigger strategy, strategies that were not possible in a one-time game.

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b. Can the firms adopt a strategy that gives the game a cooperative equilibrium? The game has a cooperative equilibrium. If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. Take the case of the tit-for-tat strategy. If both firms comply for, say, three periods, both firms make $3 million profit. If a firm cheats in the first period while its opponent complies, the cheater makes a $1.5 million profit. In the second period, the opponent cheats, so if the first firm complies, it losses $0.5 million. In the third period the opponent will comply so the first firm can again cheat and make $1.5 million. However, in these three periods the total profit is only $2.5 million, so the cooperative equilibrium is possible.

c. Would one firm still be tempted to cheat in a cooperative equilibrium? Explain your answer. If the firms employ a trigger strategy or a tit-for-tat strategy, they can reach the cooperative comply/comply outcome. In these cases, the long-run profit from complying with the agreement exceeds that from cheating and so the cooperative equilibrium is likely. But a firm’s short-run profit would be larger if the firm (and that firm alone) cheated. So each firm still has an incentive to cheat because each firm can temporarily increase its profit.

AT&T offers iPhone users a $15 a month plan for 200 megabytes of data and a $25 a month plan for 2 gigabytes of data. It won’t take Verizon Wireless long to begin offering data plans too. Source: Cnet News, June 3, 2010 a. Is AT&T likely to be using predatory pricing? AT&T is unlikely to use predatory pricing. If AT&T tried to use predatory pricing to drive, say, Verizon Wireless out of the market, AT&T might or might not succeed. But regardless of its success or failure, AT&T would definitely experience lower profits, perhaps even economic losses during its period of predatory pricing. And if AT&T does succeed in driving Verizon Wireless out of the market and then boosts its price, then other competitors—Sprint, for instance—might enter the market, thereby eliminating AT&T’s attempt to earn an economic profit through its higher prices.

b. If a price war develops in the market for data services, who benefits most? The consumers benefit the most because they wind up paying a lower price.

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Answers to Additional Problems and Applications 9.

New Entrants Pose a Challenge to Boeing's Share of the Global Commercial Airplane Market Competition is going to get tougher for Boeing. Currently, the global commercial airplane market for airplanes with a seating capacity of over 100 passengers is lead by Boeing and Airbus. Last year, Boeing with 648 commercial airplane deliveries occupied 43 percent of this market. Airbus with 626 commercial airplane deliveries stood second. Source: Forbes, March 06, 2014 a. According to Reuters, the market share of Boeing in the large commercial aircraft segment was above 75 percent before 1990. Describe how the structure of the airplane market has changed over the past few decades. The structure of the airplane market has changed from a virtual monopoly before 1990, where Boeing occupied more than three quarters of the entire market, to a more oligopolistic market, in which Boeing’s market share has fallen below 50 percent and Airbus’s market share has grown close to Boeing.

b. If Boeing and Airbus formed a cartel, how would the price charged for airplanes and the profits made change? If Boeing and Airbus successfully formed a cartel, the price of airplanes would rise and their profits would increase.

Use the following data to work Problems 10 and 11. Bud and Wise are the only two producers of aniseed beer, a New Age product designed to displace root beer. Bud and Wise are trying to figure out how much of this new beer to produce. They know: (i) If they both produce 10,000 gallons a day, they will make the maximum attainable joint economic profit of $200,000 a day, or $100,000 a day each. (ii) If either firm produces 20,000 gallons a day while the other produces 10,000 a day, the one that produces 20,000 gallons will make an economic profit of $150,000 and the other will incur an economic loss of $50,000. (iii) If both produce 20,000 gallons a day, each firm will make zero economic profit. 10. Construct a payoff matrix for the game that Bud and Wise must play. The payoff matrix has four cells: Both limit production: Bud makes $100,000 profit, and Wise makes $100,000 profit; both expand production: Bud makes $0 profit, and Wise makes $0 profit; Bud limits production and Wise expands production: Bud incurs an economic loss of $50,000, and Wise makes an economic profit of $150,000; Bud expands production and Wise limits production: Bud makes an economic profit of $150,000, and Wise incurs an economic loss of $50,000. These payoffs, in thousands of dollars, are shown in the payoff matrix.

11.

Find the Nash equilibrium of the game that Bud and Wise play. The Nash equilibrium is for both Bud and Wise to expand production. From Bud’s perspective, if Wise limits production Bud’s profit is larger if it expands production. If Wise expands production then Bud’s profit is larger if Bud expands production. For Bud “expand production” is a dominant strategy. Wise’s situation is similar, so Wise, too, has a dominant strategy of “expand production.”

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Asian Rice Exporters to Discuss Cartel The Asian rice-exporting nations planned to discuss a proposal that they form a cartel. Ahead of the meeting, the countries said that the purpose of the rice cartel would be to contribute to ensuring food stability, not just in an individual country but also to address food shortages in the region and the world. The cartel will not hoard rice and raise prices when there are shortages. The Philippines says that it is a bad idea. It will create an oligopoly, and the cartel could price the grain out of reach for millions of people. Source: CNN, May 6, 2008 a. Assuming the rice-exporting nations become a profit-maximizing colluding oligopoly, explain how they would influence the global market for rice and the world price of rice. To maximize their profit, the nations would decrease the quantity of rice they produce and raise its price. Similar to any monopoly, they would produce the quantity of rice so that the marginal cost equals the marginal revenue and then use the demand curve to determine the highest price that enables them to sell the profit-maximizing quantity.

b. Assuming the rice-exporting nations become a profit-maximizing colluding oligopoly, draw a graph to illustrate their influence on the global market for rice. Figure 15.2 shows the outcome of this cartel in the market for rice. Before the oligopoly organized, the rice market was competitive. The equilibrium price and quantity were determined by the intersection of the market demand and market supply. In the figure the competitive market supply curve is MC, so before the oligopoly the equilibrium price was $1.50 per pound and 30,000 tons of rice were produced. After the oligopoly organized, the equilibrium quantity decreases to 20,000 tons of rice and the price of a pound of rice rises to $2.00 per pound.

c. Even in the absence of international antitrust laws, why might it be difficult for this cartel to successfully collude? Use the ideas of game theory to explain. The rice exporting countries will find it difficult to successfully collude for two reasons. First, as is the case in any successful cartel, the incentive is for each producer to cheat on the collusive agreement by producing more rice. This incentive lowers the likelihood that the cartel will succeed. In addition, the members of the cartel are not the only rice exporting countries. Other countries also export rice and, if the price of rice rises, still other countries could export rice. If the cartel is temporarily successful in raising the price, other nations will increase their production of rice, which will drive the price back down.

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13.

Suppose that Apple and Samsung each develop their own versions of a new smartphone that is totally different from the existing ones. Their products have similar functions and design. Each firm is trying to decide whether to sell the new smartphone at a high price or a low price. What are the likely benefits from each action? Which action is likely to occur? If a company sells the new smartphone at a high price and the competitor sells it at a low price, it is likely that the one selling at a low price will gain market share and a larger economic profit. If both companies sell the new smartphone at a low price, it is likely that both companies will make a comparable economic profit. And if both companies sell the new smartphone at a high price, it is likely that both companies will make the largest economic profit because the price elasticity is low. The payoff matrix on top reflects this analysis. The numbers in the matrix are the economic profit for the companies. Apple’s profits are in the blue upper triangles and Samsung’s profits are in the white lower triangles. The fact that for any given situation Apple’s profits are larger than Samsung’s is realistic but does not affect the analysis. The joint profit is the largest when the news smartphone is sold at a high price and is the smallest when it is sold at a low price. With the profits in the payoff matrix, the Nash equilibrium is to sell the smartphone at a low price, which will likely occur when the two companies do not communicate prior to setting prices because in the absence of information about the competitor’s move, the more profitable strategy of each company is always setting a low price, regardless of the competitor’s ultimate pricing. The joint profit will be $7 million. On the contrary, if the two collude, i.e. both promising to set a high price, the best scenario where the joint profit is the largest ($11 million) may be achieved, but this requires that neither of them cheats. This is an example of the prisoners’ dilemma.

14.

Why do Coca-Cola and PepsiCo spend huge amounts on advertising? Do they benefit? Does the consumer benefit? Explain your answer by constructing a game to illustrate the choices CocaCola and PepsiCo make. Coca-Cola and PepsiCo are engaged in an advertising game. In an advertising game, two firms can advertise or not advertise. Advertising is costly but if one firm advertises and the other does not, the one not advertising loses market share and profit while the one advertising gains market share and profit. Both firms would be better if neither advertised but the Nash equilibrium is that both firms advertise. The game to the right is a possibility. Both companies have the choice of whether to advertise or not. Coke’s economic profits, in millions of dollars, are in the grey triangles and Pepsi’s profits, also in millions of dollars, are in the white triangles. If both advertise, each makes a profit of $100 million; if

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one advertises but the other does not, the one advertising makes a profit of $500 million and the one not advertising incurs a loss of $100 million; and if neither advertise, each makes a profit of $300 million. The Nash equilibrium of this game is for each firm to advertise. Consumers benefit if the advertising gives them new information, for example information about a new drink. They also benefit if the advertising allows the firms to increase their production and enjoy economies of scale that allow lower prices. At one time in history, it is likely that consumers benefited from lower prices due to the increased economies of scale as Coca-Cola and PepsiCo drove smaller firms from the market. Today, however, most of the advertising does not convey new information and there are probably not many economies of scale left to exploit. It is likely that consumers are generally harmed by the advertising because the price of the product is higher.

Use the following news clip to work Problems 15 and 16. PS4 vs. Xbox One Battle Means Gamers Win, Sony Says Microsoft’s latest move in the PlayStation 4 vs. Xbox One battle was to lower the price of Xbox One to $399--the same price as the PS4. Source: GameSpot, July 1, 2014 15. a. Thinking about the competition between Sony and Microsoft in the market for game consoles as a game, describe the firms’ strategies concerning design, marketing, and price. Strategies are all the possible actions of each of the players. The news clip shows that the current strategy in the game between Sony and Microsoft is setting the price, with the possibility of setting a high price or a low price.

b. What, based on the information provided, turned out to be the equilibrium of the game? The equilibrium of the game was the outcome that occurred in the market for game consoles: Both ultimately set a low price as Microsoft lowered its price to equal Sony’s price.

16.

Can you think of reasons why the three consoles are so different? The consoles are so different because the firms also are competing, in large part, in innovation and technology. In particular, each manufacturer is innovating in a way that it expects will most appeal to consumers.

17.

If Bud and Wise in Problems 10 and 11 play the game repeatedly, what is the equilibrium of the game? If the game is played repeatedly, then Bud and Wise might be able to reach the cooperative equilibrium (both limit production) if they use a tit-for-tat or trigger strategy.

18.

Agile Airlines’ profit on a route on which it has a monopoly is $10 million a year. Wanabe Airlines is considering entering the market and operating on this route. Agile warns Wanabe to stay out and threatens to cut the price so that if Wanabe enters it will make no profit. Wanabe determines that the payoff matrix for the game in which it is engaged with Agile is shown in the table. Does Wanabe believe Agile’s assertion? Does Wanabe enter or not? Explain. Wanabe does not believe Agile’s assertion. If Wanabe does not enter, Agile’s best strategy is to set a high price. And, even if Wanabe enters the market, Agile’s best strategy is to set a high price because Agile has a larger payoff from setting a high price, 7, than by setting a low price, 1. So Wanabe has no reason to believe Agile’s assertion. Wanabe enters the market. If Wanabe does not enter, Wanabe receives a payoff of 0. If Wanabe enters, Agile sets a high price and so Wanabe receives a payoff of 5.

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19.

Price War in the Airline Industry All four leading U.S. airlines—American Airlines, Delta, United, and Southwest—are down about 10 percent from their respective highs set two weeks ago. The fall came after Southwest Airline's decision to increase fleet capacity 7 percent and American Airline's response that they will “compete aggressively” on price to retain customers from low-cost carriers resulting from capacity increases. Source: www.seekingalpha.com, June 1, 2015 As implied in the news clip, what type of market best describes the U.S. airline industry? The news clip implicitly views the U.S. airline industry as an oligopoly.

Use the following news clip to work Problems 20 and 21. Gadgets for Sale … or Not How come the prices of some gadgets, like the iPod, are the same no matter where you shop? No, the answer isn’t that Apple illegally manages prices. In reality, Apple uses an accepted retail strategy called minimum advertised price to discourage resellers from discounting. The minimum advertised price (MAP) is the absolute lowest price of a product that resellers can advertise. Marketing subsidies offered by a manufacturer to its resellers usually keep the price at or above the MAP. Stable prices are important to the company that is both a manufacturer and a retailer. If Apple resellers advertised the iPod below cost, they could squeeze the Apple Stores out of their own markets. The downside to the price stability is that by limiting how low sellers can go, MAP keeps prices artificially high (or at least higher than they might otherwise be with unfettered price competition). Source: Slate, December 22, 2006 20. a. Describe the practice of resale price maintenance that violates the Sherman Act. Resale price maintenance in which a manufacturer agrees with a distributor on the price for which a product will be sold is illegal under the Sherman Act if the practice is judged to be anticompetitive. Whether a particular resale price maintenance program is illegal or not is judged on a case-by-case basis.

b. Describe the MAP strategy used by Apple and explain how it differs from a resale price maintenance agreement that would violate the Sherman Act. The MAP strategy used by Apple does not run afoul of the Sherman Act prohibition of resale price maintenance because Apple does not agree with the retailer about the price. Instead Apple “rewards” those retailers who do not lower their price below the MAP by giving those retailers money to help them pay for advertising the iPod. Apple “punishes” retailers who set a price lower than the MAP by not giving those retailers money to help pay for advertising.

21.

Why might the MAP strategy be against the social interest and benefit only the producer? The MAP might harm consumers because it keeps the price of iPods higher than would otherwise be the case if the retailers competed more vigorously on price. In this case, the producers benefit but society is made worse off because the high price means that fewer than the allocatively efficient quantity of iPods are sold.

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Economics in the News 22.

After you have studied Economics in the News on pp. 398–399, answer the following questions. a. What are the strategies of T-Mobile and AT&T in the market for cellphone service? The strategies of T-Mobile are to increase the value of a cellphone service plan or not increase the value of the service plan. The strategies of AT&T are to keep the price of its service plan constant or lower the price.

b. Why, according to the news article, is it that AT&T and T-Mobile are in a fierce battle? AT&T and T-Mobile are in a particularly fierce battle because their cell phone technologies are similar, which makes it easier for customers to switch from one company to the other.

c. Why wouldn’t AT&T stick with its high price and leave T-Mobile to incur the cost of offering higher-valued plans? If T-Mobile improves the value of its plans, AT&T’s profit is larger if it cuts the price of its plans. If AT&T had kept its price high, its sales would suffer and its profit would be significantly smaller.

d. Could T-Mobile do something that would make it the market leader? Would that action maximize T-Mobile’s profit? T-Mobile could slash the price it charges for its (enhanced) plans and win market share away from AT&T. But by so doing T-Mobile could suffer a loss on each plan it sold and therefore T-Mobile would not be maximizing its profit.

23.

Boeing and Airbus Predict Asian Sales Surge Airlines in the Asia-Pacific region are emerging as the biggest customers for aircraft makers Boeing and Airbus. The two firms predict that over the next 20 years, more than 8,000 planes worth up to $1.2 trillion will be sold there. Source: BBC News, February 3, 2010 a. In what type of market are big airplanes sold? There are only two sellers of big airplanes, so this market is an oligopoly.

b. Thinking of competition between Boeing and Airbus as a game, what are the strategies and the payoffs? Boeing and Airbus are playing the duopolists’ game. They can set either low prices or high prices. If both Boeing and Airbus set low prices, then they will both make a smaller profit, perhaps even zero economic profit. If they both set high prices, then both will make a large economic profit. However, if one sets a low price and the other sets a high price, then the one with the low price will make a very large economic profit and the one with the high price will incur an economic loss.

c. Set out a hypothetical payoff matrix for the game you’ve described in part (b). What is the equilibrium of the game? The payoff matrix is to the right. In it the profits are in millions of dollars. The equilibrium is the prisoners’ dilemma equilibrium, that is, both firms set low prices and both make zero economic profit.

d. Do you think the market for big airplanes is efficient? Explain and illustrate your answer. The market for big airplanes is probably not efficient. It is efficient only if Boeing and Airbus compete against each other as if they were in perfect competition. But this outcome is unlikely. More likely is an

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outcome in which Boeing and Airbus together operate a monopoly or, if not precisely as a monopoly, then approaching that status. This outcome is especially likely because Boeing and Airbus will be playing a repeated game in which they (potentially) compete with each other for over two decades. In that situation, the repeated game makes it more likely that they will reach the cooperative equilibrium in which they operate together as a monopoly. Figure 15.3 shows the range of outcomes. If the two firms compete with each other, the equilibrium will be the competitive equilibrium, where they sell a total of 300 planes per year at a price of $15 million per plane. This outcome is the efficient outcome. However if Boeing and Airbus attain the cooperative equilibrium in which they act together to reach the monopoly outcome, then a total of 200 planes per year is sold and the price is $20 million per plane. In this case the outcome is inefficient and a deadweight loss results.

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PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Answers to the Review Quizzes Page 411 1.

List the economic functions of governments. Governments exist to establish and maintain property rights, to provide nonmarket ways of allocating resources, and to create methods that redistribute income and wealth.

Describe the political marketplace. Who are the participants, what do they do, and what is a political equilibrium? Voters, firms, politicians, and bureaucrats interact in the political marketplace. Voters and firms demand policies. Voters provide votes and/or funds while firms supply funds and other help to politicians or political parties that supply the policies they want. Politicians and political parties supply the policies and in exchange receive votes and/or contributions from voters and firms. Politicians attempt to supply proposals that attract enough votes to be elected and then reelected. Bureaucrats are in charge of implementing the policies. The political equilibrium is a situation in which no one has the incentive to change their efforts or their policies.

Distinguish among public goods, private goods, common resources, and natural monopoly goods. Public goods are nonexcludable and nonrival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s use of the good does not decrease the amount available for other people. Private goods are excludable and rival. As a result, only the person who pays for the good can consume it and one person’s use decreases the amount available for others. Common resources are nonexcludable and rival. As a result, anyone can consume the good whether or not he or she paid for it and one person’s consumption decreases the amount available for other people’s consumption. Natural monopoly goods are nonrival and excludable. Potential users of the good can be excluded if they do not pay but once having paid their use of the good is nonrival.

Why are healthcare and education not public goods and why do governments play a large role in the markets for these services? Healthcare and education are not public goods because they are rival and excludable. But governments play a major role in the market for these services because a majority of voters want these goods provided to people regardless of the people’s ability to pay for them. Because of this view, public choices are used to determine the quantity of healthcare and education services provided.

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Page 415 1.

What is the free-rider problem? Why do free riders make the private provision of a public good inefficient? If a firm were to provide a public good, it would suffer from the free-rider problem, which arises when non-paying consumers consume the public good without paying, enjoying a “free ride.” Public goods are, in part, characterized by inability to exclude nonpaying consumers. A private firm would not receive a sufficient level of revenue to provide the efficient level of the public good.

Under what conditions will competition among politicians for votes result in an efficient provision of a public good? Competition in the political marketplace will provide the efficient quantity of a public good only if the voters are well informed and are motivated to carefully evaluate the alternative policies that the politicians propose.

How do rationally ignorant voters and budget maximizing bureaucrats prevent the political marketplace from delivering the efficient quantity of a public good? If the marginal benefit to the voter of becoming well informed about a particular policy issue is much smaller than the marginal cost of becoming well informed, the voter is likely to remain rationally ignorant about the policy and the level of any related public goods provision. The marginal benefit of providing public goods is very high to both bureaucrats and the contractors who are employed to produce and distribute the public goods. So they have a concentrated interest in lobbying politicians to direct the bureaucrats to provide more than the efficient quantity of the public good, even to where the net benefit to the economy is zero.

Explain why public choices might lead to the overprovision rather than the underprovision of a public good. Rational ignorance of voters, combined with lobbying by public goods contractors and bureaucrats, causes the political equilibrium to provide public goods at a higher level than is economically efficient. In this case, it is in the self-interest of the politicians to provide more than the efficient quantity of the public good because they reap benefits from the lobbyists and bureaucrats while suffering little or no loss from voters.

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What is special about healthcare that makes it a good provided by the government? The government provides healthcare services because the marginal social benefit of healthcare exceeds the marginal benefit perceived by its consumers, Consumers underestimate the benefit of healthcare because they underestimate the health risks they face. They also underestimate their future needs for healthcare. And some people cannot afford the healthcare they need. For these reasons the majority of voters want healthcare to be available on need rather than on the ability and willingness to pay

Why would the market economy produce too little healthcare? The markets for healthcare will produce less than the efficient quantity because consumers of healthcare take account of only the benefits that accrue to them. They ignore the marginal social benefit that exceeds their perceived marginal benefit. Therefore the consumers’ demand for healthcare is less than the marginal social benefit from healthcare so the quantity of healthcare services produced is less than the efficient quantity.

How do Canada and the United Kingdom deliver healthcare and what is the problem left unresolved? Canada and the United Kingdom provide healthcare using a universal coverage, single payer system. Everyone is covered by health insurance and the government pays for all healthcare services. The government’s public choice determines the quantity of healthcare services provided. Consumers pay little or nothing for any healthcare service. Consequently the quantity of healthcare services demanded exceeds the quantity provided by the government which creates a problem: There often is a long waiting period until a patient receives services.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

What are the problem with Medicare and Medicaid? The government expenditure on Medicare and Medicaid are determined by the quantity of healthcare demanded, not by a fixed government budget. The scale of expenditure on Medicare and Medicaid in the United States is much than that in other rich nations. The U.S. population is aging. Older people demand more healthcare services than do younger people. Consequently, without changes in the Medicare and Medicaid programs, the expenditure on these programs, already huge, will increasingly grow.

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What is the problem that Obamacare seeks to solve and how does the solution work? The Patient Protection and Affordable Care Act, or Obamacare, attempts to overcome the problem of too many people who do not have health insurance. It seeks to make quality, affordable, private healthinsurance plans available for those currently uninsured and to stop insurance companies from denying coverage of pre-existing conditions, This act created a Health Insurance Market in which subsidized health insurance is provided. On the supply-side of the market are private healthcare insurance companies. On the demand-side are individuals. Many of the consumers qualify for subsidies which lower the cost to them of the healthcare insurance. By reducing the price, the act increases the number of people with healthcare insurance.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Answers to the Study Plan Problems and Applications 1.

Classify each of the following items as excludable, nonexcludable, rival, or nonrival. Explain your answer. • A Big Mac • •

•

A Big Mac is excludable and rival. It’s excludable because a person must pay for a Big Mac to consume it. It’s rival because one person’s consumption decreases the quantity available for others to consume.

Brooklyn Bridge The Brooklyn Bridge is nonexcludable (because there is no toll for using it) and rival (especially when it is crowded).

A view of the Statue of Liberty Viewing the Statue of Liberty is nonexcludable and nonrival. It is nonexcludable because a person cannot be prevented from viewing the statue and it is nonrival because one person’s view does not decrease people’s views.

A hurricane warning system A hurricane warning system is nonexcludable and nonrival. It is nonexcludable because once a warning is sounded, everyone can learn of it and nonrival because one person learning of the warning does not limit other people’s use of the warning.

Classify each of the following items as a public good, a private good, a natural monopoly good, or a common resource. Explain your answer. • Highway control services •

• •

Highway control services are nonexcludable and nonrival so they are a public good.

Internet service Internet service is a natural monopoly good. Internet service is excludable because a consumer must pay for the service or else he or she does not receive it. But once access is granted, use of Internet service is nonrival.

Fish in the Atlantic ocean Fish in the ocean are a common resource because they are nonexcludable and rival.

UPS courier service UPS is rival (a carrier cannot deliver a package to my house and your house simultaneously) and excludable (a user must pay) so it is a private good.

• •

For each of the following goods, explain why a free-rider problem arises or how is it avoided. July 4th fireworks display The fireworks display is a public good so there is a potential free-rider problem. Area residents might be taxed to finance the display, but visitors to the area, who don’t pay local taxes, are free riders.

Interstate 81 in Virginia Interstate 81 potentially has a free rider problem. However if the state of Virginia uses the gas tax revenue it receives from the sale of gasoline near the interstate to pay to maintain the freeway, then users of the Interstate pay for the road. In this case there is no free rider problem.

Wireless Internet access in hotels Wireless Internet access in hotels can avoid the free rider problem if the hotel limits access to guests staying at the hotel.

The public library in your city The public library has a free rider problem because people can use the library even if they pay no taxes to support it. Potentially the free rider problem can be mitigated if the library charges a fee for its services.

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The table sets out the benefits that Terri and Sue receive from on-campus police at night. Suppose that Terri and Sue are the only students on the campus. Draw a graph to show the marginal social benefit from the police at night. The marginal social benefit at every number of police officers equals Terri’s marginal benefit plus Sue’s marginal benefit. Figure 16.1 shows the marginal social benefit curve.

Use the data on a mosquito control program in the table to work Problems 5 and 6. 5.

What quantity of spraying would a private firm provide? What is the efficient quantity of spraying? In a single-issue election on mosquito spraying, what quantity would the winner provide?

Police officers on duty (number per night) 1 2 3 4 5

Marginal benefit Terri Sue (dollars per police officer)

Quantity (square miles sprayed per day)

Marginal social cost

1 2 3 4 5

18 14 10 6 2

22 18 14 10 6

Marginal social benefit (thousands of dollars per day) 2 10 4 8 6 6 8 4 10 2

Mosquito spraying is a public good and subject to free riding. As a result, a private mosquito would supply no spraying. The efficient quantity of spraying is 3 square miles a day, which is the quantity at which marginal social cost equals marginal social benefit. In a single issue election, the outcome will be that each party eventually proposes spraying 3 square miles per day and the election outcome will be the efficient quantity of spraying.

If the government appoints a bureaucrat to run the program, would mosquito spraying most likely be underprovided, overprovided, or provided at the efficient quantity? With the bureaucratic department in charge of spraying, mosquito spraying likely would be overprovided.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Use the following figure, which shows the marginal benefit from health insurance and the willingness and ability to pay for it, to work Problems 7 to 10. The marginal cost of insurance is a constant $6,000 per family per year. Marginal social benefit from insurance exceeds the willingness and ability to pay by a constant $4,000 per family per year. 7.

With no public health insurance market, how many families buy insurance, what is the premium, and is the coverage efficient? With a private and competitive health insurance market, the price of health insurance equals the marginal cost, or $6,000 per year. At this price, 10 million families buy insurance. The coverage is not efficient because the marginal social benefit exceeds the marginal (private) benefit. When 10 million families are insured the marginal social benefit is $10,000, which exceeds the marginal cost of the insurance. Accordingly insurance is underprovided by the private market.

If the government provides healthcare to achieve the efficient coverage, how many families are covered and how much must taxpayers pay? The efficient quantity of health insurance is 50 million families covered. At this quantity, the marginal social benefit equals the marginal benefit of $2,000 plus $4,000, or $6,000. Therefore the marginal social benefit equals the marginal cost, so 50 million families covered is the efficient quantity. With 50 million families insured, the demand curve shows that consumers will pay $2,000 per family. The marginal cost of this quantity of policies is $6,000 so the taxpayers must subsidize each family by an amount of $6,000 − $2,000, or $4,000. Therefore the total subsidy taxpayers must pay is $4,000 per family multiplied by 50 million families, or $200 billion.

If the government subsidizes private insurers, what subsidy will achieve the efficient coverage? To insure 50 million families, the insurers’ total cost equals $6,000 per family multiplied by 50 million, or $300 billion. With 50 million families covered, the demand curve shows that a family is willing to pay $2,000 per policy. Accordingly families will pay 50 million × $2,000, or $100 billion. Therefore the government must provide a subsidy of $200 billion to private insurers.

10.

If the government gave coverage to everyone what problems would arise in the related market for healthcare services? If the government gave everyone coverage, then 70 million families—the quantity of insurance policies demanded at a price of $0—will be insured. This larger quantity of insured households means that the quantity of healthcare services will be larger. Unless the government is going to provide additional healthcare services, there will be a long wait until a patient can receive treatment, at least for non-life threatening ailments.

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Answers to Additional Problems and Applications 11.

•

Classify each of the following items as excludable, nonexcludable, rival, or nonrival. Oxygen in the air Oxygen in the air is nonrival (the use of oxygen in the air by one person does not decrease the quantity available for someone else) and nonexcludable (it is impossible to prevent anyone from benefiting from it).

•

A bottle of wine

•

A view of a harbo

A bottle of wine is rival and excludable. A view of a harbor is nonexcludable and nonrival.

•

A public square

•

A Facebook post

A public square is nonexcludable. It is generally nonrival except in very crowded areas A Facebook post is nonexcludable because anyone can post for the same item and is nonrival because one person’s post does not decrease the posts available to anyone else.

12.

Classify each of the following items as a public good, a private good, a natural monopoly good, or a common resource. Explain your answer. • A free ice-cream •

A free ice-cream is a private good. It is excludable and rival. It is only for free in price, but there are costs for producing the ice-cream.

Wild goats in the forest Wild goats in the forest are a common resource because they are nonexcludable and rival.

•

Wealth management services

•

A Highway

Wealth management service is a private good because they are excludable and rival. A highway is a natural monopoly good because it is excludable but once access is granted, use of it is nonrival except when there is a traffic congestion.

13.

Classify each of the following goods as either a private good, a public good, a natural monopoly good, or none of the above. • A pair of glasses •

A pair of glasses is excludable and rival so it is a private good.

WiFi service Wifi service is a natural monopoly good. It is excludable because a consumer must pay for access. But once access is granted, use of the WiFi service is nonrival.

•

Swimming pool

•

A smartphone

•

Public library

Swimming pool is a private good because it is excludable and, when crowded, is rival. A smartphone is a private good. The public library is nonexcludable and rival so it is none of the above. (It is a common resource.)

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

14.

The table sets out the marginal benefits that Sam and Nick receive from the town’s street lighting: a. Is the town’s street lighting a private good or a public good? It is a public good.

b. Suppose that Sam and Nick are the only residents of the town. Draw a graph to show the marginal social benefit from the town’s street lighting.

Number of street lights 1 2 3 4 5

Marginal benefit Sam Nick (dollars per street light) 10 12 8 9 6 6 4 3 2 0

Figure 16.3 shows the marginal social benefit curve. The marginal social benefit at every quantity equals Sam’s marginal benefit plus Nick’s marginal benefit.

15.

What is the principle of diminishing marginal benefit? In Problem 14, does Sam’s, Nick’s, or the society’s marginal benefit diminish faster? The principle of declining marginal benefit asserts that as the quantity of the good or service consumed increases, the marginal benefit of an additional unit decreases. Society’s marginal benefit decreases more rapidly than does Sam’s marginal benefit or Nick’s marginal benefit. For every additional street light, Sam’s marginal benefit decreases by $2, Nick’s marginal benefit decreases by $3, and society’s marginal benefit decreases by $5.

Use the following news clip to work Problems 16 and 17. Chinese auditors find billions collected in illegal road tolls Since 1984, the government has let high-quality roads be built with bank credit and loans that would be then repaid through charging the motorists. However, some local governments use toll roads to raise funds. They set up excessive numbers of tollgates, raise charging standards and prolong tolling terms— against all of which the motorists have a problem. Source: www.China.org.cn, February 27, 2008 16. What are the advantages and disadvantages of letting the government control toll roads? The advantage is that the government is expected to work for social benefit and thus, efficiently allocate funds while financing new infrastructure. In this case, after the construction of roads and highways, the government should charge optimal toll charges, repay the loan, and let people use them freely. The disadvantage is, if there is rampant corruption in the government, it will not manage the roads and highways efficiently and prolong tolling terms much to the chagrin of motorists, as in the news clip.

17.

What in this news clip points to a distinction between public production of a public good and public provision? Give examples of three public goods that are produced by private firms but provided by government and paid for with taxes. The difference between public production of a public good and public provision hinges around, whether, the public sector actually provides the public good, or it produces the good, and then the good is provided to the public by the private sector. For instance, many local governments contract with private agencies to provide sweeping services for streets that are a public good. Some

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governments have contracted with private companies for the day-to-day running of parks. Some countries even buy fighter planes from private companies for national defense.

18.

Vaccination Dodgers Doctors struggle to eradicate polio worldwide, but one of the biggest problems is persuading parents to vaccinate their children. Since the discovery of the vaccine, polio has been eliminated from Europe and the law requires everyone to be vaccinated. People who refuse to be vaccinated are “free riders.” Source: USA Today, March 12, 2008 a. Explain why someone who has not opted out on medical or religious grounds and refuses to be vaccinated is a “free rider.” The person who has not been vaccinating is free riding because he or she is benefiting from the people who have been vaccinated. The people who have been vaccinated will not spread the disease to others. The people who have not been vaccinated are enjoying a free ride because they are not providing the same disease prevention benefit to others.

b. Polio in poor countries such as Myanmar has reappeared in 2010 and is increasing. Are People are too poor to afford the vaccination “free riders”? Should vaccinations be compulsory? Explain your answer. People too poor to afford the vaccination are free riding but they are doing so involuntarily. Whether vaccinations should be compulsory is a normative decision, which will differ from one student to the next.

19.

Obamacare Hits Enrollment Goal A last-minute enrollment surge enabled the White House to meet its 7 million sign-up target for the Affordable Care Act. President Barack Obama said on Tuesday that 7.1 million people had signed up on federal or state exchanges for coverage under the healthcare law. Source: CNN, April 1, 2014 a. If the White House target was to enroll the efficient quantity of families in Obamacare, how would it have determined that target? The target would be the quantity of families that sets the marginal social benefit of healthcare insurance equal to the marginal cost.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

b. Draw a graph to illustrate the health insurance market and illustrate how the Obamacare subsidy influences the number of families covered. Figure 16.4 shows the market for health insurance. In the absence of any subsidy, the price of a health insurance policy is $4,000 per year and 30 million families buy a policy. The subsidy under Obamacare increases the quantity of families buying health insurance. Presuming that the subsidy brings about the efficient outcome, the figure shows that the subsidy is $4,000 per family. With this subsidy, 50 million families will buy insurance because the price paid for a policy falls to $2,000. In the figure, Obamacare has increased the number of families insured from 30 million to 50 million.

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c. How would the demand for health insurance change if the penalty for not signing up for Obama care were abolished? Draw a graph to illustrate the outcome The penalty increases the demand for health insurance. In Figure 6.5, with the penalty the demand curve for health insurance is DPenalty and the $4,000 subsidy per family leads to the efficient quantity of families insured, 50 million. But if the penalty is abolished, the demand curve for insurance is D = MB. In this case, the same $4,000 subsidy leads to only 40 million families being insured. There is a deadweight loss because the quantity of insured families is less than the efficient quantity. To reach the efficient quantity, in the absence of the penalty the subsidy needs to be increased to $6,000 per family.

Use the following information and figure to work Problems 20 and 22. The marginal cost of health insurance is a constant $8,000 a year and the figure shows the marginal benefit and willingness and ability to pay curve. Suppose that the marginal social benefit of insurance exceeds the willingness and ability to pay by a constant $2,000 per family per year. 20.

If all health insurance is private and the market for insurance is competitive, how many families are covered, what is the premium, and what is the deadweight loss created? If the market is private and competitive, the price of health insurance is $8,000 a year. As Figure 16.7 (on the next page) shows, the equilibrium quantity of policies is 10 million families insured. The efficient quantity, however, is 20 million quantities because that is the quantity that sets the marginal social benefit, MSB, equal to the marginal cost, MC. When only 10 million families are insured, the deadweight loss is the grey triangle in the figure. The area of this triangle is the amount of the deadweight loss and is equal to ½ × 10 million × $2,000 = $10 billion.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

21.

If the government decides to provide public health insurance (like Canada), what healthcare fee does it charge to achieve an efficient coverage? How much will taxpayers have to pay? If the government provides public health insurance as does Canada, Canada will insure 20 million families. The cost of insuring each family is $8,000. Canada uses a single payer method of health care, which means that the Canadian government pays for all health care expenditures. Therefore Canadian taxpayers must pay for the entire cost of the insurance, $8,000 × 20 million or $160 billion.

22.

If the government decides to subsidize health insurance (like Obamacare), what subsidy will achieve the efficient coverage? The subsidy must lead to insuring 20 million families because that is the efficient quantity that sets the marginal social benefit equal to the marginal cost. The demand and marginal benefit curve, D = MB, shows that the price of an insurance policy must be $6,000 per year to have 20 million families enrolled. The subsidy per family equals $8,000 − $6,000, or $2,000 per family.

Economics in the News 23.

After you have studied Economics in the News on pp. 424–425, answer the following questions: a. What is the source of revenue for constructing and maintaining the transportation infrastructure? The gasoline tax is the main source of funds for constructing and maintaining the transportation capital.

b. Why has that revenue source not grown fast enough to deliver an efficient scale of infrastructure provision? As cars become more fuel efficient, they use less gasoline, thereby generating less gasoline tax revenue. Taxpayers remember scandals over past use of these funds, so there is little support for raising the gasoline tax.

c. What other revenue sources can you suggest that could provide a solution to underprovision? General tax revenue could be used to maintain the infrastructure. More tolls could be established for using bridges and freeways, with the funds generated devoted to the infrastructure. Drivers might be taxed for the miles they drive rather than the gasoline they use, which could generate additional funds.

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d. How would you expect population growth to influence the marginal social benefit of highways and bridges? Population growth increases the marginal social benefit of highways and bridges.

e. Illustrate your answer to (d) by drawing a version of the figure on p. 423 that shows the effect of an increase in population. Figure 16.8 shows how the marginal social benefit curve shifts rightward to MSB1. As a result, the efficient number of bridges to repair increases from 6,000 per year to 8,000 per year.

24.

Who’s Hiding Under Our Umbrella? Students of the Cold War learn that, to deter possible Soviet aggression, the United States placed a “strategic umbrella” over NATO Europe and Japan, with the United States providing most of their national security. Under President Ronald Reagan, the United States spent 6 percent of total income on defense, whereas the Europeans spent only 2 to 3 percent and the Japanese spent only 1 percent, although all faced a common enemy. Thus the U.S. taxpayer paid a disproportionate share of the overall defense spending, whereas NATO Europe and Japan spent more on consumer goods or saved. Source: International Herald Tribune, January 30, 2008 a. Explain the free-rider problem described in this news clip. The free rider problem is that European nations and Japan relied on the United States to provide defense services against aggression from the Soviet Union. The United States paid about 6 percent of its total output on defense while its European and Japanese allies paid a much smaller percentage.

b. Does the free-rider problem in international defense mean that the world has too little defense against aggression? Free riding because of the public goods aspect of defense means that the world has too little defense against aggression.

c. How do nations try to overcome the free-rider problem among nations? Nations can sign treaties that either obligate them to cut their weapons systems or jointly develop new weapon systems. By cutting weapons, less additional defense spending is required, which limits the total amount of free riding that occurs. By jointly developing new weapon systems the nations eliminate free riding because all the nations who signed the treaty help pay for the weapons system.

C h a p t e r

EXTERNALITIES

Answers to the Review Quizzes Page 430 1.

What are the four types of externality? Externalities can be: a negative production externality, a positive production externality, a negative consumption externality, or a positive consumption externality.

Provide an example of each type of externality that is different from the ones described above. Dumping dangerous chemicals in river while producing paper is an example of a negative production externality. Baking bread and the resulting odor enjoyed by by-passers is an example of a positive production externality. Littering while hiking is an example of a negative consumption externality. Planting a beautiful bamboo garden that by-passers enjoy is an example of a positive consumption externality.

Page 438 1.

What is the distinction between private cost and social cost? A private cost of production is the cost of producing a good or service that is borne only by the producer. A social cost of production includes the private costs of production as well as the external costs of production borne by people other than the producer.

How do external costs prevent a competitive market from allocating resources efficiently? External costs create a marginal social cost (MSC) that exceeds the marginal private cost (MC) for producing or consuming a good or service. That is, with an external cost, MSC > MC. When the firm produces a good or service with an external cost, it chooses to produce the quantity at which marginal cost equals marginal benefit, MC = MB. Marginal benefit equals marginal social benefit, MSB. In this case, the firm produces the quantity at which MC = MSB. This level of production exceeds the level at which MSC = MSB. Too much of the good or service is produced, resulting in an inefficient allocation of resources.

How can external costs be eliminated by assigning property rights? The existence of a negative externality means some group must bear some of the costs of a production or consumption activity for which they are not involved. The Coase theorem implies that assigning a property right to either the group generating the externality or the group bearing the externality costs will eliminate the inefficient allocation of resources. The Coase theorem applies if the number of parties involved is small and if transactions costs are low.

How do taxes, pollution charges, and cap-and-trade work to reduce emissions? An emissions tax or pollution charge on the producers of the activities that generate pollution or other negative externality will force these producers, when deciding about their level of production, to take account of the external costs they impose on society. Producers' costs increase and, in response, they decrease their production, which decreases pollution emissions. For cap-and-trade, the regulating agency first determines the total amount of pollution to be allowed. Each firm that might potentially pollute is then assigned a permitted amount of pollution to be emitted per period and is allocated

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sufficient permits to allow this amount of pollution. For any firm to exceed this amount, it must buy permits held by another firm. Each firm faces an opportunity cost for selling its emissions permits, namely the cost of cleaning up its pollution. The price of buying an extra permit will reflect the opportunity cost of the firm that sells the permits. Those firms with lower costs of cleaning pollution will sell their permits to those firms with higher costs. The total amount of pollution emitted will equal the total amount allowed.

Page 443 1.

What is the tragedy of the commons? Give two examples, including one from your state. The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. The private market place will not produce the efficient quantity of a common resource. Some examples include the congestion of traffic during rush hour, the congestion near a college football stadium whenever a major game is played, or the free Internet access computer at the local library.

Describe the conditions under which a common resource is used efficiently. A common resource is used efficiently when the marginal social benefit equals the marginal social cost at the quantity produced.

Review three methods that might achieve the efficient use of a common resource and explain the obstacles to efficiency. There are three different methods that government can use to obtain the efficient allocation of resources in the event of a common resource: •

Property Rights are assigned to private property, which is a resource that someone owns and has an incentive to use in a way that maximizes its value. However, assigning property rights to resources is not always feasible, such as with the fish that migrate over the vast depths of the oceans.

•

Production Quotas can be set for total catch and divided among harvesting consumers so that the marginal social benefit from harvesting equals the marginal social cost of harvesting. However, it is in every harvester’s best interest to cheat on the quota, because marginal private benefit from exceeding the quota allotment is greater than the marginal cost of harvesting.

•

An Individual Transferable Quotas (ITQ) is a production limit that is assigned to an individual harvester who is free to transfer the quota to someone else.

Page 447 1.

Why would the market economy produce too little education? The markets for education will produce less than the efficient quantity because consumers of education take account of only the benefits that accrue to them. They ignore the marginal external benefit that others gain. Therefore the consumers’ demand for education is less than the marginal social benefit from education.

How might governments achieve an efficient provision of education? Governments could use public provision, private subsidies, or vouchers to achieve efficiency in the market for education. Public provision: The government could determine the efficient amount of education and create public colleges. This method is the primary method used for K-12 education. Private subsidies: The government could offer subsidies to private colleges. Vouchers: The government would give vouchers to students. Pell grants are an example of vouchers.

EXTERNALITIES

What are the key differences among public production, private subsidies, and vouchers? Public production means that the government is the producer of the product. Private subsidies, however, are given to private producers of the product. Both public production and private subsidies affect the supply-side of the market. Vouchers, however, are given to households to help pay for the product. Vouchers therefore affect the demand-side of the market.

Why do economists generally favor vouchers to achieve an efficient outcome? Economists generally favor vouchers because they allow for competition and they limit the opportunity for overproduction. First, a voucher gives the consumer of the good the buying power, which forces producers to compete for business. Vouchers allow for competition between public producers and private producers. Second, vouchers can also limit overproduction because setting the value of the vouchers and the total voucher budget is transparent so that bureaucrats have less ability to pad their budgets. In addition, vouchers spread the spending over millions of consumers so no one consumer has the incentive to lobby for increased spending.

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Answers to the Study Plan Problems and Applications 1.

Describe three consumption activities that create external costs. Wearing heavy perfume creates an external cost; littering fast-food containers or soda cans creates an external cost; and, a drunk at a bar creates an external cost.

Describe three production activities that create external benefits. Presuming people like the smell of baking bread, a bakery creates an external benefit; basic research creates an external benefit; and recycling at a business has an external benefit because it decreases the harm created by waste disposal sites.

Use Figure 17.1, which illustrates the market for cotton, to work Problems 3 and 4. Suppose that the cotton growers use a chemical to control insects and waste flows into the town’s river. The marginal social cost of producing the cotton is double the marginal private cost. 3.

If no one owns the river and the town takes no action to control the waste, what is the quantity of cotton and the deadweight loss created? 400 tons of cotton is produced. In Figure 17.2, the deadweight loss that is created is equal to the area of the grey triangle. So the deadweight loss is equal to ½ × ($75 per ton − $37.50 per ton) × 100 tons, which is $1,875.

If the town owns the river and taxes cotton growers so that the efficient quantity is grown. How much tax revenue does the town receive? Is the quantity of waste zero? Explain your answer. The tax is equal to the marginal external cost at the efficient quantity, $37.50 per ton of cotton. The efficient quantity of cotton is produced, 300 tons. Therefore the town receives $37.50 per ton × 300 tons, which is $11,250. The quantity of waste is not zero because 300 tons of cotton are produced. But the quantity produced is the efficient amount, so the marginal social benefit from the last ton of cotton produced equals the marginal social cost, which includes the external cost.

EXTERNALITIES

Use Figure 17.3 to work Problems 5 and 6.

The figure illustrates the market for North Atlantic tuna. 5. a. What is the quantity of tuna that fishers catch and the price of tuna? Is the tuna stock being used efficiently? Explain why or why not. When the market is unregulated, the quantity of fish caught and their price is determined by the equilibrium between supply and demand. The demand curve is the same as the MSB curve so Figure 17.3 shows that the equilibrium quantity of tuna is 80 tons and the equilibrium price is $100 per ton. The tuna stock is not being used efficiently, The efficient quantity of tuna is determined by the intersection of the MSC curve and the MSB curve. Figure 17.3 shows that the efficient quantity of tuna is 40 tons. Tuna, a common resource, is overfished.

b. What would be the price of tuna, if the stock of tuna were used efficiently? If tuna were used efficiently, 40 tons per month would be caught and the price would be $150 per ton.

With a quota of 40 tons a month for the tuna fishing industry, what is the price of tuna and the quantity caught? Does overfishing occur? With a quota of 40 tons per month, the quantity of tuna caught will be 40 tons and the price will be $150 per ton. As long as the quota is enforced so that fishers cannot cheat on their allocation, the equilibrium with the 40-ton quota is efficient. Tuna is not overfished.

Use Figure 17.4, which shows the demand for college education, to work Problems 7 to 9. The marginal cost is a constant $6,000 per student per year. The marginal external benefit from a college education is a constant $4,000 per student per year. 7.

What is the efficient number of students? If all colleges are private, how many people enroll in college and what is the tuition? The efficient number of students is 50,000 because this quantity is the number of students that sets the marginal social benefit equal to the marginal cost. If all colleges are private, then 30,000 students enroll in college because this quantity is the number that sets the marginal benefit equal to the marginal cost.

If the government provides public colleges, what tuition will achieve the efficient number of students? How much will taxpayers have to pay? The tuition will be $2,000 because this tuition will lead 50,000 students to enroll. The taxpayers must pay $4,000 per student (the $6,000 marginal cost minus the $2,000 tuition) for 50,000 students, so the taxpayers will pay $200,000,000 in total.

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If the government offers students vouchers, what is the value of the voucher that will achieve the efficient number of students? The efficient number of students is 50,000. The value of the voucher must be $4,000 a student. The private colleges charge tuition of $6,000 per student and, of this tuition, students pay $2,000 so 50,000 students enroll.

EXTERNALITIES

Answers to Additional Problems and Applications 10.

What externalities arise from smoking tobacco products and how do we deal with them? There are at least two externalities from smoking. First, many people who do not smoke find the smell of smoking offensive. Second, tobacco smoke can pose a health risk for non-smokers. To deal with these external costs, many locations ban smoking. For example, smoking on airplanes is illegal. Many states have banned smoking in restaurants. Some college campuses and most hospitals have gone “smoke free” by prohibiting smoking while on their premises.

11.

What externalities arise from beautiful and ugly buildings and how do we deal with them? Beautiful buildings create external benefits from the pleasure that people get from observing them. For ugly buildings, it is the reverse: They create external costs from the displeasure people get from observing them. To try to create more beautiful buildings, some locations require architectural review in which the planned building must pass inspection. Buildings of significant historical value are given heritage designations. People who pile trash around their buildings are fined.

12.

Betty and Anna work at the same office in Philadelphia and they have to attend a meeting in Pittsburgh. They decide to drive to the out-of-town meeting together. Betty is a cigarette smoker and her marginal benefit from smoking a package of cigarettes a day is $40. Cigarettes are $6 a pack. Anna dislikes cigarette smoke, and her marginal benefit from a smoke-free environment is $50 a day. What is the outcome if a. Betty drives her car with Anna as a passenger? If Betty drives her car, Betty has the property right to the air in her car. Anna can offer to pay Betty some amount more than $34 and less than $50 to not smoke. Betty will accept and will not smoke on the trip. Betty’s net benefit from smoking is $34 (the net benefit equals the marginal benefit, $40, minus the price of the pack, $6) so for any amount greater than $34 she is willing to not smoke. Anna values a smoke-free environment at $50, so Anna is willing to pay any amount less than $50 for a smoke-free environment.

b. Anna drives her car with Betty as a passenger? If Anna drives her car, Anna has the property right to the air in her car. Betty will not smoke because she will not offer Anna a high enough price to allow Betty to smoke.

Use the following data and Figure 17.5, which illustrates the market for a pesticide with no government intervention, to work Problems 13 to 16. When factories produce pesticide, they also create waste, which they dump into a lake on the outskirts of the town. The marginal external cost of the waste is equal to the marginal private cost of producing the pesticide (that is, the marginal social cost of producing the pesticide is double the marginal private cost). 13.

What is the quantity of pesticide produced if no one owns the lake and what is the efficient quantity of pesticide? If no one owns the lake the equilibrium quantity of pesticide produced is determined at the intersection of the demand curve and supply curve, 30 tons per week. The efficient quantity is determined at the intersection of the marginal social benefit curve and the marginal social cost curve. The marginal social benefit curve is the same as the demand curve. But the marginal social cost curve differs from the supply curve because of the external cost. The efficient quantity of pesticide is 20 tons per week because at this quantity the marginal social benefit, $100 per ton, equals the marginal social cost, also $100 per ton.

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If the town owns the lake, what is the quantity of pesticide produced and how much does the town charge the factories to dump waste? Assuming that the transactions costs are low so that the Coase theorem applies, if the residents of the town own the lake, the efficient quantity of pesticide is produced, 20 tons per week. The residents charge the pesticide companies $50 per ton to dump their waste in the lake.

15.

If the pesticide factories own the lake, how much pesticide is produced? Assuming that the transactions costs are low so that the Coase theorem applies, if the pesticide companies own the lake, 20 tons of pesticide is produced. In this case the residents pay the company to limit the dumping of waste.

16.

If no one owns the lake and the government levies a pollution tax, what is the tax that achieves the efficient outcome? The tax is equal to the marginal external cost at the efficient quantity, which is $50 per ton of pesticide.

Use the following table to work Problems 17 to 19. The first two columns of the table show the demand schedule for electricity from a coal burning utility; the second and third columns show the utility’s cost of producing electricity. The marginal external cost of the pollution created equals the marginal cost. 17.

With no government action to control pollution, what is the quantity of electricity produced, the price of electricity, and the marginal external cost of the pollution generated?

Price (cents per kilowatt) 4 8 12 16 20

Quantity demanded (kilowatts per day) 500 400 300 200 100

Marginal cost (cents per kilowatt) 10 8 6 4 2

With no pollution control, the quantity of electricity produced is 400 kilowatts per day, the price of electricity is 8¢ per kilowatt, and the marginal external cost of the pollution generated is 8¢ per kilowatt.

18.

With no government action to control pollution, what is the marginal social cost of the electricity generated and the deadweight loss created? With 400 kilowatts of electricity being produced, the marginal social cost is 16¢ per kilowatt. To calculate the deadweight loss, it is necessary to determine the efficient quantity of electricity. That quantity is 300 kilowatts per day because that is the quantity at which the marginal social cost, 12¢ per kilowatt, equals the marginal social benefit (the price from the demand curve, also 12¢). The deadweight loss then equals the area of the triangle with a base equal to the difference between the efficient quantity and the equilibrium quantity, 100 kilowatts, and a height equal to the marginal external cost at the equilibrium quantity, 8¢ per kilowatt. The deadweight loss equals ½ × 100 kilowatts per day× 8¢ per kilowatt, which is $4 per day.

19.

If the government levies a pollution tax such that the utility produces the efficient quantity, what is the price of electricity, the tax levied, and the government’s tax revenue per day? The tax will equal the amount of the marginal external cost at the efficient quantity, 6¢ per kilowatt. The quantity of electricity generated is 300 kilowatts per day and the price of electricity is 12¢ per kilowatt. The government collects as revenue 6¢ per kilowatt × 300 kilowatts per day, which is $18 per day.

EXTERNALITIES

20.

Polar Ice Cap Shrinks Further and Thins With the warming of the planet, the polar ice cap is shrinking and the Arctic Sea is expanding. As the ice cap shrinks further, more and more underwater mineral resources will become accessible. Many countries are staking out territorial claims to parts of the polar region. Source: The Wall Street Journal, April 7, 2009 Explain how ownership of these mineral resources will influence the amount of damage done to the Arctic Sea and its wildlife. The Arctic Sea minerals might be privately owned, government owned, or owned by no one—common resources. Regardless of who owns them, mining minerals creates pollution and disturbs marine life habitat, which have external costs. If the minerals are privately owned, then the quantity mined will be the amount that sets the marginal private cost equal to the marginal private benefit. This quantity will have a deadweight loss because the marginal social cost exceeds the marginal private cost. If the minerals are government owned, then their allocation will be by majority vote. Lobbyists will pressure elected officials to adopt their position in return for help with reelection. In this case, “green” lobbyists and “business” lobbyists likely will square off. If the greens prevail, there is a possibility that no minerals will be mined. This situation has a deadweight loss because less than the efficient quantity is mined. If the business groups prevail, then there might be significant amounts mined. This situation, similar, to the case of private ownership, has a deadweight loss because of overuse of the minerals. Finally if the minerals are owned by no one, they become a common resource. In this case the quantity mined will be that at which marginal private cost equals marginal private benefit. This quantity creates a deadweight loss because the marginal external cost of damage to the Arctic Sea and also the marginal social cost of resource depletion will be ignored.

Use Figure 17.6 to work Problems 21 to 23. A spring runs under a village. Everyone can sink a well on her or his land and take water from the spring. Figure 17.6 shows the marginal social benefit from and the marginal cost of taking water. 21.

What is the quantity of water taken and what is the private cost of the water taken? With no government intervention, the quantity of water taken is 400 gallons per day, determined in the figure by where the marginal social benefit and the marginal private cost curves intersect. The marginal private cost of this quantity of water is 20¢ per gallon.

22.

What is the efficient quantity of water taken and the marginal social cost at the efficient quantity? The efficient quantity of water taken is 200 gallons per day, determined in the figure by where the marginal social benefit and the marginal social cost curves intersect. The marginal social cost of this quantity of water is 30¢ per gallon.

23.

If the village council sets a quota on the total amount of water such that the spring is used efficiently, what would be the quota and the market value of the water taken per day? The quota would be set at 200 gallons per day. This quantity of water would sell for a price of 30¢ per gallon, so the market value of this quantity of water is 200 gallons × 30¢ per gallon, which is $60.

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If hikers and other visitors were required to pay a fee to use the Appalachian Trail, a. Would the use of this common resource be more efficient? The Appalachian Trail, or AT, is a common resource because it is nonexcludable and rival. As those who have hiked the AT know, this resource is over utilized; the natural beauty is adversely affected by the number of hikers. If there was a fee to hike the trail, its use would be more efficient

b. Would it be even more efficient if the most popular spots along the trail had the highest prices? It would be even more efficient if the fee to use the trail was higher in more popular areas, such as Annapolis Rock, because these areas are even more over-utilized than the less popular areas.

c. Why do you think we don’t see more market solutions to the tragedy of the commons? It is probably the case that fees are not imposed because politicians resist imposing fees that their constituents must pay on goods and services that had previously been “free.”

Use the following data to work Problems 25 to 28. The table shows the demand for college education. The marginal cost of educating a student is a constant $4,000 a year and education creates an external benefit of a constant $2,000 per student per year. 25.

If all colleges are private and the market for education is competitive, calculate the number of students, the tuition, and the deadweight loss.

Price (dollars per student) 6,000 5,000 4,000 3,000 2,000

Quantity (students per year) 10,000 20,000 30,000 40,000 50,000

The equilibrium number of students will be 30,000 and the tuition will be $4,000. To calculate the deadweight loss, Figure 17.7 is helpful. The efficient quantity of students is 50,000. Therefore deadweight loss is equal to the area of the grey triangle in the figure, which is $20 million.

26.

If all colleges are public colleges, calculate the tuition that will achieve the efficient number of students. How much will taxpayers have to pay? The efficient quantity of students is 50,000. To have 50,000 students attending college, the tuition must be $2,000. The marginal cost of educating a student is $4,000 so taxpayers must pay $2,000 per student. The total amount paid by taxpayers equals $2,000 per student × 50,000 students, which is $100 million.

27.

If the government decides to subsidize private colleges, what subsidy will achieve the efficient number of college students? The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

28.

If all colleges are private and the government offers vouchers to those who enroll at a college, calculate the value of the voucher that will achieve the efficient number of students. The subsidy must equal to the marginal external benefit at the efficient quantity, or $2,000 per student,

Economics in the News 29.

After you have studied Economics in the News on pp. 448–449, answer the following questions: a. What are the marginal private costs of and marginal private benefits from using gas rather than coal to generate electricity? The marginal private cost of using gas is the price paid by the utilities for the gas; the marginal private cost of using fuel made from coal is the price paid for the fuel plus any additional taxes or fees imposed on the fuel. The marginal private benefit from using gas is the same as that using coal, namely the marginal private benefits from electricity.

EXTERNALITIES

b. What are the marginal social costs of and marginal social benefits from using gas rather than coal to generate electricity? The marginal social cost of using gas is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (smaller amount of) carbon dioxide emitted. The marginal social cost of using fuel from coal is the marginal private cost of the fuel (the price paid by the utilities for the fuel) plus the marginal external cost from the (larger amount of) carbon dioxide emitted. The marginal social benefit from using gas is the same as that from using coal, namely the marginal social benefits from electricity.

c. How will the EPA’s plan for power utilities to switch from coal to gas change the price that households pay for electricity? The price of electricity will rise as utilities switch from the lower-cost fuel, coal, to the higher cost fuel, natural gas.

d. How will the EPA’s plan for utilities to switch from coal to gas change the efficiency of electricity production? The efficiency will increase because utilities will use less coal, which generates a larger external cost, and more natural gas, which creates a smaller external cost.

30.

Traffic: Why It’s Time to Get Serious About the Bloody Illegal Wildlife Trade Wildlife trafficking and poaching are on the rise. According to CITES, an estimated 25,000 elephants were poached across Africa in 2011, and in South Africa alone 668 rhinos were killed by poachers in 2012. The resurgence of poaching is driven by the tremendous increase in the demand for ivory and other animal products and economic growth, which means more money in the hands of consumers who are willing to pay for ivory and other animal products. Source: Time, March 05, 2013 a. How are wildlife trafficking and poaching related to property rights? The wild animals that are poached roam across land that no one owns and no one owns the animals either; that is, the property rights to the land and animals were not established.

b. Can the tragedy of the wildlife trafficking be curtailed by establishing property rights to the land and animals? Once the property rights to the land and the animals are established, then the marginal private benefit will become the same as the marginal social benefit and the tragedy of the commons will be averted. However, it must be possible to establish property rights to the land where the wild animals roam and also to restrict the animals to certain areas so that they can be “owned.” It is not clear how this can be done.

c. How can ‘bag limits’ change the short-term outlook of hunters to a long-term outlook? A bag limit is a law imposed on hunters. ‘Bag limits’ can change hunters’ incentives by limiting the number of animals within a specific species that are hunted. Bag limits may also place restrictions on the size of those animals and the time of the year the animals may be killed. In this case, once the hunter hits the prescribed ‘bag limit’, he or she cannot continue to hunt but a bag limit means that he or she can harvest the specified quantity of animals within a specific species indefinitely, that is, day after day. But poaching and wildlife trafficking are illegal and poachers violate the bag limit and other hunting laws.

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MARKETS FOR FACTORS OF PRODUCTION

Answers to the Review Quizzes Page 458 1.

What are the factors of production and their prices? The factors of production and their prices are: labor, which is paid a wage rate for labor services; capital, which is paid a rental rate for capital services; land, which is paid a rental rate for land services; and entrepreneurship, which receives a profit or bears a loss that results from business decisions.

What is the distinction between capital and the services of capital? Capital is the actual tools, instruments, machines, buildings, and constructions that have been produced in the past and that businesses now use to produce goods and services. Capital services are the services of the unit of capital. For example, a copy machine at a local Quik Print is capital but the copying performed by the machine is the service of that particular unit of capital.

What is the distinction between the price of capital equipment and the rental rate of capital? The price of a unit of capital is how much must be paid to acquire the piece of capital equipment. The rental rate of capital is the amount that must be paid to use the unit of capital equipment. For instance, the copy machine at the local Quik Print has a price of $10,000 but its services can be rented from the Quik Print for $50 per hour.

Page 461 1.

What is the value of marginal product of labor? The value of marginal product of labor is the value to the firm of hiring one more unit of labor. The value of marginal product of labor, VMP, is the change in total revenue from employing an additional unit of labor.

What is the relationship between the value of marginal product of labor and the marginal product of labor? VMP is equal to the price of a unit of the output, P, multiplied by the marginal product of labor, MP. So VMP = P  MP.

How is the demand for labor derived from the value of marginal product of labor? The demand for labor is determined by the value of marginal product of labor. To maximize its profit a firm hires the number of workers that sets the wage rate equal to the value of marginal product of labor. When the wage rate changes, the firm changes the quantity of labor it demands so that the (new) wage rate equals the value of marginal product. So when the wage rate changes, the firm moves along its value of marginal product of labor curve to determine the quantity of labor demanded, thereby making its value of marginal product of labor curve its demand for labor curve.

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What are the influences on the demand for labor? Factors that influence the demand for labor are the wage rate, the price of the firm’s output, the prices of other factors of production, and technology. A lower wage rate increases the quantity of labor demanded. A rise in the price of a substitute for labor or a fall in the price of a complement for labor increases the demand for labor. A new technology or new capital that increases the marginal product of labor increases the demand for labor.

Page 469 1.

What determines the amount of labor that households plan to supply? When households decide how much labor to provide in the labor market, they compare the market wage rate to the value of the lost leisure that supplying labor would entail. If the market wage rate exceeds the individual’s reservation wage rate, the individual forgoes leisure and supplies labor to the labor market. The quantity of labor the person supplies depends on the wage rate. At most wage rates the substitution effect dominates the income effect so that a person increases the quantity of labor supplied if the wage rate rises. But at high wage rates the income effect dominates the substitution effect so that a person decreases the quantity of labor supplied if the wage rate increases.

How are the wage rate and employment determined in a competitive labor market? In a competitive labor market, the wage rate and employment are determined at the intersection of the demand for labor curve and the supply of labor curve.

How do labor unions influence wage rates? Unions increase their members’ wage rates by increasing the demand for their members’ labor and decreasing the supply of labor. In particular, to increase the demand for their members’ labor, unions: increase the value of marginal product of union members by sponsoring training schemes and apprenticeship programs; encourage import restrictions so that consumers must buy goods and services produced by union members; and, support minimum wage laws to raise the wage of a substitute for their members’ labor. Unions also try to restrict the supply of labor, say by supporting immigration restrictions to decrease the supply of low-skilled labor. By decreasing the supply of lowskilled labor, the wage rate paid low-skilled labor rises, which increases the demand for high-skilled union labor.

What is a monopsony and why is a monopsony able to pay a lower wage rate than a firm in a competitive labor market? A monopsony is a market with a single buyer. A monopsony uses its market power to force down the price it pays for what it buys in a similar way to how a monopoly uses its market power to force upward the price of the good it sells. Compared to a competitive labor market, a monopsony in a labor market hires fewer workers. Because it hires fewer workers, it pays a lower wage rate.

How is the wage rate determined when a union faces a monopsony? When a monopoly seller, such as union, bargains with a monopsony buyer, such as a large firm, the situation is called bilateral monopoly. The wage rate will be lower than the union’s monopoly wage rate and higher than the buyer’s monopsony wage rate. Within this range, the actual wage rate depends on the cost that each party can inflict on the other. Everything else the same, the more cost that one party can inflict on the other, the closer the actual wage rate will be to that party’s desired wage rate.

What is the effect of a minimum wage law in a monopsony labor market? A minimum wage rate can increase employment in a monopsony market. Over a range of employment, a minimum wage can lower the cost of hiring additional workers for a monopsony. In the absence of the minimum wage, the marginal cost of labor, MCL, curve exceeds the wage rate because hiring another worker requires that the firm must boost the pay of all its workers. With a minimum wage, hiring another worker at this wage rate requires that the firm pay this worker the minimum wage but the firm does not raise the wage rate paid its others workers because they, too, are paid the minimum wage. As a result, in this range of employment, a monopsony’s cost of hiring another worker is lower with a minimum wage. The lower cost of hiring workers leads the monopsony to increase its employment.

MARKETS FOR FACTORS OF PRODUCTION

Page 473 1.

What determines demand and supply in rental markets for capital and land? The demand for capital depends on the value of marginal product of capital; the demand for land depends on the value of marginal product of land. The higher the marginal product of capital or land, the greater the demand for capital or land. Additionally the demand for capital depends on the rental rate of capital and the demand for land depends on the rental rate of land. The higher the rental rates, the lower the quantities demanded. The supply of capital depends on the rental rate of capital. The higher the rental rate of capital, the greater is the quantity of capital supplied. The supply of land, however, is perfectly inelastic because its quantity is fixed.

What determines the demand for a nonrenewable natural resource? The demand for a nonrenewable natural resource depends on the resource’s value of marginal product and the expected future price of the resource.

What determines the supply of a nonrenewable natural resource? The supply of a nonrenewable natural resource depends on the total known amount, such as the known oil reserves in the market for oil. It also depends on the scale of current production facilities, which determines the marginal cost of producing the resource. For instance, when more oil wells are sunk, the supply of oil increases. The expected future price also affects the supply. The higher the future expected price, the smaller the present supply of the resource.

What is the market fundamentals price and how might it differ from the equilibrium price? The market fundamentals price is the price determined by the fundamental determinant of demand, the value of marginal product, and the fundamental determinant of supply, the marginal cost of extraction. When people’s expectations of the price differ from the market fundamentals price, then the demand and supply are affected by the expected price. At this point the equilibrium price, determined in part by people’s expectations, differs from the market fundamentals price.

Explain the Hotelling principle. The Hotelling principle is the result that the price of a nonrenewable natural resource is expected to rise at a rate equal to the interest rate. Only when this situation exists can the market be in equilibrium. For example, if the price is expected to rise more rapidly than the interest rate, supply decreases and demand increases, and the present price rises. Supply will continue to decrease, demand will continue to increase, and the present price will continue to rise until the percentage increase from the present price to the future expected price equals the interest rate. At that point, which is the situation outlined by the Hotelling principle, the market is in equilibrium because supply stops decreasing and demand stops increasing.

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Answers to the Study Plan Problems and Applications 1.

Tim is opening a new online store. He plans to hire two workers at $10 an hour. Tim is also considering buying or leasing some new computers. The purchase price of a computer is $900 and after three years it is worthless. The annual cost of leasing a computer is $450. a. In which factor markets does Tim operate? Tim is operating in the labor market when he hires his workers. Tim also is operating in the capital market when he buys or leases his computers. Tim, himself, is an entrepreneur.

b. What is the price of the capital equipment and the rental rate of capital? The price of the capital equipment—Tim’s computer—is $900. The rental rate of capital is $450.

Use the following data to work Problems 2 to 6. Wanda’s is a fish store that hires students to pack the fish. Students can pack the amounts of fish shown in the table. The fish market is competitive and the price of fish is 50¢ a pound. The market for packers is competitive and their market wage rate is $7.50 an hour. 2.

Calculate the value of marginal product of labor and draw the value of marginal product curve. The value of marginal product of labor is the increase in total revenue that results from hiring one additional student. For example, if Wanda hires 4 students, they produce 120 pounds of fish. Wanda sells the fish for 50¢ a pound, so total revenue is $60. If Wanda increases the number of students hired from 4 to 5, total product increases to 145 pounds and total revenue increases to $72.50. The value of marginal product when the number of students increases from 4 to 5 is $12.50 ($72.50 minus $60). Alternatively, the value of marginal product equals marginal product multiplied by price. The value of marginal product when the number of students increases from 4 to 5 is $12.50, which is the marginal product of 25 pounds of fish multiplied by the price of 50¢ a pound. The value of marginal products calculated in this problem are plotted midway between the two levels of employment. Figure 18.1 shows the value of marginal product when the number of students increases from 4 to 5 as well as the other value of marginal products.

Number of students 1 2 3 4 5 6 7 8

Quantity of fish (pounds) 20 50 90 120 145 165 180 190

3. a. Find Wanda’s demand for labor curve. The demand for labor curve is the same as the value of marginal product curve.

b. How many students does Wanda employ? Wanda hires the number of students that makes the value of marginal product equal to the wage rate of $7.50 an hour. When Wanda increases the number of students from 6 to 7, marginal product is 15 pounds of fish an hour, which Wanda sells for 50¢ a pound. The value of marginal product is $7.50—the same as the wage rate. The value of marginal product is plotted at the mid-point between 6 and 7 students a day, so Wanda hires 6.5 students a day.

MARKETS FOR FACTORS OF PRODUCTION

Use the following additional information to work Problems 4 and 5. The market price of fish falls to 33.33¢ a pound, but the packers’ wage rate remains at $7.50 an hour. 4.

How does the students’ marginal product change? How does the value of marginal product of labor change? The marginal product does not change. For instance, if Wanda hires 5.5 students a day, the marginal product is still 20 pounds of fish. The value of marginal product decreases. For instance, if Wanda hires 5.5 students a day, the marginal product is 20 pounds of fish. When Wanda now sells the fish for 33.33¢, the value of marginal product falls to $6.67, down from $10.00 when the price was 50¢ a pound.

How does Wanda’s demand for labor change? What happens to the number of students that Wanda employs? Wanda’s demand for labor decreases because her value of marginal product decreases at each quantity of labor and her demand for labor curve shifts leftward. Wanda hires fewer students. At the wage rate of $7.50, the number of students Wanda hires decreases as the demand for labor curve shifts leftward.

At Wanda’s fish store, packers’ wages increase to $10 an hour, but the price of fish remains at 50¢ a pound. a. What happens to the value of marginal product of labor? The value of marginal product does not change. For example, if Wanda hires 5.5 students an hour, the marginal product is 20 pounds of fish, which she sells at 50¢ a pound. So, just as before, the value of marginal product remains at $10.00.

b. What happens to Wanda’s demand for labor curve? Wanda’s demand for labor and her demand for labor curve remain the same because the value of marginal product has not changed.

c. How many students does Wanda employ? Wanda hires fewer students. At the wage rate of $10 an hour, Wanda hires the number of students that makes the value of marginal product equal to $10 an hour. Wanda now hires 5.5 students an hour—down from 6.5 students an hour. The marginal product of 5.5 students is 20 pounds of fish an hour, and Wanda sells this fish for 50¢ a pound. The value of marginal product is $10 an hour.

Use the following news clip to work Problems 7 to 9. In Modern Rarity, Workers Form Union at Small Chain In New York’s low-income neighborhoods, labor unions have virtually no presence. But after a year-long struggle, 95 workers at a chain of 10 sneaker stores have formed a union. After months of negotiations, the two sides signed a three-year contract that sets the wage rate at $7.25 an hour. Source: The New York Times, February 5, 2006 7.

Why are labor unions scarce in New York’s low-income neighborhoods? Labor unions probably are scarce because unions find these workers difficult to organize. In particular, most of them are low-skilled workers and the supply of low-skilled workers is probably elastic and difficult for unions to control or influence. In this situation, unions are unlikely to have much success in raising the wage rate.

Who wins from this union contract? Who loses? The workers who signed the contract (and keep their jobs) win from the new union contract. The owners of the companies lose. Customers lose because supply will decrease. In addition, any workers who are fired due to the higher wage rate (or are unable to be hired because of the higher wage rate) lose.

How can this union try to change the demand for labor? This union can try to change the demand for its members’ labor by creating training programs to boost their productivity. In addition, it can support advertising that promotes “buy-American” policies and restrictions of foreign imported sneakers.

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Land Prices Reflect High Commodity Prices As their family grows, the Steens are finding it more difficult for the next generation to stay in ranching. “The problem is they don’t create any more land,” Steen said. As the prices for cattle, corn, and other commodities climb, so does the value of land in South Dakota. Source: Rapid City Journal, January 30, 2012 a. Why does the price of land in South Dakota keep rising? In your answer include a discussion of the demand for and supply of land. Because of the increased prices for the products grown on land in South Dakota, the demand for land has increased. The supply is perfectly inelastic and has not changed. The demand increased and, with no change in supply, the price of the land rose.

b. Use a graph to show why the price of land in South Dakota has increased over the past decade. Figure 18.2 shows the market for this land. The supply is perfectly inelastic so the supply curve is vertical. Initially, the demand curve was D0 and the price was $2,000 per acre. The demand has increased so that the new demand curve is D1 and the price is $6,000 per acre.

c. Is the supply of land in South Dakota perfectly inelastic? The supply of land is perfectly inelastic.

MARKETS FOR FACTORS OF PRODUCTION

Answers to Additional Problems and Applications 11.

Mariam is opening a pizza joint. She plans to hire a cook to make pizzas at $10 an hour. She is also considering purchasing or leasing a convection oven. The purchase price of the oven is $500 and after 3 years it is worthless. The annual cost of leasing the oven is $150. a. In which factor markets does Mariam operate? Mariam is operating in the labor market when she hires a cook. If she buys or leases a convection oven, Mariam is operating in the capital market. Mariam, herself, is an entrepreneur.

b. What is the price of the capital equipment and rental rate of capital? The price of Mariam’s capital equipment is $500; and the rental rate of her capital is $150.

Use the following data to work Problems 12 to 15. Kaiser’s Ice Cream Parlor hires workers to produce milk shakes. The market for milk shakes is perfectly competitive, and the price of a milk shake is $4. The labor market is competitive, and the wage rate is $40 a day. The table shows the workers’ total product schedule. 12.

Calculate the marginal product of hiring the fourth worker and the fourth worker’s value of marginal product.

Number of workers 1 2 3 4 5 6

Quantity produced (milk shakes per day) 7 21 33 43 51 55

By hiring the 4th worker the number of milk shakes increases by 10 milk shakes (43 milk shakes – 33 milk shakes). So the marginal product of this worker is 10 milk shakes. The value of the marginal product of the 4th worker equals the price of a milk shake, $4, multiplied by the worker’s marginal product, 10 milk shakes, so the value of marginal product is $40.

13.

How many workers will Kaiser’s hire to maximize its profit and how many milk shakes a day will Kaiser’s produce? Kaiser’s will hire 3.5 workers. The value of marginal product of 3.5 workers is $40 which equals the wage rate.

14.

If the price of a milk shake rises to $5, how many workers will Kaiser’s hire? If the price rises to $5 a milk shake, Kaiser’s will hire 4.5 workers. The value of marginal product of 4.5 workers is the marginal product, 8 milk shakes, multiplied by the price, $5 a milk shakes, or $40, which equals the wage rate.

15.

Kaiser’s installs a new machine for making milk shakes that increases the productivity of workers by 50 percent. If the price of a milk shake remains at $4 and the wage rises to $48 a day, how many workers does Kaiser’s hire? Kaiser’s hires 4.5 workers because this is the quantity of workers that sets the value of marginal product equal to the wage rate. With the old machine, the marginal product of 4.5 workers was 8 milk shakes. The new machine increases the marginal product by 50 percent to 12 milk shakes. The price of a milk shake is $4. The value of marginal product equals the marginal product multiplied by the price, so the value of marginal product of 4.5 workers is 12 milk shakes × $4 a milk shake, or $48 which equals the wage rate.

16.

Chocolate Prices Rise Due To Asia’s Increased Appetite Chocolate prices could soar due to an increased demand for chocolate in Asia—the consumption in China alone has doubled in the last decade. Another reason for higher prices is smaller harvests in key cocoa-growing nations. Source: BBC News, December 19, 2013 a. Explain how rising chocolate prices influence the market for labor employed in the chocolate industry. The demand for labor curve is the value of marginal product curve. The value of marginal product is calculated as marginal product of labor multiplied by price of the output, chocolate. When the price of

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chocolate rises, the value of the marginal product of chocolate industry workers increases, and the demand for them increases.

b. Draw a graph to illustrate the effects of rising chocolate prices on the market for labor employed in the chocolate industry. Figure 18.3 shows the impact in the market for labor employed in the chocolate industry. The demand for the labor increases so the demand for labor curve shifts rightward from D0 to D1. The supply does not change. The wage rate rises and the quantity of workers employed increases.

Use the following news clip to work Problems 17 and 18. Miner Sacks 17,000 Workers Over Pay Dispute Impala Platinum has sacked 17,000 South African miners at its Rustenburg mine because they took part in an illegal strike. The miners refused to have their union negotiate in the two-week pay dispute with the world’s second largest platinum producer. Mining provides a quarter of all jobs in Rustenburg. Source: abc.com.au, February 3, 2012 17.

How would the wage rate and employment for the Rustenburg miners be determined in a competitive market? In a competitive labor market, the wage rate and employment are determined by the supply of labor and the demand for labor. The equilibrium wage rate is the wage rate that sets the quantity of labor demanded equal to the quantity of labor supplied and equilibrium employment is equal to that quantity of labor.

18. a. Explain how it is possible that the mine workers were being paid less than the wage that would be paid in a competitive labor market. The mine provides a large fraction of total employment in the region. Hence Impala Platinum, the owner of the mine, might have monopsony power in the labor market. If Impala Platinum is a monopsonist, it will maximize its profit by hiring the quantity of labor that sets its marginal cost of labor equal to the value of the marginal product. This quantity of labor is less than the equilibrium quantity in a competitive labor market. Then Impala Platinum will pay the lowest wage rate for which that quantity of labor will work. This wage rate is lower than the equilibrium wage rate in a competitive labor market.

b. What would be the effect of a minimum wage law in the market for miners? A minimum wage rate set above the monopsony wage rate increases the wage rate paid the workers. The minimum wage rate makes the supply of labor perfectly elastic at this wage rate so the firm’s marginal cost of labor (the cost of hiring another worker) equals the minimum wage. At the monopsony quantity of labor, the marginal cost of labor with the minimum wage is less than the marginal cost of labor without the minimum wage, so the firm maximizes its profit by increasing the quantity of labor it employs.

MARKETS FOR FACTORS OF PRODUCTION

Today, Wal-Mart employs more people—1.7 million—than any other private employer in the world. With size comes power: Wal-Mart’s prices are lower and United Food and Commercial Workers International Union argues that Wal-Mart’s wages are also lower than its competitors. Last year, the workers at a Canadian outlet joined the union and Wal-Mart immediately closed the outlet. But does Wal-Mart behave any worse than its competitors? When it comes to payroll, Wal-Mart’s median hourly wage tracks the national median wage for general retail jobs. Source: The Atlantic, June 2006 19. a. Assuming that Wal-Mart has market power in a labor market, explain how the firm could use that market power in setting wages. Wal-Mart can use its market power to decrease the wage rate it pays by decreasing the number of workers it hires.

b. Draw a graph to illustrate how Wal-Mart might use labor market power to set wages. Figure 18.4 shows Wal-Mart’s situation if it is a monopsony in the labor market. Wal-Mart’s demand curve is the same as its value of marginal product curve and is labeled D = VMP in the figure. The labor supply curve is upward sloping and is labeled S in the figure. Wal-Mart’s marginal cost of labor exceeds the wage rate it pays so the marginal cost of labor curve, labeled MCL, lies above the labor supply curve. Wal-Mart’s profit-maximizing quantity of labor is determined at the intersection of the D = VMP curve and the MCL curve and is 1.7 million workers. Wal-Mart determines the wage rate from the labor supply curve as the lowest wage rate it can pay and hire its profit-maximizing quantity of labor. In the figure the wage rate is $9 dollars per hour.

20. a. Explain how a union of Wal-Mart’s employees would attempt to counteract Wal-Mart’s wage offers (a bilateral monopoly). A union will bargain with Wal-Mart. If Wal-Mart faces a union, the situation is a bilateral monopoly: a monopoly seller of labor services (the union) bargains with a monopsony buyer of labor services (WalMart). In this case the wage rate depends on the relative strengths of the two and will lie between the monopsony wage Wal-Mart offers, $9 per hour in Figure 18.4, and the wage the union wants, which is the value of marginal product, $11 per hour in Figure 18.4.

b. Explain the response by the Canadian Wal-Mart to the unionization of employees. Wal-Mart’s profits are decreased if it must pay higher wage rates. Wal-Mart realizes that a union will force the wage rate higher and Wal-Mart fears that a union at one store could spread to other stores. To avoid this outcome, Wal-Mart closed its unionized Canadian store.

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Based upon evidence presented in this article, does Wal-Mart function as a monopsony in labor markets, or is the market for retail labor more competitive? Explain. The key piece of evidence in the news clip is the point that Wal-Mart’s median wage is similar to the national median wage rate. If Wal-Mart had significant monopsony power its wage rate would probably be less than the national median wage rate. Because the wage rates are similar, it appears that Wal-Mart functions in a competitive labor market.

22.

If the market for retail labor is competitive, explain the potential effect of a union on the wage rates. Draw a graph to illustrate your answer. Figure 18.5 shows a union in a competitive labor market. The union decreases the supply of labor and the supply of labor curve shifts leftward from S0 to S1. The union increases the demand for labor and the demand for labor curve shifts rightward from D0 to D1. The wage rate rises, in the figure from $10 per hour to $13 per hour. If the change in the supply of labor is larger than the change in demand, the case illustrated in the figure, employment decreases from 1.7 million workers to 1.6 million workers.

23.

New X-ray technology has been discovered in Australia which can detect any form of gold. This technology is efficient in terms of speed and accuracy. a. What effect do you think the new X-ray technology will have on the price of gold in Australia? The new X-ray technology will increase the supply of gold in Australia and will keep gold prices from rising higher than they would have otherwise.

b. Who will benefit from this new technology? Explain your answer. The new technology is efficient in terms of speed and accuracy; it will benefit the suppliers of gold. Consumers in Australia will also benefit because the price of gold is lower.

24.

The U.S. produces corn in abundance whereas Japan faces a shortage of corn. a. If the U.S. starts to export corn in large quantities to Japan, what do you predict will be the effect on the price of corn in Japan? If the U.S. exports corn to Japan in large quantities, the supply of corn will increase in Japan. This increase in the supply will lower the price of corn in Japan.

b. Will the U.S. eventually run out of corn? The U.S. will not run out of corn as it can grow corn in abundance owing to its favorable climatic and land conditions.

c. Do you think the Hotelling Principle applies to America’s corn? Why or why not? The Hotelling Principle doesn’t apply to America’s corn because the Hotelling principle applies only to nonrenewable natural resources. Corn is a renewable natural resource.

25.

Countries in Tug-of-War over Arctic Resources Estimates reveal that the Arctic Circle has buried beneath it tons of oil, natural gas liquids, and natural gas. Unlike Antarctica, there is no treaty prohibiting territorial claims over the Arctic Circle. Russia, Canada, the United States—all have a stake in the Arctic's icy real estate for exploration and for extracting natural resources such as oil. Amid concerns of pollution and environmental damage, who will drill and what is drilled for in the Arctic will depend on the global economy. Drilling makes sense when oil is selling or $150 a barrel and not so when it is at $40 a

MARKETS FOR FACTORS OF PRODUCTION

barrel.

Source: CNN, January 2, 2009 a. Explain why the demand for access to the Arctic Circle has increased. The countries are involved in a territorial dispute because each one of them wants to acquire access to most of the Arctic Circle. This is because of the prevailing high demand for oil and natural gas, and the fact that these can be extracted from the Arctic Circle. The value of marginal product of the oil/natural gas from the Arctic Circle, which equals price of oil/natural gas multiplied by marginal product of the Arctic Circle in producing oil/natural gas, has increased, so demand for access to the Arctic Circle has increased.

b. Why is it better to drill in the Arctic Circle when oil is selling at $150 a barrel than at $40? Acquiring access to the Arctic Circle for drilling makes sense when the price of oil per barrel rockets sky-high, say, $150 a barrel. Otherwise, acquiring access and drilling in the Arctic Circle involves possible risks of environmental damage, pollution and huge investments, which may not be profitable when oil is selling at $40 a barrel.

c. What could cause price of natural gas to fall in future? Technological change that decreases the demand for natural gas can lead the price to fall in the future. Lower prices for substitutes for natural gas, such as coal or heating oil, will lower the demand for natural gas and lead to a lower price for natural gas. Discoveries of large new reserves of natural gas will lead to a lower price for natural gas.

Economics in the News 26.

After you have studied Economics in the News on pp. 474–475, answer the following questions: a. Is the average difference in the salaries of charter school and regular public school teachers greater or smaller than the difference at the top end of the pay scales? The average difference in the salaries of charter school and regular public school teachers is smaller than the difference at the top end of the pay scales.

b. What are the influences on the demand for the highest paid teachers that explain their high wage rates? There are three factors that affect the demand for the highest paid teachers. These teachers are located in public schools, and the union has increased the demand for public school teachers in general. Second, the overall budget is higher in the public school system. And, the highest paid teachers are those with the highest value of marginal product, which means they are likely the most experienced teachers.

c. What are the influences on the supply of the highest paid teachers that explain their high wage rates? There are two factors that affect the supply of the highest paid teachers. These teachers are located in public schools, and the union has decreased the supply of public school teachers in general. Second, the highest paid teachers are those with the most experience, which further decreases the supply because many teachers will change jobs before they acquire much experience.

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d. Draw a graph of the market for the highest paid teachers. Figure 18.6 shows the market for the highest paid teachers. In the figure, the equilibrium wage rate is $60,000 per year and the equilibrium quantity of the highest-paid teachers is 300.

e. If all charter school teachers became unionized, how would the market for these teachers change? Illustrate your answer with a graph. If charter school teachers become unionized, the union will strive to increase the demand for charter teachers and will strive to decrease the supply of teachers in the market. It is probably more difficult for the union to increase the demand for charter teachers and is probably less difficult for the union to decrease the supply of teachers in the market (For instance, the union might require additional credentials to qualify to teach in charter schools). In this case, the demand for charter schools increases less than the supply decreases, which is illustrated in Figure 18.7, in which the rightward shift of the demand for labor curve is less than the leftward shift of the supply of labor. In Figure 18.7, the original salary is $30,000 and. After the market is unionized, the salary rises to $60,000. In the figure, employment decreases from 400 teachers to 300 teachers. However, if the union is able to boost the demand for charter school teachers more than it decreases the supply, the wage rate rises and the quantity of teachers increases. In general, the wage rate unambiguously rises but the effect on the quantity is ambiguous.

How would you expect unionization of charter school teachers to influence the unionized market for regular public school teachers? If charter school teachers were unionized, there would be several effects in the unionized market for public school teachers. First, if unionizing of charter school teachers decreases the equilibrium employment of charter school teachers, some of these teachers will try to gain employment in the public schools. These efforts increase the supply of teachers to public schools, which makes it more difficult for public school unions to restrict the supply of teachers for the public schools. Second, unionizing charter school teachers increases their salaries and thereby increases the tuition at charter

MARKETS FOR FACTORS OF PRODUCTION

schools. Faced with the higher tuition at charter schools, some families will opt to send their children to public schools, which increases the demand for public school teachers.

g. If the public school systems were able to break the teachers’ union, how would the market for regular public school teachers change? Illustrate your answer with a graph. The union is broken, the supply of teachers would increase and the demand would decrease. In Figure 18.8, the supply curve shifts rightward and the demand curve shifts leftward. Then, as illustrated in the figure, the salary paid public school teachers would fall (from $60,000 per year to $30,000). The change in the quantity of public school teachers employed depends on the relative sizes of the changes. In Figure 18.8, the shift in the supply curve is larger than the shift in the demand curve, so employment increases, If the magnitudes of the shifts was reversed, employment would decrease.

27.

Keshia is opening a new bookkeeping service. She is considering buying or leasing some new laptop computers. The purchase price of a laptop is $1,500 and after three years it is worthless. The annual lease rate is $550 per laptop. The value of marginal product of one laptop is $700 a year. The value of marginal product of a second laptop is $625 a year. The value of marginal product of a third laptop is $575 a year. And the value of marginal product of a fourth laptop is $500 a year. a. How many laptops will Keshia lease or buy? Keshia will lease or buy 3 laptops. The fourth laptop’s value of marginal product is less than the annual lease rate, so Keisha will never lease the fourth laptop. And the present value of the value of marginal products for the fourth laptop is always less than $1,500 regardless of the interest rate. (The value of marginal products sum to $1,500 when not discounted, so when discounted they must sum to less than $1,500.) Keisha will never rent nor buy the fourth laptop because it is not profitable to do so. For each year the value of marginal product for the third laptop always exceeds the annual lease rate, so leasing that laptop will be profitable. Therefore Keisha will always be willing to lease the third laptop.

b. If the interest rate is 4 percent a year, will Keshia lease or buy her laptops? Keshia compares the present value of leasing the laptops to the price of buying the laptops. When the interest rate is 4 percent, the present value of leasing the laptops is

$550 $550 $550 + + =$1, 526. The present value of leasing the laptops exceeds the price of 2 1.04 (1.04) (1.04)3 buying the laptops, so Keisha buys the laptops.

c. If the interest rate is 6 percent a year, will Keshia lease or buy her laptops? Keshia again compares the present value of leasing the laptops to the price of buying the laptops. When the interest rate is 6 percent, the present value of leasing the laptops is

$550 $550 $550 + + =$1, 470. The present value of leasing the laptops is less than the price of 2 1.06 (1.06) (1.06)3 buying the laptops, so Keisha leases the laptops.

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Answers to the Review Quizzes Page 490 1.

Which is distributed more unequally, income or wealth? Why? Which is the better measure? The distribution of wealth is more unequally distributed than income. Wealth is distributed more unequally than income because wealth data do not include the value of human capital, while the income data measure income from all wealth, including human capital. That is why income is a better measure for economic inequality than wealth.

How has the distribution of income changed in the past few decades? From 1970 economic inequality in the United States has increased. The share of income received by the richest quintile (20 percent) of the population has increased and this is the major change in the distribution of income.

What are the main characteristics of high-income and low-income households? There are four major characteristics that influence the amount of income earned by an individual: i) Education: The more education attained by a person the higher the human capital that person has, and the more income that person enjoys; ii) Type of household: Married couples earn more, on average, than single people living alone, especially females living alone; iii) The age of householder: The oldest and youngest households have lower incomes than middle age households; and iv) Race: Individuals living in households headed by an Asian person have the highest incomes, followed by white households, Hispanic households, and then black households.

What is poverty and how does its incidence vary across the races? Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. Poverty is a relative concept. Minorities have historically been over-represented among those households living in poverty in the United States. In particular, 13 percent of white households live in poverty while 26 percent of Hispanic-origin households and 27 percent of black households lived in poverty.

How much mobility has there been through the income quintiles since 2007? There is some mobility but not a vast amount, particularly in the lowest and highest quintiles. In both these quintiles, about 70 percent of households remained in the same quintile. In the other three quintiles, somewhere between 45 percent and 50 percent of households remained in the same quintile. But there was some mobility. In the bottom four quintiles, about 25 percent of household moved up a quintile. (It is impossible for a household in the top quintile to move up.) Similarly, in the top four quintiles, about 25 percent of household moved down a quintile. (It is impossible for a household in the bottom quintile to move down.) A few household also moved up and down by more than one quintile.

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Page 492 1.

In which countries are incomes distributed most unequally and least unequally? Brazil and South Africa have the most unequally distributed incomes. Finland and Sweden and some other European nations have the most equally distributed incomes.

Which income distribution is more unequal and why: the income distribution in the United States or in the entire world? The world Gini ratio is larger than the U.S. Gini ratio which means that the distribution of world income is less equally distributed than in the United States. The world income distribution ranges from extremely poor individuals living on less than $2.50 per day to the very wealthy living in the United States and other advanced countries.

How can incomes become more unequally distributed within countries and less unequally distributed across countries? Income within nations generally has become distributed less equally. However because the average income within the poorest nations has been rising more rapidly than average income within richer nations, the world distribution of income has become more equally distributed.

Page 496 1.

What role does human capital play in accounting for income inequality? In general acquiring human capital is a costly endeavor so the supply of workers with a lot of human capital is less than the supply of workers with little human capital. The difference in supply means that the more human capital an individual attains, the more income that individual will likely earn, other things remaining the same. Greater variation in human capital across the population of households increases the degree of income inequality among households. While the level of human capital attained varies across households, this factor alone does not completely explain the observed variation in income across households in the United States

What role might discrimination play in accounting for income inequality? If the levels of VMP of labor for a racial group or one sex are perceived to be higher than that of another racial group or the other sex, then the equilibrium wages earned will vary across these groups, despite the fact that the two groups have equal ability. Economists disagree to the extent that discrimination pervades the labor market. One line of reasoning states that those firms that practice race or sex discrimination in the labor market face higher production costs (pay higher wages for the same value of marginal product) than those firms that do not. If this line of reasoning is correct, the profit margins for the firms practicing discrimination will be lower and the market price of their goods and services would be higher than non-discriminating firms. Either way, the market pressures increase the opportunity cost to firms (and the consumers who buy their goods) for practicing race or sex discrimination, eventually eliminating these practices.

What role might contests among superstars play in accounting for income inequality? Contests can explain why the super-rich have incomes that have increased greatly over the years. With increased globalization, the pool of “contestants” has increased dramatically. With the larger number of conspiracy, each contestant’s probability of winning has shrunk. So contests need to have larger differences in payouts for the winners versus the losers so as to induce larger efforts to win the contest. The result is that the contest winners—be they sports stars, entertainment stars, of CEOs— nowadays have much larger incomes than the vast number of losers.

How might technological change and globalization explain trends in the distribution of income? Technological change and globalization have both changed the distribution of income so that the “rich get richer and the poor get poorer.” More specifically, technological change has increased the demand for high-skilled workers and increased their wage rates and incomes. It also has decreased the demand for low-skilled workers and decreased their wage rates and their income. Globalization also has increased the demand for high-skilled workers and decreased the demand for low-skilled workers in the United States. Globalization has made contests worldwide, so the prizes for the best superstars— be they athletes or business managers—have increased with the increase in the size of the market.

ECONOMIC INEQUALITY

Does inherited wealth make the distribution of income less equal or more equal? An inheritance from older to a younger generations can only increase wealth and can never decreases wealth within a family, which helps make the distribution of wealth more unequal over time, all else equal. However if a generation is “lucky” and earns a high income and then passes some of it along as an inheritance to more typical less lucky lower-income generations, then inherited wealth makes the distribution of income more equal.

Page 499 1.

How do governments in the United States redistribute income? The governments in the U.S. use three main ways to redistribute income and reduce, to some degree, economic inequality: i) Income taxes: Taxes on household income are charged by the U.S. federal government and by many state governments,; ii) Income maintenance programs: There are three major types of programs that provide direct payments to individuals; and iii) Subsidized services: A great deal of income redistribution takes the form of subsidized services, where people other than those who pay for services consume the services provided.

Describe the scale of redistribution in the United States. In the United States, income redistribution increases the share of total income received by the lowest 60 percent of households and decreases the share of total income received by the highest 40 percent of households. Specifically, the poorest 20 percent of households receive only 0.9 percent of total market income earned in the United States, but receive 4.6 percent of income after taxes and benefits. The richest 20 percent of households receive 55.6 percent of total market income earned in the United States, but receive only 46.7 percent of income after taxes and benefits.

What is one of the major welfare challenges today and how is it being tackled in the United States? The major welfare challenge is households headed by single mothers The poorest people in the United States are young, minority women who have not completed high school, have one or more dependent children, and live without a spouse. The Temporary Assistance for Needy Families (TANF) program is the current attempt to meet this challenge. TANF is a block grant paid to the states, which administer payments to individuals. It is not open-ended. Adults receiving assistance must work or perform community service. There is a five-year limit for assistance.

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Answers to the Study Plan Problems and Applications 1.

What is money income? Describe the distribution of money income in the United States in 2012. Money income equals market income (wages, interest, rent, and profit earned in factor markets, before paying income taxes) plus cash payments from the government. The distribution of money income in the United States is unequal. While the median household income was $51,017, the poorest 20 percent of household received less than 4 percent of the total income and the richest 20 percent of household received slightly more than 50 percent of the total income.

The table shows money income shares in the United States in 2001. Draw a U.S. Lorenz curve in 2001. Was the U.S. distribution of income more equal in 2001 than in 2012 (see p. 485)? Explain your answer. The Lorenz curve is illustrated in Figure 19.1. To draw it, plot the cumulative percentage of households on the x-axis and the cumulative percentage of income on the y-axis. The Lorenz curve will pass through the following

Households (quintile) Lowest Second Third Fourth Highest

Money income (percentage of total) 3.5 8.8 14.5 23.1 50.1

points: 20 percent on the x-axis and 3.5 percent on the y-axis; 40 percent on the x-axis and 12.3 percent on the y-axis; 60 percent on the x-axis and 26.8 percent on the y-axis; 80 percent on the x-axis and 49.9 percent on the y-axis; and 100 percent on the x-axis and 100 percent on the yaxis. The Lorenz curve for the U.S. economy in 2001 lies closer to the Line of equality than does the Lorenz curve in 2012, which means the distribution of money income was more equal in 2001. In 2001, the lowest `quintile received a greater percentage of income than in 2012 and the highest quintile received a smaller percentage of income than in 2012.

Incomes in China and India are a small fraction of U.S. income, but incomes in China and India are growing at more than twice the rate of U.S. incomes. a. Explain how economic inequality in China and India is changing relative to that in the United States. Inequality between people in China and India and people in the United States is lessening. Income for the typically poorer people in China and India is increasing more rapidly than income for the typically richer people in the United States, so the fraction of world income going to the people in China and India is growing.

b. How is the world Lorenz curve and world Gini ratio changing? The world Lorenz curve is moving closer to the line of equality and the Gini ratio is falling in value.

ECONOMIC INEQUALITY

Use the table to work Problems 4 and 5. The table shows the income shares in the United States, Canada, and the United Kingdom in 2009. Households (percentage) Lowest 20 Second 20 Middle 20 Next highest 20 Highest 20 4.

United States Canada United Kingdom (percentage of total income) 3 7 3 8 13 5 15 18 14 23 25 25 50

Draw the Lorenz curves for the United States and Canada. In which country was money income less equally distributed in 2009? To draw the Lorenz curve for Canada, it is necessary to calculate the cumulative percentage of households and cumulative percentage of income. The table to the right has these data. Figure 19.2 shows the Lorenz curve for the United States and Canada. Income is distributed less equally in the United States.

Canada Households (quintile) Lowest Second Third Fourth Highest

Cumulative percentage of income 7 20 38 63 100

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Draw the Lorenz curves for the United States and the United Kingdom. In which country was income less equally distributed in 2009? To draw the Lorenz curve for Canada, it is necessary to calculate the cumulative percentage of households and cumulative percentage of income. The table to the right has these data. Figure 19.3, shows the Lorenz curve for the United States and the United Kingdom. Income is distributed less equally in the United Kingdom.

United Kingdom Cumulative Households percentage of (quintile) income Lowest 3 Second 8 Third 22 Fourth 47 Highest 100

Figure 19.4 shows the market for low-skilled labor. The value of marginal product of highskilled workers is $16 an hour greater than that of low-skilled workers at each quantity of labor. The cost of acquiring human capital adds $12 an hour to the wage that must be offered to attract high-skilled labor. Compare the equilibrium wage rates of lowskilled labor and high-skilled labor. Explain why the difference between these wage rates equals the cost of acquiring human capital. The wage rate adjusts to make the quantity of labor demanded equal to the quantity supplied. Figure 19.4 shows that the wage rate of low-skilled labor is $12 an hour. The value of marginal product of high-skilled labor at each employment level is $16 greater than the value of marginal product of low-skilled labor, so firms are willing to pay high-skilled labor a higher wage rate than they are willing to pay low-skilled labor. For example, the demand curve for low-skilled labor tells us that firms are willing to hire 4,000 hours of lowskilled labor at a wage rate of $8 an hour. Because the value of marginal product of high-skilled labor is $16 greater than the value of low-skilled labor, firms are willing to hire 4,000 hours of high-skilled labor at a wage rate of $24 an hour. The demand curve for high-skilled labor lies above the demand curve for lowskilled labor such that at each quantity of labor the wage rate paid high-skilled labor is $16 greater than that paid low-skilled labor. The supply curve of high-skilled labor lies above the supply curve of low-skilled labor such that the vertical distance between the two supply curves equals the cost of acquiring the human

ECONOMIC INEQUALITY

capital—$12 an hour. That is, high-skilled labor will supply any amount of labor a day if the wage rate is $24 an hour. Equilibrium in the labor market for high-skilled labor occurs at a wage rate of $24 an hour. The wage rate increases by exactly the cost of acquiring the skill because the supply of labor is perfectly elastic. High-skilled labor is willing to supply any amount of labor at a wage rate of $24 an hour. They will supply no labor at wage rates below $24 an hour.

Use the table to work Problems 7 and 8. The table shows three redistribution schemes. Before-tax income (dollars) 10,000 20,000 30,000 7.

Plan A tax (dollars)

Plan B tax (dollars)

Plan C tax (dollars)

1,000 2,000 3,000

1,000 4,000 9,000

2,000 2,000 2,000

Which scheme has (i) a proportional tax? (ii) a regressive tax? (iii) a progressive tax? Tax Plan A is a proportional tax. At each level of income, 10 percent of income is paid in taxes. Tax Plan C is regressive. When income is $10,000, 20 percent of income is paid in taxes; when income is $20,000, 10 percent of income is paid in taxes; and, when income is $30,000, 6.67 percent of income is paid in taxes. Tax Plan B is progressive. When income is $10,000, 10 percent of income is paid in taxes; when income is $20,000, 20 percent of income is paid in taxes; and, when income is $30,000, 30 percent of income is paid in taxes.

Which scheme will (i) increase economic inequality? (ii) reduce economic inequality? (iii) have no effect on economic inequality? Tax Plan C increases inequality. The poor pay 20 percent of their income as tax while the rich pay only 6.7 percent. Tax Plan B decreases inequality. The poor pay only 10 percent of their income as tax while the rich pay 30 percent. Tax Plan A has no effect on inequality because all income groups pay 10 percent of their income as tax.

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Answers to Additional Problems and Applications Use the table to work Problems 9 and 10. The table shows the distribution of money income in India in 2010. 9. a. What is the definition of money income? Why does money income tend to be more equally distributed than market income?

Households (quintile) Lowest Second Third Fourth Highest

Market income (percentage of total) 8.6 12.4 15.8 20.8 42.2

Money income is defined as a sum of market income and cash payments to households by government. Market income is the before-tax income earned by factors of production in the marketplace. Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profit. Money income is distributed more equally than market income because money income includes cash payments to poor households, which increases their income.

b. Draw the Lorenz curve for the distribution of money income in India. Figure 19.5a shows the distribution of money income in India. To draw this Lorenz curve, plot the cumulative percentage of households on the x-axis and the cumulative percentage of money income on the y-axis. Make the scale on the two axes the same. The Lorenz curve will pass through the following points: 20 percent on the x-axis and 8.6 percent on the y-axis; 40 percent on the x-axis and 21 percent on the y-axis; 60 percent on the x-axis and 36.8 percent on the y-axis; 80 percent on the x-axis and 57.6 percent on the y-axis; and 100 percent on the x-axis and 100 percent on the yaxis.

10.

Compare the distribution of money income in India with the distribution of money income in U.S. shown in Fig. 19.3 on p. 483. Which distribution is more unequal? India’s money income in 2010 is distributed more equally than U.S. money income in 2012. The Lorenz curve for India’s money income in 2012 lies closer to the line of equality than does the Lorenz curve for U.S. money income.

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Use the table to work Problems 11 to 13. The table shows shares of income in Australia. 11.

Draw the Lorenz curve for the income distribution in Australia and in Brazil and South Africa (use the data in Fig. 19.6 on p. 491). Is income distributed more equally or less equally in Brazil and South Africa than in Australia? Figure 19.6 shows these Lorenz curves. Income is distributed less equally in Brazil and South Africa.

12.

Households (quintile) Lowest Second Third Fourth Highest

Market income (percent of total) 7 13 18 24 38

Is the Gini ratio for Australia larger or smaller than that for Brazil and South Africa? Explain your answer. The Gini coefficient is smaller in Australia because the distribution of income is more equally distributed in Australia.

13.

What are some reasons for the differences in the distribution of income in Australia and in Brazil and South Africa? In both Brazil and South Africa there are wealthy citizens descended from European settlers and poorer citizens descended from large indigenous native populations. The income disparity between these two relatively large groups creates an unequal distribution of income in Brazil and South Africa. In Australia the indigenous native population is smaller, so the population is comprised mainly of citizens descended from European settlers. Because there is not a large pool of low-income indigenous natives, the distribution of income is more equal in Australia.

14.

Figure 19.7 shows the market for a group of workers who are discriminated against. Suppose that other workers in the same industry are not discriminated against and their value of marginal product is perceived to be twice that of the workers who are discriminated against. Suppose also that the supply of these other workers is 2,000 hours per day less at each wage rate. a. What is the wage rate of the workers who are discriminated against? The wage rate of workers who are discriminated against is $10 an hour.

b. What is the quantity of workers employed who are discriminated against? Firms employ 5,000 hours of labor per day from workers facing discrimination.

c. What is the wage rate of the workers who do not face discrimination? Because the value of marginal product of workers not facing discrimination is perceived to be twice the value of marginal product of the other workers, firms are willing to pay the workers not facing discrimination twice the wage rate that they are willing to pay the workers who face discrimination. For example, the demand curve for the workers being discriminated against tells us that firms are willing to

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hire 6,000 hours of these workers at a wage rate of $8 an hour. So with workers not facing discrimination perceived to be twice as productive as the other workers, firms are willing to hire 6,000 hours of labor from the non-discriminated group at $16 an hour. The demand curve for labor for the workers not facing discrimination lies above the demand curve for workers facing discrimination such that at each quantity of workers the wage rate for workers not facing discrimination is double that of workers facing discrimination. The supply curve of workers not facing discrimination lies to the left of the supply curve of workers facing discrimination by 2,000 hours of labor. The vertical distance between the two supply curves is $4 an hour. That is, workers not facing discrimination will supply 6,000 hours a day if the wage rate is $16 an hour. The equilibrium wage rate of workers who do not face discrimination is $16 an hour.

d. What is the quantity of workers employed who do not face discrimination? Firms employ 6,000 hours of labor per day from workers not facing discrimination.

15.

Women Bouncers Rapidly Grow in Numbers, Earn More than Male Counterparts Women bouncers have not just broken the proverbial glass ceiling in the country but also rapidly grown in numbers as concerned parents, cautious event managers, and pub and restaurant owners all seek their services. Security agents estimate that in just the past one-and-a-half years, the number of women bouncers in India has grown fourfold to about 5,000. Unlike most other jobs, where gender disparity is prevalent to the disadvantage of women, in this profession women often get paid more than men—their wages range from Rs 1,500-2,000 per shift along with conveyance compared with Rs 800-1,200 offered to men. Source: The Economic Times, March 14, 2015 a. Draw a graph to illustrate why discrimination could result in female bouncers getting paid more than male bouncers. Figure 19.8 shows labor market for bouncers in which men are discriminated against in favor of women. With the discrimination, the value of marginal product of women bouncers exceeds that of men. As a result, the value of marginal product curve for females, labeled VMPw, lies above the value of marginal product curve for males, labeled VMPM. In the figure the supply of male labor is the same as that of females, so the supply curve is labeled SM = Sw. The figure shows that the wage rate paid to women bouncers, INR 1700 per shift, exceeds the wage rate paid to their male counterparts, INR 1000 per shift.

b. Explain how market competition could potentially eliminate this wage differential. Men bouncers are paid less than their women counterparts. If men and women are equally productive and the price paid for their output is the same, then firms which hire men have lower costs and higher profits than firms which hire women. Firms that hire men bouncers would increase their sales at the expense of the high-cost and therefore higher-price firms that hire only women bouncers. The increase in revenue of firms that hire men increases the demand for men, which raises their wage rate. Firms that hire women bouncers lose revenue and so the demand for women decreases, which lowers their wage rate.

c. If customers “prefer dealing with women bouncers”, how might that lead to a persistent wage differential between men and women bouncers? If customers prefer dealing with a woman bouncer, then women’s value of marginal product remains permanently higher than men’s value of marginal product so the wage rate paid to women bouncers remains permanently higher than the

ECONOMIC INEQUALITY

wage rate paid to men bouncers.

Use the following information to work Problems 16 and 17. In 2010, 828,000 Americans had full-time management jobs that paid an average of $96,450 a year while 4.3 million Americans had full-time retail sales jobs that paid an average of $20,670 a year. Managers require a high school certificate while retail sales people don’t but they undergo training. Source: Bureau of Labor Statistics 16.

Explain why managers are paid more than retail salespeople. Managers have more human capital than retail salespeople. Their higher human capital means that their value of marginal product is higher, so the demand for managers exceeds that of retail salespeople. Additionally the cost of acquiring their human capital means that the supply of managers is less than the supply of retail salespeople. The higher demand for managers combined with the lower supply of managers means that their salaries exceed those of retail salespeople.

17.

If the online shopping trend continues, how do you think the market for salespeople will change in coming years? Shopping on-line decreases the demand for in-person salespeople. If on-line shopping continues to increase in importance, the decrease in demand for salespeople will lower the salary and decrease the quantity of salespeople. If, in response to the lower salary, the supply of salespeople also decreases, then the employment definitely decreases but the effect on the salary becomes ambiguous.

18.

Use the information provided in Problem 9 and in Fig. 19.3 on p. 485. a. What is the percentage of total income that is redistributed from the highest income group? Redistribution lowers the highest income group’s share by 4.0 percent of total income. The highest income group receives 55.1 percent of total market income and 51.1 percent of total money income. So redistribution lowers the highest income group’s share by 4.0 percent of total income.

b. What percentages of total income are redistributed to the lower income groups? Redistribution raises the lowest income group’s share by 2.1 percent of total income. The lowest income group receives 1.1 percent of market income and 3.2 percent of total money income. So redistribution raises the lowest income group’s share by 2.1 percent of total income.

19.

Describe the effects of increasing the amount of income redistribution in the United States to the point at which the lowest income group receives 15 percent of total income and the highest income group receives 30 percent of total income. If the highest income group’s share falls from 55.1 to 30 percent of total income, redistribution takes 25.1 percent of income from this group. If the lowest income group’s share rises from 1.1 to 15 percent, redistribution raises this group’s share by 13.9 percent of total income. The other 11.2 percent (25.1 minus 13.9 percent) would be distributed to other groups. This redistribution scheme would require a tax on the highest groups of 45.5 percent— (25.1/55.1) 100 percent. Such a large increase in the tax rate and redistribution might create the big tradeoff effect. The highly taxed people might choose to do less work and if they do, total income decreases.

Use the following news clip to work Problems 20 and21. David Cameron Promises £7.2 Billion Tax Cuts to the Rich David Cameron has handed the rich a massive tax break while clobbering the poorest with more spending cuts. The Prime Minister promised £7.2 billion of tax cuts for the well-off, leaving them £1,900 a year better off. And the cash will come from £25 billion slashed from town halls, education, police, welfare and other vital services. While a worker on £12,500 would save £500 a year, someone earning £50,000 would keep £1,900 extra. Source: Mirror, October 1, 2014

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Explain why tax cuts in a progressive income tax system are consistently criticized for favoring the wealthy. In a progressive tax system, the wealthy pay a larger fraction of their income as tax than others. With this type of tax system, tax cuts must favor the wealthy because it is the wealthy that pay the vast majority of taxes.

21.

How might the benefits of tax cuts “trickle down” to others whose taxes are not cut? The benefits of tax cuts can trickle down because tax cuts mean that the wealthy have more income, some of which they might invest in the businesses they run. For instance, a wealthy entrepreneur who is given a tax cut might increase the size of his or her business, which creates more employment and higher wages for less wealthy workers. Additionally, the wealthy spend some of their additional funds on goods and services. Some of the firms producing these goods and services expand, once again increasing the employment and wage rate of less wealthy workers.

Economics in the News 22.

After you have studied Economics in the News on pp. 500–501, answer the following questions. a. What is the trend in top executive pay? The trend in top executive pay has been dramatically upward, especially after 1980. In 1960 the average family in the top 0.01 percent of income received 27 times the average family income in the bottom quintile. Nowadays the ratio is 296 times the income of the average family in the bottom quintile.

b. How can the idea of a contest among potential top executives explain their high pay? The salaries of top executives are determined by a “contest” among potential executives. The idea is that the firm, by offering a very high salary for its top executives, motivates all of the potential aspirants to these positions to work very hard in order to “win” the contest by being appointed. The larger the number of potential top executives, the smaller the chance any one person will win the job. With globalization the number of “contestants” increased, which increased the salary necessary to offset the fall in the chance of winning.

c. How can the idea of a contest among potential top executives explain the trend in their pay? The salaries of top executives are determined by a “contest” among potential executives. The idea is that the firm, by offering a very high salary for its top executives, motivates all of the potential aspirants to these positions to work very hard in order to “win” the contest by being appointed. The larger the number of potential top executives, the smaller the chance any one person will win the job. In order to offset the fall in the chance of winning, to give the “players” the incentive to work hard, the “prize,” that is, the top executive’s salary, must be increased. Because of globalization, since the 1960s the number of “contestants” to top positions—the players—has increased and so the salary paid these positions has trended higher.

d. If the contest among potential top executives is the correct explanation for their high pay, what would be the effects of a cap on top executive pay? A cap on top executive pay will decrease the effort put forth by all the managers attempting to become the next top executive.

ECONOMIC INEQUALITY

23.

The Best and Worst College Degrees by Salary Business administration is always a strong contender for honors as the most popular college major. This is no surprise since students think business is the way to making big bucks. But is business administration really as lucrative as students and their parents believe? Nope. In a new survey by PayScale, Inc. of salaries by college degree, business administration didn’t even break into the list of the top 10 or 20 most lucrative college degrees. A variety of engineering majors claim eight of the top 10 salary spots with chemical engineering ($65,700) winning best for starting salaries. Out of 75 undergrad college majors, business administration ($42,900) came in 35th, behind such degrees as occupational therapy ($61,300), information technology ($49,400), and economics ($48,800). Source: moneywatch.com, July 21, 2009 a. Why do college graduates with different majors have drastically different starting salaries? The differences in starting salaries are the result of differences in the demand for and supply of the different majors. Different majors require different skill sets and different amounts of human capital. These differences mean that the value of marginal product and therefore the demand for different majors can be substantially different. In addition different numbers of students major in the different subjects because some majors are high-cost majors (in terms of time and/or effort) while other majors are lower cost. This difference means that the supply of the different majors can be substantially different.

b. Draw a graph of the labor markets for economics majors and business administration majors to illustrate your explanation of the differences in the starting salaries of these two groups. Economics majors likely have more human capital and more marketable skills than do business administration majors, so the demand for economics majors is greater than the demand for business administration majors. There are probably more business administration majors than economics majors, so the supply of business administration majors exceeds the supply of economics majors. Both these differences are illustrated in Figure 19.9. In the figure the demand curve for economics majors is labeled DE and lies to the right of the demand curve for of business administration majors, labeled DBA. Also in the figure the supply curve of business administration majors, labeled SBA, lies to the right of the supply curve of economics majors, labeled SE. These different demand and supply curves result in a starting salary for economics majors of $48,800 and for of business administration majors of $42,900.

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Answers to the Review Quizzes Page 510 1.

What is the distinction between expected wealth and expected utility? Expected wealth is the money value of what a person expects to own at a point in time. Expected utility is the utility value of what a person expects to own at a point in time. These concepts both measure the value of what a person expects to own at a point in time but they differ because expected wealth is the money value and expected utility is the utility value.

How does the concept of utility of wealth capture the idea that pain of loss exceeds the pleasure of gain? The utility of wealth has diminishing marginal utility. Diminishing marginal utility means that the decrease in utility from a dollar decrease in wealth, that is, the pain of loss, is greater than the increase in utility from a dollar increase in wealth, that is, the pleasure of gain.

What do people try to achieve when they make a decision under uncertainty?

How is the cost of risk calculated when making a decision with an uncertain outcome?

When making decisions under uncertainty people maximize their expected utility. A decision made with uncertainty has an expected wealth and an expected utility that depend on the probability, wealth, and utility associated with the different outcomes. Because people are risk averse, the amount of certain wealth that creates the utility equal to the expected utility in the uncertain case is less than the expected wealth in the uncertain case. The difference between the expected wealth in the uncertain case and the certain wealth that creates the same level of utility is the cost of risk.

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How does insurance reduce risk? Insurance reduces the risk any individual faces because insurance pools risks. Everyone pays into the pool but only the small fraction of people who suffer a loss are paid from the pool. Essentially people reduce the risk of a large adverse financial outcome in exchange for the small, certain payment to the insurance company.

How do we determine the value (willingness to pay) for insurance? The amount that someone would be willing to pay to avoid risk is measured using the person’s utility of wealth schedule or curve. The important feature of the curve is that the marginal utility of wealth diminishes as wealth increases. The rate at which the marginal utility of wealth declines determines the degree of the individual’s risk aversion, that is, how much he or she is willing to pay to avoid risk.

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Suppose a person faces the risky situation of receiving wealth of W1 (with utility of U 1 ) or a smaller amount, W 2 (with utility of U 2 ). The expected wealth from this situation is EW, and the expected utility is EU. This risky situation has the same utility as receiving some amount of certain wealth, W. The difference in wealth between the risky high level of wealth and the sure case, W1 – W, measures the value of insurance in this situation to this individual. The more rapidly the marginal utility of wealth declines, the more risk averse is the person because the more wealth the individual is willing to give up to guarantee a certain (albeit lower) amount of wealth. That is, the more concave the utility of wealth curve, the less is the certain wealth that has the same utility as the expected utility from an uncertain, risky outcome.

How can an insurance company offer people a deal worth taking? Why do both the buyers and the sellers of insurance gain? Insurance companies work by pooling risks so that everyone pays into the pool but only the (small) fraction of people who suffer a loss are paid from the pool. Although the likelihood of a bad occurrence is small for each individual, for a large enough group the total number and total amount of losses can be estimated very closely. The insurance company can calculate the size of the pool required to cover losses. From this calculation the company can compute the amount of the premium each person must pay into the pool to cover all the anticipated losses and other costs the company incurs. People buy insurance because they are risk averse; they want to avoid unwanted outcomes. Insurance is worth buying because people are willing to give up a relatively small amount of income all the time to guarantee that they do not face the uncommon occurrence of having to give up a large amount of income since this deal increases their expected utility. An insurance company will always try to take in more in premiums paid than claims paid out to claimants so that their owners receive at minimum a normal profit.

What kinds of risks can’t be insured? Insurance works because the risks of adverse outcomes are independent, that is, one person suffering a loss does not affect the likelihood that other people will suffer similar losses. If the losses from an event are not independent, so that “everyone” suffers a loss at the same time, then the risk of loss cannot be insured.

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How does private information create adverse selection and moral hazard? Both moral hazard and adverse selection are the result of private information. Moral hazard occurs when, after an agreement has been reached, one of the parties to the agreement has the incentive to gain additional benefits at the expense of the other party. Adverse selection refers to people who accept certain contracts and have private information that allows them to benefit from the contract while harming the other party. Both moral hazard and adverse selection can affect negatively the way in which markets function.

How do markets for cars use warranties to cope with private information? Warranties serve to limit the adverse selection and moral hazard problems in the market for cars. Essentially, warranties (and guarantees in general) are signals provided to potential buyers that the product under consideration has been examined by experts and is a high-quality item. Without the existence of these signals, the lemon problem, whereby only low-quality products are offered for sale, may occur because buyers realize that all sellers claim that they are selling high-quality goods but that adverse selection implies that the goods sold are of low quality.

How do markets for loans use signaling and screening to cope with private information? Lenders in the loans market want to separate high-risk borrowers from low-risk borrowers so that they can charge high-risk borrowers a high interest rate and low-risk borrowers a low interest rate. They use signals and screens to help them do so. They screen borrowers by asking for information that helps them assess the riskiness of the loan and the borrower. If the borrower does not reveal the information requested, the lender has screened the borrower into the high-risk category. The

UNCERTAINTY AND INFORMATION

information requested will provide signals about the borrower’s riskiness. For instance, if a borrower has defaulted on debt in the past this fact signals that the borrower is a high-risk individual.

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How do markets for insurance use no-claim bonuses to cope with private information? “No-claim” bonuses are commonly used in auto insurance. One of the most important pieces of information a person can give an auto insurance company is his or her propensity to drive safely and avoid accidents. However, this information is only believable to the extent that driving records really do differentiate good drivers from bad drivers. Driving records cover only a short period of time and, randomly, some bad drivers will establish good records. So a good driving record is not a guarantee that the driver is a safe driver. The screening device that insurance companies use to overcome this potential problem is the “no-claim” bonuses that drivers accumulate when they do not make an insurance claim. Presumably, having not made a claim means that you were a good driver and did not need to make a claim!

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Thinking about information as a good, what determines the information people are willing to pay for? People are willing to pay for information so long as the marginal cost is less than or equal to its marginal benefit. For instance, consumers are willing to purchase information that has a marginal benefit to them that exceeds the price they must pay. Consumers might be willing to purchase information about the price(s) of large-ticket goods and services that are of interest. Workers might well be interested in buying information about salaries paid in occupations that interest them or salaries paid their coworkers. Employers are willing to buy information about the average salary offer given to college graduates with different majors.

Why is it inefficient to be overinformed? Information is costly to obtain. If the marginal cost of obtaining the information exceeds its marginal benefit, the individual would be better off by not obtaining the information. It is inefficient to acquire the information because the marginal benefit from the information does not make up for the marginal cost of obtaining it.

Why are some of the markets that provide information likely to be dominated by monopolies? Objective information about, say, the quality of a good or service or the risk associated with a particular activity is costly to obtain. Once it is obtained, however, the marginal cost of disseminating it is low. With the low marginal cost, the firm can enjoy significant economies of scale, so these markets might be close to natural monopolies, that is, a market in which one firm can meet the demand at lower cost than could two or more firms.

UNCERTAINTY AND INFORMATION

Answers to the Study Plan Problems and Applications 1.

The figure shows Lee’s utility of wealth curve. Lee is offered a job as a salesperson in which there is a 50 percent chance that she will make $4,000 a month and a 50 percent chance that she will make nothing. a. What is Lee’s expected income from taking this job? Lee’s expected income is (0.5  $4,000) + (0.5  $0) = $2,000 a month.

b. What is Lee’s expected utility from taking this job? When Lee’s income is $4,000, her utility is 100. When Lee’s income is $0, her utility is 0. So Lee’s expected utility is (0.5  100) + (0.5  0) = 50.

c. How much would another firm have to offer Lee with certainty to persuade her not to take the risky sales job? Lee would have to be offered about $1,250 a month with certainty to persuade her not to take the risky job. Lee would have to be offered the income that would give her with certainty 50 units of utility. This income, $1,250, is read from the graph at the 50 units on the y-axis.

d. What is Lee’s cost of risk? Lee’s cost of risk is the difference between Lee’s expected income, $2,000, and the certain income that gives her the same total utility, $1,250. Lee’s cost of risk is $750.

Use the following news clip to work Problems 2 and 3. Larry lives in a neighborhood in which 20 percent of the cars stolen every year. Larry’s car, which he parks on the street overnight, is worth $20,000. (This is Larry’s only wealth.) The shows Larry’s utility of wealth schedule. 2.

If Larry cannot buy auto theft insurance, what is his wealth and his expected utility? Larry’s expected wealth is $20,000 × 0.80 + $0 × 0.20, $16,000. Larry’s expected utility is 400 × 0.80 + 0 × 0.20,

Wealth (dollars) 20,000 16,000 12,000 8,000 4,000 0

Utility (units) 400 350 280 200 110 0

are table expected which is or 320.

High-Crime Auto Theft, an insurance company, offers to sell Larry insurance at $8,000 a year and promises to provide Larry with a replacement car worth $20,000 if his car is stolen. Is Larry willing to buy this insurance? If not, is he willing to pay $4,000 a year for such insurance? If Larry buys the insurance for $8,000 his wealth will be $12,000 with no risk. This amount of wealth gives him utility of 280. This amount of utility is less than what his utility would be if he did not buy insurance, so Larry will not buy the insurance for $8,000. If Larry buys the insurance for $4,000 his wealth will be $16,000 with no risk. This amount of wealth gives him utility of 350. This amount of utility is more than what his utility would be if he did not buy insurance, so Larry will buy the insurance for $4,000.

Suppose that there are three national soccer leagues: Time League, Goal Difference League, and Bonus for Win League. The leagues are of equal quality, but the players are paid differently. Players in the Time League are paid by the hour for time spent practicing and playing. Players in the Goal Difference league are paid an amount that depends on the goals scored by the team minus the goals scored against it. Players in the Bonus for Win League are paid one wage for a loss, a higher wage for a tie, and the highest wage of all for a win.

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a. Describe the predicted differences in the quality of the games played by each of the leagues. In the Time League, players have no incentive to play hard or to win the game. In this league the games are likely to be dull, drawn out, low quality affairs with players not playing particularly hard. In the Goal Difference League, the players have the incentive to play as hard as possible throughout the game to score as many goals as possible. These games are likely to be action-oriented, high quality games. In the Bonus for Win League the players have an incentive to play hard but not as hard as in the Goal Difference League. For instance, if one team is ahead by a couple of points near the end of the game, the players on that team have the incentive to shirk as long as the other team does not tie or win the game. So these games will be medium quality.

b. Which league is the most attractive to players? Assuming that the average salaries are the same, if players are risk averse then the Time League is most attractive.

c. Which league will generate the largest profits? If fans like action packed games and if the average salary is the same in all leagues, then the Goal Difference League will attract the most fans and be the most profitable.

You can’t buy insurance against the risk of being sold a lemon. Why isn’t there such a market? How does the market provide a buyer with some protection against being sold a lemon? What are the main ways in which markets overcome the lemons problem? There is not a market for “lemon insurance” for several reasons. Defining a “lemon” is far from clear cut. The definition would need to be specified in the contract. But that leads to a moral hazard problem because a buyer with a car close to meeting the requirements for a lemon will behave in a way that increases the probability that the car will be deemed a lemon. Moral hazard also arises once the insurance is purchased but before the car is bought. Once the customer has the insurance, he or she will no longer search for a “non-lemon,” a creampuff. So it is likely that many of the cars purchased by people with the insurance will be lemons. These reasons combine to make it impossible for an insuring company to offer the insurance at a price that customers will pay and that allows the insurance firm to make a profit. Adverse selection also enters because people who are less likely to spend time searching for a high-quality car are more likely to buy the lemon insurance. Even without insurance, the market does give protection against lemons. Warranties are designed to help cope with the moral hazard and adverse selection problems on cars. Warranties signal that the car is not a lemon because if the car is a lemon servicing the car would be costly. The fact that the seller, who is the person with the private information, is willing to offer a warranty signals that the car is not a lemon.

Show Us Our Money I have no clue what my colleagues make and I consider my salary my own business. It turns out that could be a huge mistake. What if employers made all employee salaries known? If you think about it, who is served by all the secrecy? Knowing what other workers make might be more ammunition to gun for a raise. Source: Time, May 12, 2008 Explain why a worker might be willing to pay for the salary information of other workers. A worker could demand a higher salary by comparing his or her pay with that of a (perceived) less valuable colleague. The worker would be willing to pay for the salary information if the marginal cost of obtaining the information is less than or equal to the marginal benefit from obtaining it.

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Answers to Additional Problems and Applications Use the table, which shows Jimmy’s and Zenda’s utility of wealth schedules, to work Problems 7 to 9. 7.

What are Jimmy’s and Zenda’s expected utilities from a bet that gives them a 50 percent chance of having a wealth of $600 and a 50 percent chance of having nothing? Jimmy’s expected utility is (0.5 393) + (0.5  0) = 196.5. Zenda’s expected utility is (0.5  683) + (0.5  0) = 341.5.

8. a. Calculate Jimmy’s and Zenda’s marginal utility of wealth schedules.

Wealth 0

The table to the right sets out their marginal utility of wealth schedules.

b. Who is more risk averse, Jimmy or Zenda? How do you know? Zenda is more risk averse because her marginal utility of wealth decreases more quickly as wealth increases than does Jimmy’s marginal utility of wealth.

100

Jimmy’s utility 0 200 300 350 375 387 393 396

Wealth 0 100 200 300 400 500 600 700

Jimmy’s utility 0 200

200

300

350

400

375

Jimmy’s marginal utility 2.00 1.00 0.50 0.25 0.12

Zenda’s utility 0 512 640 672 678

Zenda’s utility 0 512 640 672 678 681 683 684 Zenda’s marginal utility 5.12 1.28 0.32 0.06

0.03 Suppose that Jimmy and Zenda 500 387 681 each have $400 and are offered a 0.06 0.02 business investment opportunity 600 393 683 that involves committing the entire 0.03 0.01 $400 to the project. The project 700 396 684 could return $600 (a profit of $200) with a probability of 0.85 or $200 (a loss of $200) with a probability of 0.15. Who goes for the project and who hangs on to the initial $400? Jimmy puts his money into the project, but Zenda does not. Jimmy maximizes his expected utility. If Jimmy puts his money into the project and it makes a profit, his utility is 393; if Jimmy puts his money into the project and it fails, his utility is 300. So Jimmy’s expected utility from the project is (0.85  393) + (0.15  300), which equals 379. If Jimmy keeps his $400 and does not join the project, his utility is 375. Jimmy will choose to join the project because joining gives him greater utility. Zenda maximizes her expected utility. If Zenda puts her money into the project and it makes a profit, her utility is 683; if Zenda puts her money into the project and it fails, her utility is 640. So Zenda’s expected utility from the project is (0.85  683) + (0.15  640), which equals 677. If Zenda keeps her $400 and does not join the project, her utility is 678. Zenda will choose not to join the project because not joining gives her greater utility.

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CHAPTER 20

Use the following information to work Problems 10 to 12. Two students, Jim and Kim, are offered summer jobs managing a student house-painting business. There is a 50 percent chance that either of them will be successful and end up with $21,000 of wealth to get them through the next school year. But there is also a 50 percent chance that either will end up with only $3,000 of wealth. Each could take a completely safe but back-breaking job picking fruit that would leave them with a guaranteed $9,000 at the end of the summer. The table shows Jim’s and Kim’s utility of wealth schedules. 10.

Does anyone take the painting job? If so, who takes it and why? Does anyone take the job picking fruit? If so, who takes it and why?

Wealth 0 3,000 6,000 9,000 12,000 15,000 18,000 21,000

Jim’s utility 0 100 200 298 391 482 572 660

Kim’s utility 0 200 350 475 560 620 660 680

Jim will take the painting job. If Jim takes the job managing the house painters, his expected utility is 0.5 × 660 + 0.5 × 100, which is 380. If Jim takes the job picking fruit, his expected (and actual) utility is 298. Jim will take the job managing the house painters because his expected utility from that job is larger than his expected utility from picking fruit. Kim will take the fruit-picking job. If Kim takes the job managing the house painters, her expected utility is 0.5 × 680 + 0.5 × 200, which is 440. If Kim takes the job picking fruit, her expected (and actual) utility is 475. Kim will take the picking fruit because her expected utility from that job is larger than her expected utility from managing the house painters.

11.

In Problem 10, what is each student’s maximized expected utility? Who has the larger expected wealth? Who ends up with the larger wealth at the end of the summer? Jim’s expected utility is 380; Kim’s expected utility is 475. Jim has higher expected wealth. Jim’s expected wealth is $12,000; Kim’s expected (and actual) wealth is $9,000. It is not possible to determine who has the actual larger wealth because Jim’s wealth is uncertain.

12.

In Problem 10, if one of the students takes the risky job, how much more would the fruit-picking job have needed to pay to attract that student? Jim takes the risky job. His expected utility with the risky job is 380. The fruit picking job must offer pay that gives Jim utility of more than 380. If the fruit picking job paid $12,000, Jim’s utility would be 391 and he would take the fruit picking job. So to entice Jim to take the fruit picking job, it would need to pay $3,000 more than its current payment of $9,000.

Use the table, which shows Chris’s utility of wealth schedule, to work Problems 13 and 14. Chris’s wealth is $5,000 and it consists entirely of her share in a risky ice cream business. If the summer is cold, the business will fail, and she will have no wealth. Where Chris lives there is a 50 percent chance each year that the summer will be cold. 13.

If Chris cannot buy cold-summer insurance, what is her expected wealth and what is her expected utility? Chris’s expected wealth is $5,000 × 0.50 + $0 × 0.50, which is $2,500. Her expected utility is 150 × 0.50 + 0 × 0.50, which is 75.

Wealth (dollars) 5,000 4,000 3,000 2,000 1,000 0

Utility (units) 150 140 120 90 50 0

UNCERTAINTY AND INFORMATION

14.

Business Loss Recovery, an insurance company, is willing to sell Chris cold-summer insurance at a price of $3,000 a year and promises to pay her $5,000 if the summer is cold and the business fails. Is Chris willing to buy this loss insurance? If she is, is she willing to pay $4,000 a year for it? If Chris buys the insurance for $3,000 her wealth will be $2,000 with no risk. This amount of wealth gives her utility of 90, which is more than what her utility would be if she did not buy insurance. Chris will buy the insurance for $3,000. If Chris buys the insurance for $4,000 her wealth will be $1,000 with no risk. This amount of wealth gives her utility of 50, which is less than what her utility would be if she did not buy insurance. Chris will not buy the insurance for $4,000.

Use the following information to work Problems 15 to 17. Larry has a good car that he wants to sell; Harry has a lemon that he wants to sell. Each knows what type of car he is selling. You are looking at used cars and plan to buy one. 15.

If both Larry and Harry are offering their cars for sale at the same price, from whom would you most want to buy, Larry or Harry, and why? If you know that Larry’s car is a good car and Harry’s car is a lemon, you most want to buy from Larry. If you do not know that Larry’s car is a good car and Harry’s car is a lemon, you are indifferent between the two.

16.

If you made an offer of the same price to Larry and Harry, who would sell to you and why? Describe the adverse selection problem that arises if you offer the same price to Larry and Harry. The price offered will be the price for which a lemon sells. Harry, who has a lemon, will be willing to sell at that price; Larry, who has a good car, will not be willing to sell. The adverse selection problem that arises is that only sellers with lemons are willing to sell their cars at the going (lemon) price.

17.

How can Larry signal that he is selling a good car so that you are willing to pay Larry the price that he knows his car is worth, and a higher price than what you are willing to offer Harry? Larry can offer a warranty on his car. For instance, Larry might offer to pay any repair bills (aside from accidents!) that come about for the next 6 months.

18.

Pam is a safe driver and Fran is a reckless driver. Each knows what type of driver she is, but no one else knows. What might an automobile insurance company do to get Pam to signal that she is a safe driver so that it can offer her insurance at a lower premium than it offers to Fran? One possibility is to offer insurance with a higher deductible at a lower cost. Pam knows that she is less likely to need the insurance, so she is willing to accept the higher deductible to save on the insurance premiums. Fran knows that she is more likely to use the insurance, so she is not interested in a high deductible. Fran is more likely to pay the higher insurance premiums to have the low deductible.

19.

Why do you think it is not possible to buy insurance against having to put up with a low-paying, miserable job? Explain why a market in insurance of this type would be valuable to workers but unprofitable for an insurance provider and so would not work. Insurance against a low-paying job is not available because of moral hazard and adverse selection. In particular, the moral hazard exists that once someone purchased this type of insurance, the person could then take a low-paying job that he or she, for some reason, enjoyed. The person could then easily document that the job is low-paying and could also (falsely) assert the job was miserable and thereby collect on the insurance. Adverse selection also makes the insurance unlikely because the people most likely to wind up with low-paying jobs are the most likely to buy the insurance, whereas people who are most likely to wind up with high-paying jobs are least likely to buy the insurance.

271

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CHAPTER 20

Use the following news clip to work Problems 20 and 21. Why We Worry About the Things We Shouldn’t … and Ignore the Things We Should We pride ourselves on being the only species that understands the concept of risk, yet we have a confounding habit of worrying about mere possibilities while ignoring probabilities, building barricades against perceived dangers while leaving ourselves exposed to real ones: 20% of all adults still smoke; nearly 20% of drivers and more than 30% of backseat passengers don’t use seat belts; two thirds of us are overweight or obese. We dash across the street against the light and build our homes in hurricaneprone areas—and when they’re demolished by a storm, we rebuild in the same spot. Source: Time, December 4, 2006 20.

Explain how “worrying about mere possibilities while ignoring probabilities” can result in people making decisions that not only fail to satisfy social interest, but also fail to satisfy self-interest. By “worrying about mere possibilities while ignoring probabilities,” society sometimes devotes its scarce resources in ways that do not make people as well off as possible. In particular resources devoted to preventing mad cow pathogen might be better utilized to fight cholesterol. Similarly individuals can make decisions that do not advance their well being. For instance, a person’s decision to eat less beef to reduce the chances of catching mad cow disease while continuing to smoke and not use seat belts ignores the probabilities of these latter two actions while focusing on the probability of the first decision.

21.

How can information be used to improve people’s decision making? Information can improve people’s decision making by providing them with data about the potential outcomes of their decisions. With this information readily at hand, the marginal benefit and marginal cost of actions can be more readily determined. Related to the news clip, with more information people might worry less about mere possibilities and pay more attention to probabilities, thereby making better decisions so that society is more efficient.

Economics in the News 22.

After you have studied Economics in the News on pp. 520–521, answer the following questions. a. What information do accurate grades provide that grade inflation hides? Accurate grades provide valuable information about the student’s productivity and the extent of the student’s skill base. High grades would be correlated with high skills and high ability so that these students would be sorted into higher paying jobs immediately upon graduation. Of course, this result also means that students with lesser skills are sorted in lower paying jobs immediately upon graduation.

b. If grade inflation became widespread in high schools, colleges, and universities, what new arrangements do you predict would emerge to provide better information about student ability? If grade inflation becomes too severe, a student’s class ranking, for instance, 23rd out of a class of 300, might become more important. Standardized tests administered across groups of students also would gain in importance.

c. Do you think grade inflation is in anyone’s self-interest? Explain who benefits and how they benefit from grade inflation. The people who benefit from grade inflation are the students who first received inflated grades. At this time potential employers and graduate schools were unaware that higher grades were commonplace and so assigned more informational content to the high grades than was justified.

d. How do you think grade inflation might be controlled? Grade inflation could be controlled if the university put limits on the number of high grades that can be assigned in a class.

UNCERTAINTY AND INFORMATION

23.

Tracking Bad Borrowers: Banks Now Take Help of Detectives In the light of accumulating bad loans, some banks, including Indian Bank, have resorted to utilizing the services of private detective agencies to track the whereabouts of borrowers who have not repaid loans. Once the process of recovery commences, the bank looks to attach other assets of the borrower, if the security provided is lower than the loan amount. Here is where the role of the detective comes into play. The detective, on the basis of primary leads such as the address provided by the borrower in the loan documents and secondary leads such as voter ID, tracks the whereabouts of the borrower for the bank. Source: The Times of India, November 20, 2014 a. Explain the role asymmetric information can play in interest rates charged by banks. Asymmetric information can lead to adverse selection and moral hazard, both of which play a role in determining interest rates charged by banks. For instance, adverse selection occurs if a bank charges both high-risk and low-risk borrowers the same interest rate. If this uniform rate is high, it will attract only high-risk borrowers. Moral hazard results when low-risk borrowers have no incentive to borrow from the bank as the interest rate is not appropriate for the credit risk. Thus low-risk borrowers would either prefer to borrow from a bank which charges them according to their low credit risk or borrow less than they would if they were offered the low interest rate appropriate for their credit risk. On the other hand, high-risk borrowers would borrow more than they would if they faced the high interest rate appropriate for their high credit risk.

b. What adverse selection problem exists if a bank charges its borrowers a higher interest rate? If a bank charges both its high- and low-risk borrowers a high interest rate, low-risk borrowers will leave to borrow from a bank which charges them a lower interest rate and high-risk borrowers will stay.

c. What will determine whether a bank should actually hire a detective to track the borrowers or not? The bank should compare the marginal benefit from hiring a detective, i.e. the amount of loans recovered by tracking the borrowers, and the marginal cost of hiring a detective, i.e. the remuneration paid to the detective. If the marginal benefit exceeds the marginal cost, the bank should hire a detective.

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MONITORING JOBS AND INFLATION**

Answers to the Review Quizzes Page 150 1.

(page 558 in Economics)

What determines if a person is in the labor force? Workers who have a job and workers who are unemployed are in the labor force. To be “officially” counted as unemployed, and thus in the labor force, means that the person does not have a job but is available and willing to work and has made some effort to find work within the past four weeks, or waiting to be called back to a job from which he or she has been laid off, or waiting to start a new job within 30 days.

What distinguishes an unemployed person from one who is not in the labor force? A general definition of unemployment is a person who wants to work but does not have a job. A person who is not in the labor force does not have a job and does not want one. More specifically to be considered as unemployed, and thus in the labor force, the person must not have a job but must be available and willing to work. The person must also have made some effort to find work within the past four weeks, or be waiting to be called back to a job from which he or she has been laid off, or be waiting to start a new job within 30 days.

Describe the trends and fluctuations in the U.S. unemployment rate from 1980 to 2014. The unemployment rate has had several significant fluctuations around its average of 6.5 percent. It started by soaring to a high that exceeded 10 percent during the 1982 recession. Then there was a gradual downward trend particularly insofar as the peaks during the recessions in 1990-1991 and 2001 were much lower than in 1982. But that situation reversed itself with the severe and prolonged recession of 2008-2009 when the unemployment once more jumped (slightly) above 10 percent. Since that peak the unemployment rate has fallen to around 6 percent.

Describe the trends and fluctuations in the U.S. employment-to-population ratio and labor force participation rate from 1980 to 2014. The labor force participation rate and the employment-to-population ratio had an upward trend from 1980 until about 2000 after which they turned downward. Both show fluctuations around these trends, especially the employment-to-population ratio which rises during expansions and falls during recessions but its fall between 2008 and 2010 was particularly severe. The labor force participation rate also fell between 2008 and 2010 but the fall was not as dramatic. Recently the labor force participation rate has been near 63 percent and the employment-to-population ratio has been near 59 percent.

* This is Chapter 22 in Economics.

CHAPTER 5

Describe the alternative measures of unemployment. The Bureau of Labor Statistics keeps track of 6 alternative measures of unemployment: • U-1 measures long-term unemployment. It counts as unemployed only workers who have been unemployed for 15 or more weeks. • U-2 measures job losers; that is, only workers who lost their jobs (as opposed to quitting or reentering the labor market) are counted as unemployed. • U-3 is the conventional measure of unemployment. • U-4 adds discouraged workers to the conventional measure of unemployment. • U-5 adds all marginally attached workers to the U-4 measure of unemployment. • U-6 adds part-time workers who would like a full-time job (economic part-time workers) to the U-5 measure of unemployment.

Page 153 1.

(page 561 in Economics)

Why does unemployment arise and what makes some unemployment unavoidable? In a dynamic economy some unemployment is unavoidable. For instance, growth means that some workers will always be entering the labor force without a job and therefore be unemployed. Consumers changing their demand for one good over another means workers in the newly less-favored industry will lose their jobs and also be unemployed. Moreover some workers will always be leaving their current job to search for a better job and these workers, too, will be unemployed. So some unemployment is unavoidable as the economy churns and reacts to changes.

Define frictional unemployment, structural unemployment, and cyclical unemployment. Give examples of each type of unemployment. Frictional unemployment is the unemployment that arises from the normal labor turnover from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. For instance, newly graduated students entering the labor market looking for work are frictionally unemployed. Structural unemployment represents the unemployment created by changes in technology or international competition that change the skills needed to perform jobs or change the locations of jobs in the economy. For instance, workers are structurally unemployed if they lose their jobs because of changes in the amount of foreign competition and if they have different skills from those required by new jobs or if they live in a different region of the country from where new jobs are being created. Finally, cyclical unemployment is the unemployment created by business cycle fluctuations in economic activity. Specifically the higher than normal unemployment at a business cycle trough and the lower than normal unemployment at a business cycle peak is called cyclical unemployment. For instance, a worker laid off in 2009 because of the recession is cyclically employed.

What is the natural unemployment rate? The natural unemployment rate is the unemployment rate when no cyclical unemployment exists. That is, when all unemployment is frictional or structural then the unemployment rate equals the natural unemployment rate. Full employment occurs when there is no cyclical unemployment and the unemployment rate equals the natural unemployment rate.

How does the natural unemployment rate change and what factors might make it change? Changes in the natural unemployment rate arise because of changes in frictional and structural unemployment. Any factor that changes frictional unemployment or structural unemployment changes the natural unemployment rate. For instance, a change in the age distribution of the population, a change in the scale of structural changes that are occurring, a change in the minimum wage rate or efficiency wages, or a change in unemployment benefits all change the natural unemployment rate.

Why is the unemployment rate never zero, even at full employment? The unemployment rate is never zero because there is always churning going on the economy. There are always new workers entering the labor market and searching for work, there are always workers leaving one job to search for another, better job, and there are always firms laying off workers. All these cases lead to unemployment as the workers search for a job.

MONITORING JOBS AND INFLATION

What is the output gap? How does it change when the economy goes into recession? The output gap equals the difference between real GDP and potential GDP. When the economy goes into a recession, the output gap becomes negative.

How does the unemployment rate fluctuate over the business cycle? During a recession the unemployment rate is generally rising. During an expansion the unemployment rate is generally falling.

Page 159 1.

(page 567 in Economics)

What is the price level?

The price level is the average level of prices.

What is the CPI and how is it calculated? The CPI is the Consumer Price Index. The CPI equals (Cost of CPI basket at current prices ÷ Cost of CPI basket at base-period prices) ×100.

How do we calculate the inflation rate and what is its relationship with the CPI? The inflation rate is the percentage change in a price index from one year to the next. The rate of change of the CPI is often used as a measure of inflation as faced by consumers.

What are the four main ways in which the CPI is an upward-biased measure of the price level? The CPI is biased upward because of the new goods bias; the quality change bias; commodity substitution bias; and outlet substitution bias. The new goods bias reflects the point that new goods, such as DVDs are generally more expensive than the old goods they replace, VHS tapes. The quality change bias points out that part of the reason goods and services rise in price is because their quality is improved. Commodity substitution bias occurs because consumers substitute away from goods and services that have risen in the price more than other goods and services. Outlet substitution bias occurs because consumers will use discount stores more frequently when goods and services rise in price.

What problems arise from the CPI bias? The upward bias in the CPI distorts private contracts and government outlays that include formulas based on CPI change as a measure of inflation. If the intent is to maintain the real value of a payment, indexing payments to the CPI will in fact increase the real value of payments over time if the CPI has an upward bias. In one year, the effect of the bias may not be much, but it will accumulate over time. Close to one third of federal government outlays are indexed to the CPI.

What are the alternative measures of the price level and how do they address the problem of bias in the CPI? The first of three alternative price level is the chained CPI. The chained CPI is calculated in a similar manner as chained-dollar real GDP. The chained CPI overcomes the commodity substitution and new goods bias because it uses current as well as previous period quantities. The second alternative price level is the personal consumption expenditure deflator or PCE deflator. The PCE deflator is calculated from real and nominal consumption expenditure. The PCE deflator uses a broader basket of goods and services than the CPI and, similar to the chained CPI, is also calculated using a chained method. The third alternative is the GDP deflator. The GDP deflator is similar to the PCE deflator except the GDP deflator uses the prices from all the goods and services included in GDP.

CHAPTER 5

Answers to the Study Plan Problems and Applications 1.

The BLS reported the following data for 2010: Labor force: 153.7 million Employment: 139.1 million Working-age population: 237.9 million

Calculate the a. Unemployment rate. The unemployment rate is 9.5 percent. The unemployment rate is the percentage of the labor force that is unemployed. The labor force is the sum of the people unemployed and the people employed. So the number of people who are unemployed is 153.7 million minus 139.1 million, which is 14.6 million. The unemployment rate equals (the number of people unemployed divided by the labor force) multiplied by 100. That is, (14.6 million/153.7 million) 100, which is 9.5 percent.

b. Labor force participation rate.

The labor force participation rate is 64.6 percent. The labor force participation rate is the percentage of the working-age population that is in the labor force. The working-age population is 237.9 million and the labor force is 153.7 million, so the labor force participation rate is (153.7 million/237.9 million)  100, which equals 64.6 percent.

c. Employment-to-population ratio.

The employment-to-population ratio is 58.4 percent. The employment-to-population ratio is the percentage of the people of working age who have jobs. The employment-to-population ratio is equal to the number of people employed divided by the working-age population then multiplied by 100. The employment-to-population ratio is (139.1 million/237.9 million)  100, which is 58.4 percent.

In July 2014, in the economy of Sandy Island, 10,000 people were employed, 1,000 were unemployed, and 5,000 were not in the labor force. During August 2014, 80 people lost their jobs and didn’t look for new ones, 20 people quit their jobs and retired, 150 unemployed people were hired, 50 people quit the labor force, and 40 people entered the labor force to look for work. Calculate for July 2014 a. The unemployment rate. The unemployment rate in July is 9.1 percent. The unemployment rate is the number unemployed as a percentage of the labor force. The number of unemployed workers is 1,000. The labor force is the number employed plus the number unemployed so in July it is 11,000. The unemployment rate equals (1,000/11,000)  100, which is 9.1 percent.

b. The employment-to-population ratio.

The employment-to-population ratio is 62.5 percent. The employment-to-population ratio is the number employed as a percentage of the working-age population. The number of employed people is 10,000. The working-age population is the sum of the labor force and the number of people who are not in the labor force, which is 16,000. The employment-to-population ratio is (10,000/16,000)  100, which is 62.5 percent.

And calculate for the end of August 2014 c. The number of people unemployed. The number of people who are unemployed at the end of August is 840. The number of people who are unemployed at the end of August equals the number unemployed in July plus the number of people who lost their job and who stayed in the labor market plus the number of people entering the labor market minus the number of people who were hired minus the number of people who left the labor market. So the number of people unemployed equals 1,000 + 40 − 150 − 50, which is 840.

d. The number of people employed.

The number of people who are employed at the end of August is 10,050. The number of people who are employed at the end of August equals the number employed in July minus the people whom lost their jobs plus the number of people who gained jobs.

MONITORING JOBS AND INFLATION

e. The unemployment rate. The unemployment rate at the end of August is 7.7 percent. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The number of people who are unemployed is 840. The labor force equals the number employed plus the number unemployed and at the end of August it is 10,890. The unemployment rate at the end of August equals (840/10,890)  100, which is 7.7 percent.

Use the following information to work Problems 3 and 4. In October 2009, the U.S. unemployment rate was 10.0 percent. In October 2011, the unemployment rate was 8.9 percent. Predict what happened to: 3.

Unemployment between October 2009 and October 2011, if the labor force was constant. If the labor force is constant, the only way the unemployment rate can decrease is if the number of unemployed workers decreases.

The labor force between October 2009 and October 2011, if unemployment was constant. If unemployment is constant, the only way the unemployment rate can decrease is if the labor force increases.

Shrinking U.S. Labor Force Keeps Unemployment Rate From Rising An exodus of discouraged workers from the job market kept the unemployment rate from climbing above 10 percent. Had the labor force not decreased by 661,000, the unemployment rate would have been 10.4 percent. The number of discouraged workers rose to 929,000 last month. Source: Bloomberg, January 9, 2010 What is a discouraged worker? Explain how an increase in discouraged workers influences the official unemployment rate and U–4. A discouraged worker is a person, who currently is not working, would like a job, has looked for one in the recent past, but has stopped looking for work because of repeated failures in finding a job. If a worker who had been looking for work quits looking, the official unemployment rate, U-3, falls. U-4 includes discouraged workers among the ranks of the unemployed so when the worker stops looking for work and becomes a discouraged worker, the U-4 unemployment rate does not change.

Use the following news clip to work Problems 6 and 7. Some Firms Struggle to Hire Despite High Unemployment Matching people with available jobs is always difficult after a recession as the economy remakes itself but the disconnect is particularly acute this time. Since the recovery began in mid-2009, the number of job openings has risen more than twice as fast as actual hires. If the job market were working normally, openings would be getting filled as they appear. Some five million more would be employed and the unemployment rate would be 6.8%, instead of 9.5%. Source: The Wall Street Journal, August 9, 2010 6. If the labor market is working properly, why would there be any unemployment at all? Unemployment will always exist in the labor market because of normal labor market frictions. People newly entering the labor market, workers quitting a job to look for a better job, firms laying-off workers because consumers no longer want to buy the goods produced by the firms will always be part of the labor market. All of these events create unemployment, so even when the labor market is operating at peak efficiency, unemployment will always be present.

Are the 5 million workers who cannot find jobs because of mismatching in the labor market counted as part of the economy’s structural unemployment or part of its cyclical unemployment? Even though these workers are unemployed during a recessionary period, their unemployment is the result of a mismatch between their skills and the skills required for the available jobs. So while they might be counted as part of cyclical unemployment because they lost their jobs because of the recession, the mismatch means that these workers might also be counted as part of the economy’s structural unemployment.

CHAPTER 5

Use the following information to work Problems 8 and 9. The people on Coral Island buy only juice and cloth. The CPI basket contains the quantities bought in 2013. The average household spent $60 on juice and $30 on cloth in 2013 when the price of juice was $2 a bottle and the price of cloth was $5 a yard. In 2014, juice is $4 a bottle and cloth is $6 a yard. 8.

Calculate the CPI basket and the percentage of the household’s budget spent on juice in 2013. The CPI basket is 30 bottles of juice and 6 yards of cloth. The total amount spent on the CPI basket in 2012 was $90 and of that $60 was spent on juice. The percentage of the household’s budget spent on juice was ($60/$90) × 100, which is 66.7 percent.

Calculate the CPI and the inflation rate in 2014. The CPI in 2014 is 173.3. To calculate the CPI, divide the value of the CPI basket in 2014 prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in 2014 prices is: ($4  30) + ($6  6) = $156. The value in base-year prices is $60 + $30 (provided in the question), which equals $90. So the CPI is ($156/$90)  100 = 173.3. The inflation rate in the 2014 is 73.3 percent. The inflation rate equals the CPI in 2014 year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(173.3 – 100)/ 100] × 100 = 73.3 percent.

Use the following data to work Problems 10 to 11. The BLS reported the following CPI data: June 2008 217.3 June 2009 214.6 June 2010 216.9 10.

Calculate the inflation rates for the years ended June 2009 and June 2010. How did the inflation rate change in 2010? The inflation rate for the year ended June 2009 is −1.2 percent; the inflation rate for the year ended June 2010 is 1.1 percent. The inflation rate is the percentage change in the price level. It is equal to [(Pthis year – Plast year)/ Plast year]  100. For the year ended in June 2009 the inflation rate is [(214.6 – 217.3)/217.3]  100, which is −1.2 percent. For the year ended in June 2010 the inflation rate is [(216.9 – 214.6)/214.6]  100, which is 1.1 percent. The inflation rate increased in 2010.

11.

Why might these CPI numbers be biased? How can alternative price indexes avoid this bias? The CPI numbers might be biased because of the new goods bias, the quality change bias, the commodity substitution bias, and the outlet substitution bias. The new goods bias is that new goods are often more expensive than the older goods that they replace. The quality change bias is that increases in the quality of a good are often accompanied by increases in the good’s price. The commodity substitution bias reflects the point that consumers will buy less of a good whose price increased and more of a good whose price has not changed. Finally the outlet substitution bias points out that when prices rise, consumers shop more frequently at stores with cheaper prices. Each of the alternative price indexes attempts to overcome some of the bias in the CPI numbers. The chained CPI uses prices and quantities from the previous period and the current period. The chaining process overcomes the commodity substitution process. And because it contains current period quantities, it also does not suffer from the new goods bias. The personal consumption expenditure deflator contains goods and services omitted from the CPI. It is calculated from the nominal and real consumption expenditure data and so it, too, is computed using a chaining procedure. Because the personal consumption expenditure deflator is calculated using a chaining procedure, it does not suffer from the commodity substitution bias or the new goods bias. The GDP deflator is calculated from nominal and real GDP data. It is broader than the personal consumption expenditure deflator because it contains goods and services in consumption expenditure, investment, government expenditure, and net exports. The GDP deflator is calculated using a chaining procedure and so it also avoids the commodity substitution bias and new goods bias.

MONITORING JOBS AND INFLATION

Answers to Additional Problems and Applications 12.

What is the unemployment rate supposed to measure and why is it an imperfect measure? Ideally the unemployment rate would measure the underutilization of labor resources. But it is an imperfect measure for two reasons. First the unemployment rate does not include some underutilized labor. In particular the unemployment rate completely omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate. Second the unemployment rate counts as fully employed workers who are working part time but who want full-time jobs. These workers are underutilized because they would like to work for more hours than is presently the case.

13.

According to FRED, in the fourth quarter of 2014, the labor force was 2,394,000, employment equaled 2,254,500, and working-age population was 2,984,600 in New Zealand.

Calculate the a. Labor force participation rate. The labor force participation rate equals the labor force divided by the working-age population then multiplied by 100. Using this formula with the data given in the problem shows that the labor force participation rate equals (2,394,000/2,984,600) × 100 = 80.21 percent.

b. Employment-to-population ratio.

The employment-to-population ratio equals employment divided by the working-age population then multiplied by 100. Using this formula with the data given in the problem shows that the employment-topopulation ratio equals (2,254,500/2,984,600) × 100 = 75.53 percent.

c. Unemployment rate.

The unemployment rate equals the number of people unemployed (labor force - employment) divided by the labor force, then multiplied by 100. Using this formula shows that the unemployment rate equals [(2,394,000 - 2,254,500)/2,394,000] × 100 = 5.8 percent.

14.

Jobs Report: Hiring Up, Unemployment Down The Labor Department reported that hiring accelerated in November, and the unemployment rate fell to 8.6 percent from 9 percent in October. Two reasons for the fall are that more Americans got jobs, but even more people gave up on their job searches altogether. Source: CNNMoney, December 2, 2011 a. If the only change was that all the newly hired people had been unemployed in October, explain how the labor force and unemployment would have changed. The labor force would not have changed. The number of people unemployed would have decreased so the unemployment rate would have fallen.

b. If the only change was that people gave up on their job searches, explain how the labor force and unemployment would have changed. The number of people unemployed would have fallen, so the labor force and the unemployment rate would have decreased.

15.

The BLS reported that in July 2012, employment decreased by 195,000 to 142,220,000 and the unemployment rate increased from 8.2 percent to 8.3 percent. About 3.4 million people were marginally attached workers and 0.9 million of them were discouraged. a. Calculate the change in unemployment in July 2012. At the start of July employment was 142,220,000 + 195,000 = 142,415,000. The unemployment rate, which was 8.2 percent, equals (Unemployment/[Unemployment + Employment]) × 100. Using the data for the start of July gives the result that 0.082 = (Unemployment/[Unemployment + 142,415,000]). Solving for the amount of unemployment shows that unemployment at the start of July was 12,721,166 workers. Similar calculations show that at the end of July the amount of unemployment was 12,872,694 workers. Unemployment increased in July by 151,528 workers in July.

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b. With 3.4 million marginally attached workers and 0.9 million of them discouraged workers, what are the characteristics of the other 2.5 million marginally attached workers? The other 2.5 million marginally attached workers would like a job but have stopped looking for work. Because they are not discouraged workers, these 2.5 million workers have stopped looking for reasons other than their inability to find a job. For example, a stay-at-home spouse might prefer working in the job market but have quit looking to undertake some home repairs.

16.

A high unemployment rate tells us that a large percentage of the labor force is unemployed but not why the unemployment rate is high. What unemployment measure tells us if (i) people are searching longer than usual to find a job, (ii) more people are economic part-time workers, or (iii) more unemployed people are job losers? U-1 measures long-term unemployment of 15 weeks or more. If U-1 exceeds its normal value, then people are taking longer than usual to find a job. U-6 equals U-5 plus part-time workers who want fulltime jobs as unemployed, so the difference between U-6 and U-5 is the result of part-time workers who want a full-time job. If this difference is unusually large, then more workers than normal are working at part-time jobs. U-2 measures unemployment resulting from people losing their jobs. If U-2 is larger than normal, then more unemployment than normal results from people losing their jobs.

17.

Some Firms Struggle to Hire Despite High Unemployment With about 15 million Americans looking for work, some employers are swamped with job applicants, but many employers can’t hire enough workers. The U.S. jobs market has changed. During the recession, millions of middle-skill, middle-wage jobs disappeared. Now with the recovery, these people can’t find the skilled jobs that they seek and have a hard time adjusting to lower-skilled work with less pay. Source: The Wall Street Journal, August 9, 2010 If the government extends the period over which it pays unemployment benefits to 99 weeks, how will the cost of being unemployed change? Extending unemployment benefits to 99 weeks decreases the cost of being unemployed and thereby increases the unemployment rate as some people search for a new job for a longer period of time.

18.

Why might the unemployment rate underestimate the underutilization of labor resources? The official unemployment rate underestimates the underutilization of labor resources for two reasons. First the official unemployment rate completely omits some underutilized labor. In particular the official unemployment rate omits marginally attached workers, such as discouraged workers. These workers are not included in the unemployment rate because they are not searching for a job, though if the labor market was better and jobs more plentiful they would reenter the labor market. Marginally attached workers are not a major source of mismeasurement because they are a small subset of people. Second the unemployment rate counts as fully employed workers who are working part time but who want full time jobs. These workers are underutilized because they would like to work for more hours than is presently the case. These workers are a significantly more substantial source of error because they account for a much larger part of the labor force.

Use the following data to work Problems 19 to 21. The IMF World Economic Outlook reports the unemployment rates in the table. 19.

What do these numbers tell you about the phase of the business cycle in the three regions in 2011?

Region United States Euro area Japan

2010 9.6 10.1 5.1

2011 9.0 10.9 4.5

The unemployment rates fell in the United States and Japan, so it might well be the case that the United States and Japan were entering an expansionary period. The unemployment rate in the Euro area rose, so it might be the case that the Euro area was in a recession.

MONITORING JOBS AND INFLATION

20.

What do these numbers tell us about the relative size of their natural unemployment rates? These numbers cover only two years, so making inferences about the relative size of the natural unemployment rates is potentially dangerous. To the extent that these data are representative, the natural unemployment rate is likely the highest in the Euro area and the lowest in Japan.

21.

Do these numbers tell us anything about the relative size of the labor force participation rates and employment-to-population ratios? The numbers tell us nothing about the relative sizes of the labor force participation rates or the employment-to-population ratios in these three regions.

22.

A Half-Year of Job Losses For the first six months of 2008, the U.S. economy lost 438,000 jobs. The job losses in June were concentrated in manufacturing and construction, two sectors that have been badly battered in the recession. Source: CNN, July 3, 2008 a. Based on the news clip, what might be the main source of increased unemployment? The main source of increased unemployment likely is in the form of job losses in manufacturing and construction as opposed to people entering or reentering the labor market or people leaving their jobs. The news clip makes clear that the first six months of the year had been dismal for the economy, so these job losses are likely cyclical unemployment in nature though with a mixture of structural unemployment included because the job losses were concentrated in specific areas..

b. Based on the news clip, what might be the main type of increased unemployment? While the job losses were “concentrated” in manufacturing and construction, the news clip mentioned as the reason for the unemployment the point that the two sectors were “badly battered in the recession.” These job losses represented cyclical unemployment because there were the result of the “battering” that took place during the recession.

23.

Youth and Unemployment in Lebanon The overall unemployment rate in Lebanon stands at 24 percent, and youth unemployment exceeds 35 percent. In the face of job crisis, Lebanon should introduce reforms in the education system to adapt to future labor market needs. At the same time, it is crucial to develop a viable information and communications technology sector and to speed up the process of finalizing the oil and gas exploration and production projects. Also essential to job creation are small- and medium-size enterprises. Source: The Daily Star, December 24, 2014 a. On the basis of the news clip, what is the main type of unemployment that Lebanon should use policies to control? Explain. On the basis of the news clip, Lebanon should attempt to decrease both frictional unemployment and some structural unemployment. The introduction of reforms in the education system in order to adapt to future labor needs is an attempt to decrease the frictional unemployment in newly graduated students who are looking for a job. If the students graduate with the skills that firms want to hire for, the students will quickly find suitable jobs, thereby decreasing the country’s frictional unemployment. The proposal to develop a viable information and communications technology sector, to speed up the process of finalizing the oil and gas exploration and production projects, and to encourage small- and medium-size enterprises (SMEs) are attempts to reduce structural unemployment. Information and communications technology sector, oil/natural gas industry and SMEs can create sizeable employment opportunities.

b. How might these policies impact Lebanon’s natural unemployment rate? Explain. Natural unemployment is comprised of frictional and structural unemployment. If these policies succeed, they will decrease the natural unemployment rate in Lebanon.

24.

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A typical family on Sandy Island consumes only juice and cloth. Last year, which was the base year, the family spent $40 on juice and $25 on cloth. In the base year, juice was $4 a bottle and cloth was $5 a length. This year, juice is $4 a bottle and cloth is $6 a length. Calculate a. The CPI basket. The CPI basket is 10 bottles of juice and 5 lengths of cloth.

b. The CPI in the current year. The CPI in the current year is 107.7. To calculate the CPI, divide the value of the CPI basket in current year prices by the base-year value of the CPI basket and then multiply the resulting number by100. The value of the CPI basket in current year prices is: ($4  10) + ($6  5) = $70. The value in base-year prices is $40 + $25 (provided in the question), which equals $65. So the CPI is ($70/$65)  100 = 107.7.

c. The inflation rate in the current year. The inflation rate in the current year is 7.7 percent. The inflation rate equals the CPI in the current year minus the CPI in the base year expressed as a percentage of the base-year CPI. Because the base-year CPI is 100, the inflation rate is [(107.7 – 100)/ 100] × 100 = 7.7 percent.

25.

Amazon.com agreed to pay its workers $20 an hour in 1999 and $22 an hour in 2001. The price level for these years was 166 in 1999 and 180 in 2001. Calculate the real wage rate in each year. Did these workers really get a pay raise between 1999 and 2001? The real wage rate equals the nominal wage rate divided by the price level. In 1999 the real wage rate was $20/166 × 100, for a real wage rate of $12.05. In 2001 the real wage rate was $22/180 × 100, for a real wage rate of $12.22. The workers really got a pay raise between 1999 and 2001 but it was less than the raise in their nominal wage rate.

26.

News release According to BEA, in the U.S., real personal consumption expenditure (PCE) was $10,811.4 billion and nominal PCE was $11,653.3 billion in the fourth quarter of 2013. The PCE deflator was 108.9 and real PCE was $11,119.6 billion in the fourth quarter of 2014. Calculate the PCE deflator in 2013and the percentage change in real PCE and nominal PCE. Personal consumption expenditure = (real personal consumption expenditure) × (PCE deflator) ÷ 100, so in May 2012 personal consumption expenditure equaled $9,588 billion × 115.4 ÷ 100 = $11,064 billion. The PCE deflator is given by (nominal consumption/real consumption) x 100. This is equal to (11,653.3/10,811.4) x 100 = 107.78. The percentage change in real PCE and nominal PCE is [(11,119.6 – 10,811.4)/10,811.4] x 100 = 2.8 percent. Nominal PCE for the fourth quarter of 2014 is equal to the (PCE deflator x real PCE)/100, which is (108.9 x 11,119.6)/100 = 12,109.24. Percentage change in nominal PCE is [(12,109.24 – 11,653.3)/11,653.3] x 100 = 3.91 percent.

27.

The Truth on Pay – Far More People Are Now Enjoying Real Wage Rises The average weekly earnings (AWE) series shows that wages rose 8 percent over the past five years in cash terms, while real wages were down by 7 percent. Source: The Telegraph, February 9, 2015 By what percentage did the CPI increase over these years? The percentage change in the CPI is the percentage change in nominal wage minus the percentage change in real wage. Thus, the percentage change in the CPI is 8 – (–7) = 15%. Thus the CPI increased by 15%.

28.

After you have studied Economics in the News on pp. 160–161 (568–569 in Economics), answer the following questions. a. How many jobs must be created each month to keep pace with a growing population? About 200,000 jobs per month must be created.

MONITORING JOBS AND INFLATION

b. What normally happens to the unemployment rate when the pace of job creation exceeds the increase in population? When the pace of job creation exceeds the increase in population, normally the unemployment rate falls.

c. Why might the unemployment rate sometimes increase, when the pace of job creation exceeds the increase in population? The unemployment rate might increase because the relatively rapid pace of job creation brings more discouraged workers back into the labor force. Unless they immediately find jobs, these workers are counted as unemployed, which can increase the unemployment rate.

d. How would you expect the labor force participation rate to respond to job creation in excess of population growth? One would expect the labor force participation rate to increase. But from July 013 to July 2014, there actually was a small decrease in the labor force participation rate.

e. How would you expect an increase in the growth rate of real GDP (see last paragraph of news article) to affect jobs and unemployment? An increase in the growth rate of real GDP increases the number of jobs and decreases unemployment.

29.

Greece’s Older Men May Never Work Again The unemployment rate among older Greek males is about twice the Eurozone average. These men were often families’ sole bread winners. Now, strained by the financial woes, their wives have to take jobs outside the home. In Greece, with its macho, traditional culture, this could mean shame and depression for men. They have mortgage arrears, children to put through college and bills to pay. But for a few days’ work at a factory, they have to sometimes travel across the country. Source: The Wall Street Journal, August 8, 2014 a. What type of unemployment might older workers be more prone to experience than younger workers? Older workers are more likely to experience structural unemployment.

b. Explain how the unemployment rate of older workers could be influenced by the business cycle. Older workers might be more likely to be fired when the economy enters a recession because the business would rather train its younger workers to prepare for the future. If this takes place, then the unemployment rate of older workers will rise more than that of other groups when the economy enters a recession.

c. Why might older unemployed workers become marginally attached or discouraged workers during a recession? The news clip explains that older unemployed workers have a significantly difficult time finding a new job. Often they are families’ sole breadwinners, and in Greece, with its macho, traditional culture, unemployed men are at risk of depression. They have been forced to search, wait and travel extensively for a few days’ work at a factory. In the face of financial struggle and family strain, it would be easy for some older workers to become discouraged about their job prospects and either quit looking entirely, thereby becoming marginally attached or discouraged workers.

C h a p t e r

ECONOMIC GROWTH**

Answers to the Review Quizzes Page 172 1.

(page 580 in Economics)

What is economic growth and how do we calculate its rate? Economic growth is the sustained expansion of production possibilities. It is measured by the increase in real GDP over a given time period. The economic growth rate is the annual percentage change in real GDP.

What is the relationship between the growth rate of real GDP and the growth rate of real GDP per person? The growth rate of real GDP tells how rapidly the total economy is expanding while the growth rate of real GDP per person tells how the standard of living is changing. The growth rate of real GDP per person approximately equals the growth rate of real GDP minus the population growth rate.

Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP per person in 20 years. The rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. If the level of real GDP doubles in 20 years, the rule of 70 gives 20 = 70  (growth rate) so that the growth rate equals 70  20, which is 3.5 percent per year.

Page 175 1.

(page 583 in Economics)

What has been the average growth rate of U.S. real GDP per person over the past 100 years? In which periods was growth most rapid and in which periods was it slowest? Over the past 100 years, U.S. real GDP per person grew at an average rate of 2 percent per year. Slow growth occurred during mid-1950s and 1973–1983. Very slow growth (negative growth!) also occurred during the Great Depression. Growth was rapid during the 1920s and 1960s. Growth was also (extremely!) rapid during World War II.

Describe the gaps between real GDP per person in the United States and in other countries. For which countries is the gap narrowing? For which is it widening? For which is it the same? Some rich countries are catching up with the United States, but the gaps between the United States and many poor countries are not closing. Amongst the rich countries, since 1960 Japan has closed the gap with the United States but the gaps between the United States and Canada, and the “Europe Big 4”

* This is Chapter 23 in Economics.

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(France, Germany, Italy, and the United Kingdom) have tended to remain constant. Other Western European nations and the former Communist countries of Central Europe have fallen slightly farther behind the United States. The gap between the United States and most nations in Africa, and Central and South America has widened. But some nations in Asia— including Hong Kong, Singapore, Korea, and China—have grown very rapidly. The gap between these nations and the United States has shrunk; indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually tied the United States.

Compare the growth rates in Hong Kong, Korea, Singapore, Taiwan, China, and the United States. In terms of real GDP per person, how far is China behind these others? Since 1960, income per person in the nations of Hong Kong, Singapore, Korea, Taiwan, and China have grown very rapidly and are rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and income per person in Singapore slightly exceeds that in the United States. Income in Korea also is relatively close. Income in China is the lowest, though recently China has been growing the most rapidly. China’s level of income in 2010 is similar to that of Hong Kong in 1976.

Page 181 1.

(page 589 in Economics)

What is the aggregate production function? The aggregate production function is the relationship that tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same.

What determines the demand for labor, the supply of labor, and labor market equilibrium? The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. A fall in the real wage rate increases the quantity of labor demanded because of diminishing returns. The demand for labor also depends on productivity. If productivity increases, the demand for labor increases. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. An increase in the real wage rate increases the quantity of labor supplied because more people enter the labor force and the hours supplied per person increases. The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium. The equilibrium quantity of employment is the full employment quantity of labor.

What determines potential GDP? Potential GDP is determined from the labor market equilibrium. When the labor market is in equilibrium, there is full employment. The quantity of real GDP produced by the full employment quantity of labor is potential GDP.

What are the two broad sources of potential GDP growth? The two broad sources of growth in potential GDP are growth of the supply of labor and growth of labor productivity.

What are the effects of an increase in the population on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? An increase in population increases the supply of labor. Employment increases and the real wage rate falls. The increase in employment creates a movement along the aggregate production function so potential GDP increases. Because of diminishing returns, potential GDP per hour of labor decreases.

What are the effects of an increase in labor productivity on potential GDP, the quantity of labor, the real wage rate, and potential GDP per hour of labor? The increase in labor productivity shifts the aggregate production function curve upward. The demand for labor increases, and the demand for labor curve shifts rightward. The increase in the demand for

ECONOMIC GROWTH

labor raises the real wage rate and increases employment. The increase in employment as well as the upward shift of the aggregate production function increase potential GDP. Potential GDP per hour of labor increases.

Page 183 1.

(page 591 in Economics)

What are the preconditions for labor productivity growth? The fundamental preconditions for labor productivity growth are the existence of: firms, markets, property rights, and money. These fundamental preconditions create an incentive system that can lead to labor productivity growth.

Explain the influences on the pace of labor productivity growth. Once the preconditions for growth are in place, the sources of labor productivity growth are: physical capital growth, human capital growth, and advances in technology. All of these activities enable an economy to grow and they all increase labor productivity. They all also interact: human capital creates new technologies, which are then embodied in both new human capital and new physical capital. Similarly advances in technology also lead to increases in labor productivity.

Page 189 1.

(page 597 in Economics)

What is the key idea of classical growth theory that leads to the dismal outcome? The “dismal outcome” in classical theory is the conclusion that in the long run real GDP per person equals the subsistence level. In classical growth theory, an increase in real GDP per person causes population increases that return real GDP per person to the subsistence level. In the classical growth theory, an increase in income creates a population boom. The increase in population increases the supply of labor. Because of diminishing returns to labor, the increase in the supply of labor lowers the real wage rate and people’s incomes. Eventually the real wage rate falls to equal the subsistence level, at which time the population stops growing.

What, according to neoclassical growth theory, is the fundamental cause of economic growth? In neoclassical growth theory, growth results from technological advances, which are determined by chance.

What is the key proposition of new growth theory that makes economic growth persist? The key proposition that makes growth persist indefinitely in the new growth theory is the assumption that the returns to knowledge and human capital do not diminish. As a result, increases in knowledge do not cause diminishing returns and the incentive to innovate remains high. As people accumulate more knowledge, the incentive to innovate does not fall and so people continue to innovate new and better ways to produce new and better products. This innovation means that economic growth persists indefinitely.

CHAPTER 6

Answers to the Study Plan Problems and Applications 1.

Brazil’s real GDP was 1,180 trillion reais in 2013 and 1,202 trillion reais in 2014. Brazil’s population was 198 million in 2013 and 200 million in 2014. Calculate a. The growth rate of real GDP. The economic growth rate is the growth rate of real GDP. Between 2013 and 2014 this growth rate equals [(1,202 trillion reais − 1,180 trillion reais)/1,180 trillion reais]  100, which is 1.9 percent.

b. The growth rate of real GDP per person. Brazil’s population grew at [(200 million − 198 million)/198 million]  100, which is 1.0 percent. Brazil’s economic growth rate is 1.9 percent, so the growth rate of real GDP per person is 1.9 percent − 1.0 percent, or 0.9 percent.

c. The approximate number of years it takes for real GDP per person in Brazil to double if the 2014 growth rate of real GDP and the population growth rate are maintained. Brazil’s real GDP per person is growing at 0.9 percent a year. The rule of 70 tells us that Brazil’s real GDP per person will double in 70/0.9 = 77.8 years.

China’s real GDP per person was 13,165 yuan in 2013 and 14,088 yuan in 2014. India’s real GDP per person was 49,516 rupees in 2013 and 51,521 rupees in 2014. By maintaining their current growth rates, which country will be the first to double its standard of living? China’s growth rate of real GDP per person is [(16,010 yuan − 15,040 yuan)/15,040 yuan]  100, which is 6.4 percent. India’s growth rate of real GDP per person is [(56,840 rupees − 54,085 rupees)/54,085 rupees]  100, which is 5.1 percent. China’s real GDP per person will double in approximately 70/6.4 = 10.9 years and India’s real GDP per person will double in approximately 70/5.1 = 13.7 years, so China’s standard of living will double first.

China was the largest economy for centuries because everyone had the same type of economy— subsistence—and so the country with the most people would be economically biggest. Then the Industrial Revolution sent the West on a more prosperous path. Now the world is returning to a common economy, this time technology- and information-based, so once again population triumphs. a. Why was China the world’s largest economy until 1890? GDP equals GDP per person multiplied by the number of people. Until 1890 most people in the world had approximately the same subsistence level of income so that every nation’s GDP per person was about the same. Because China had, by far, the world’s largest population, China also had the world’s largest GDP.

b. Why did the United States surpass China in 1890 to become the world’s largest economy? The United States benefited from the industrial revolution that was sweeping Western nations at the time while China did not. U.S. economic growth accelerated well beyond Chinese economic growth so that the U.S. GDP became larger than China’s GDP.

ECONOMIC GROWTH

Use the following tables to work Problems 4 to 6. The first table describes an economy’s labor market in 2014 and the second table describes its production function in 2014. Real wage rate (dollars per hour) 80 70 60 50 40 30 20 4.

Labor hours supplied 45 40 35 30 25 20 15

Labor hours demanded 5 10 15 20 25 30 35

Labor (hours) 5 10 15 20 25 30 35 40

Real GDP (2009 dollars) 425 800 1,125 1,400 1,625 1,800 1,925 2,000

What are the equilibrium real wage rate, the quantity of labor employed in 2014, labor productivity, and potential GDP in 2014? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 25 hours. With employment of 25 hours, the production function shows that potential GDP is $1,625. Labor productivity equals $1,625  25 hours, or $65.00 per hour.

In 2015, the population increases and labor hours supplied increase by 10 at each real wage rate. What are the equilibrium real wage rate, labor productivity, and potential GDP in 2015? The equilibrium real wage rate is $30 per hour and the equilibrium quantity of employment is 30 hours. With employment of 30 hours, the production function shows that real GDP is $1,800. Labor productivity equals $1,800  30 hours, or $60.00 per hour.

In 2015, the population increases and labor hours supplied increase by 10 at each real wage rate. Does the standard of living in this economy increase in 2015? Explain why or why not. The standard of living does not increase. In fact, it decreases because real GDP per person falls. The economy moves along its production function so that potential GDP increases but real GDP per person decreases.

Labor Productivity on the Rise The BLS reported the following data for the year ended June 2009: In the nonfarm sector, output fell 5.5 percent as labor productivity increased 1.9 percent—the largest increase since 2003—but in the manufacturing sector, output fell 9.8 percent as labor productivity increased by 4.9 percent—the largest increase since the first quarter of 2005. Source: bls.gov/news.release, August 11, 2009 In both sectors, output fell while labor productivity increased. Did the quantity of labor (aggregate hours) increase or decrease? In which sector was the change in the quantity of labor larger? Labor productivity equals output divided by labor hours, so labor hours equals output divided by labor productivity. In terms of growth rates, this last formula means that the growth in labor hours approximately equals the growth in output minus the growth in labor productivity. (This is the same calculation as on page 578 of the text for the approximation formula for growth in real GDP per person.) Using this equation, in the nonfarm sector labor hours fell by −5.5 percent – 1.9 percent = −7.4 percent and in the manufacturing sector labor hours fell by −9.8 percent – 4.9 percent = −14.7 percent. The change in labor was the largest in the manufacturing sector.

Explain the processes that will bring the growth of real GDP per person to a stop according to a. Classical growth theory. According to the classical theory, population growth continues at a rapid pace as long as real GDP per person exceeds the subsistence level. With population growth, the supply of labor increases and diminishing returns lowers real GDP per person. Eventually real GDP per person equals the subsistence

CHAPTER 6

amount, at which time economic growth ends.

b. Neoclassical growth theory. In the neoclassical model, technological growth leads to increased saving so that capital accumulates and real GDP per person grows. When technological growth stops, capital continues to accumulate but diminishing marginal returns drives the return on capital lower and so decreases investment and saving. Eventually the capital stock stops growing and economic growth stops.

c. New growth theory. According to the new growth theory, economic growth will not stop.

ECONOMIC GROWTH

Answers to Additional Problems and Applications 9.

In 2013, Turkey’s real GDP was growing at 4.1 percent a year and its population was growing at 1.26 percent a year. If these growth rates continued, in what year would Turkey’s real GDP per person be twice what it is in 2013? The growth rate of real GDP per person is equal to the growth rate of real GDP minus the population growth rate. Thus, it is equal to 4.1 − 1.26 = 2.84 percent. The rule of 70 states that the number of years it takes for the level of any variable to double is approximately equal to 70 divided by the growth rate. Using the rule of 70, Turkey’s real GDP per person will double in 70/2.84 = 24.65 years.

10.

Turkey’s real GDP (in U.S. dollars) was $788.9 billion in 2012 and $822.1 billion in 2013. Turkey’s population was 74 million in 2012 and 74.93 million in 2013. Calculate a. The growth rate of GDP. The growth rate of GDP is the percentage change in GDP. It is equal to [(822.1 − 788.9)/788.9]  100 = 4.21 percent.

b. The growth rate of real GDP per person. Turkey’s population grew at [(74.93 million − 74 million)/74 million]  100, which is 1.26 percent. Turkey’s growth rate of real GDP is 4.21 percent, so the growth rate of real GDP per person is 4.21 percent − 1.26 percent, or 2.95 percent.

c. The approximate number of years it takes for GDP per person in Turkey to double if the 2013 growth rate of GDP and the population growth rate are maintained. Turkey’s real GDP per person is growing at 2.95 percent a year. The rule of 70 tells us that Turkey’s real GDP per person will double in 70/2.95 = 23.72 years.

11.

Russia’s real GDP (in U.S. dollars) was $2.017 trillion in 2012 and $2.097 trillion in 2013. Russia’s population was 143.2 million in 2012 and 143.5 million in 2013. Calculate a. The growth rate of real GDP. The growth rate of real GDP between 2011 and 2012 equals [($2.097trillion − $2.017 trillion)/$2.097 trillion]  100 = 3.97 percent.

b. The growth rate of real GDP per person. Russia’s population growth rate is equal to [(143.5 million − 143.2 million)/ 143.2 million]  100, which is 0.21 percent. Russia’s economic growth rate is 3.97 percent, so the growth rate of real GDP per person is 3.97 percent − 0.21 percent, or 3.76 percent.

c. The approximate number of years it will take for real GDP per person in Russia to double if the current growth rate of real GDP is maintained. Russia’s real GDP per person is growing at 3.76 percent a year. The rule of 70 tells us that Russia’s real GDP per person will double in 70/3.76 = 18.61 years.

12.

The New World Order While gross domestic product growth is picking up a bit in emerging market economies, it is picking up even more in the advanced economies. Real GDP in the emerging market economies is forecasted to grow at 5.4% in 2015 up from 4.9% in 2012. In the advanced economies, real GDP is expected to grow at 2.3% in 2015 up from 1.4% in 2012. The difference in growth rates means that the large spread between emerging market economies and advanced economies of the past 40 years will continue for many more years. Source: World Economic Outlook, January, 2014 Do growth rates over the past few decades indicate that gaps in real GDP per person around the world are shrinking, growing, or staying the same? Explain. Gaps with a few countries are shrinking but for the most part gaps are remaining more or less the same. The gaps between U.S. real GDP per person and real GDP per person in a few Asian countries, such as Hong King, Singapore, Taiwan, Korea, and China have narrowed sharply over the last 40 years. But the gaps between U.S. real GDP per person and real GDP per person in Canada, Europe, Japan

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(since 1970), and Central and South America have remained roughly constant over the past decades. And the gap between U.S. real GDP per person and real GDP per person in Africa has widened slightly since 1960. The data in the news clip indicates that the gap between the advanced economies and the emerging market economies will decrease a bit in 2015.

13.

If a large increase in investment increases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts upward and equilibrium employment increases, both of which increase potential GDP.

b. Employment. Employment increases. The demand for labor increases, which increases equilibrium employment.

c. The real wage rate. The real wage rate rises. The demand for labor increases, which raises the equilibrium real wage rate.

14.

If a severe drought decreases labor productivity, explain what happens to a. Potential GDP. The production function curve shifts downward and equilibrium employment decreases, both of which decrease potential GDP.

b. Employment. Employment decreases. The demand for labor decreases, which decreases equilibrium employment.

c. The real wage rate. The real wage rate falls. The demand for labor decreases, which lowers the equilibrium real wage rate.

ECONOMIC GROWTH

Use the following tables to work Problems 15 to 17. The first table describes an economy’s labor market in 2014 and the second table describes its production function in 2014. Real wage rate (dollars per hour) 80 70 60 50 40 30 20 15.

Labor hours supplied 55 50 45 40 35 30 25

Labor hours demanded 15 20 25 30 35 40 45

Labor (hours) 15 20 25 30 35 40 45 50

Real GDP (2009 dollars) 1,425 1,800 2,125 2,400 2,625 2,800 2,925 3,000

What are the equilibrium real wage rate and the quantity of labor employed in 2014? The equilibrium real wage rate is $40 per hour and the equilibrium quantity of labor employed is 35 hours.

16.

What are labor productivity and potential GDP in 2014? Potential GDP is $2,625, the quantity of real GDP produced with the equilibrium quantity of employment. Labor productivity equals $2,625  35 hours, or $75.00 per hour.

17.

Suppose that labor productivity increases in 2014.What effect does the increased labor productivity have on the demand for labor, the supply of labor, potential GDP, and real GDP per person? The increase in labor productivity increases the demand for labor. The supply of labor does not change. The equilibrium wage rate rises and equilibrium employment increases. Potential GDP increases for two reasons: First, the increase in labor productivity increases potential GDP; second, the increase in equilibrium employment increases potential GDP. Real GDP per person increases.

18.

India’s Economy Hits the Wall Just six months ago, India was looking good. Annual growth was 9%, consumer demand was huge, and foreign investment was growing. But now most economic forecasts expect growth to slow to 7%—a big drop for a country that needs to accelerate growth. India needs urgently to upgrade its infrastructure and education and health-care facilities. Agriculture is unproductive and needs better technology. The legal system needs to be strengthened with more judges and courtrooms. Source: BusinessWeek, July 1, 2008 Explain five potential sources for faster economic growth in India suggested in this news clip. One suggested source of increased economic growth is increased infrastructure investment. Infrastructure includes factors such as roads, ports, railways, and electricity transmission. The second suggestion mentioned is to raise education achievement. This recommendation, while not a short-term fix, would be quite powerful at raising India’s long-term growth. The third factor is to increase healthcare facilities. Better health care for its citizens translates into increased labor productivity because India’s workers would be better able to work in the marketplace. The fourth source of increased economic growth is to increase productivity in agriculture. This suggestion, however, is not well detailed; in particular, it is much easier to suggest raising productivity than to actually do so. The last suggestion is to increase the number of judges and strengthen the legal system, and improve governance. However, while a seemingly simple suggestion, this process is likely to wind up politically quite difficult.

19.

Has The Ideas Machine Broken Down? According to Robert Gordon, the last two centuries of economic growth might actually amount

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to just “one big wave” of dramatic change rather than a new era of interrupted progress, and that the world is returning to extensive growth, which is a matter of adding more and/or better labor, capital, and resources. Source: The Economist, January 12, 2013 Which of the growth theories that you studied in this chapter best corresponds to the argument advanced by Mr. Gordon? Neoclassical growth theory best corresponds to the argument advanced by Gordon. According to this theory, technological change, which influences the economic growth rate, results from chance. When we are lucky, we have rapid technological change, and when bad luck strikes, the pace of technological advance slows.

20.

Is faster economic growth always a good thing? Argue the case for faster growth and the case for slower growth. Then reach a conclusion on whether growth should be increased or slowed. More rapid economic growth brings increased consumption possibilities in the future, which is the benefit from economic growth. Economic growth has costs: Decreased current consumption and the possibility of increased resource depletion and environmental damage. (Of course, the technological change that results from economic growth might allow for less resource depletion and less environmental damage.) Whether economic growth should be increased or decreased depends on the benefits of more rapid growth relative to the costs of more rapid growth.

21.

For Economist Paul Romer, Prosperity Depends on Ideas According to Romer, ideas and technological discoveries unlock the mystery of growth. He argues that ideas, especially those that can be contained in a piece of software, codified in a chemical formula, or used to improve organization of an assembly line, don’t obey the law of diminishing returns. Ideas and knowledge build on each other and can be reproduced cheaply. Computers, networks, and software serve as his best illustrations of how ideas create prosperity. Source: The Wall Street Journal, January 21, 1997 Explain which growth theory best describes the news clip. The new growth theory stresses the role of innovation and the birth of new firms and the death of old ones. The new growth theory best corresponds to the article because it describes the impact of ideas and technological discoveries on the economy. If these ideas and discoveries are successful, then new firms that use these ideas and produce novel products will be born and old firms that produce outdated products will die. The news clip also conveys that new technology will lead to prosperity and more profits.

Economics in the News 22.

After you have studied Economics in the News on pp. 190–191 (598–599 in Economics), answer the following questions. a. How do economic growth rates of South Africa and Botswana compare? Botswana’s economic growth rate has been much higher than South Africa’s economic growth rate.

b. For South Africa to grow faster, how would the percentage of GDP invested in new capital need to change? The percent of GDP invested in new capital needs to increase.

c. If South Africa is able to achieve a growth rate of 8 percent per year, in how many years will real GDP have doubled? The rule of 70 shows that South Africa’s GDP will double in approximately 70/8.0 , which is 8.75 years.

d. Describe the policies proposed by the author of the news article and explain how they might change labor productivity. There are a variety of proposals designed to increase labor productivity. These proposals include (1) reforming labor laws by removing the automatic extension of collective bargaining agreements across

ECONOMIC GROWTH

sectors; (2) establishing “jobs zones” that feature special exemptions from restrictive regulations; (3) lifting administrative requirements for small businesses; (4) creating a youth wage subsidy and marketdriven skills development programs; (5) distributing shares in state-owned companies; (6) introducing tax deductions to incentivize employee shared-ownership schemes; and, (7) promoting joint ownership in the agricultural sector. The first three proposals aim to increase labor productivity by decreasing rigidities in the labor market that prevent workers from being allocated to their highest-valued jobs. The fourth proposal aims to increase labor productivity by boosting workers’ human capital. The last three proposals attempt to increase labor productivity by changing the incentives of managers to a more profit-driven goal, which increases their incentives to boost their workers’ productivity.

e. What is the source of Botswana’s growth success story and what must South Africa do to replicate that success? Botswana has secure property rights and invests a very large proportion of its GDP. South Africa must increase the growth of its capital, both physical capital and human capital. South Africa must increase the growth rate of its labor productivity. It also needs to make property rights secure.

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Draw a PPF graph to show what has happened in Botswana and South Africa since 1980. Figure 6.1 shows the PPFs of Botswana and South Africa in 1980 and 2012. In 1980, South Africa’s PPF lay beyond Botswana’s PPF. But in the intervening years, Botswana has grown more rapidly so that its GDP has overtaken that in South Africa and so that now, as illustrated in the figure, Botswana’s PPF lies beyond South Africa’s PPF.

23.

Make Way for India—The Next China China grows at around 9 percent a year, but its one-child policy will start to reduce the size of China’s working-age population within the next 10 years. India, by contrast, will have an increasing working-age population for another generation at least. Source: The Independent, March 1, 2006 a. Given the expected population changes, do you think China or India will have the greater economic growth rate? Why? Economic growth occurs because labor productivity grows and because the population grows. If labor productivity grows at the same rate in China as in India, then the more rapid population growth in India will lead to more rapid economic growth in India.

b. Would China’s growth rate remain at 9 percent a year without the restriction on its population growth rate? According to the classical theory of economic growth, restricting population growth is necessary for persisting economic growth. According to the new growth theory, restricting population growth leads to slower economic growth. So whether China’s growth would remain at 9 percent a year without restricting population growth is not clear.

c. India’s population growth rate is 1.6 percent a year, and in 2005 its economic growth rate was 8 percent a year. China’s population growth rate is 0.6 percent a year, and in 2005 its economic growth rate was 9 percent a year. In what year will real GDP per person double in each country? India’s growth in real GDP per person equals 8 percent a year minus 1.6 percent a year, which is 6.4 percent a year. According to the Rule of 70, at this rate India’s real GDP per person will double in 70/6.4, which is 10.9 years. So India’s real GDP per person will double by 2016. China’s growth in real GDP per person equals 9 percent a year minus 0.6 percent a year, which is 8.4 percent a year According to the Rule of 70, at this rate China’s real GDP per person will double in 70/8.4, which is 8.3 years. So China’s real GDP per person will double in 2014.

C h a p t e r

FINANCE, SAVING, AND INVESTMENT**

Answers to the Review Quizzes Page 202 1.

(page 610 in Economics)

Distinguish between physical capital and financial capital and give two examples of each. Physical capital is the actual tools, instruments, machines, buildings and other items that have been produced in the past and are presently used to produce goods and services. Financial capital is the funds that businesses use to acquire their physical capital. Examples of physical capital are the pizza ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund their purchases of new buildings.

What is the distinction between gross investment and net investment? Gross investment is the total amount spent on new capital; net investment is the change in the value of the capital stock. Net investment equals gross investment minus depreciation.

What are the three main types of markets for financial capital? The main types of markets for financial capital are the loan markets, the bond markets, and the stock markets.

Explain the connection between the price of a financial asset and its interest rate. There is an inverse relationship between the price of a financial asset and its interest rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls, the price of the asset rises.

Page 209 1.

(page 617 in Economics)

What is the loanable funds market?

The loanable funds market is the market in which households, firms, governments, banks, and other financial institutions borrow and lend. It is the aggregate of all the individual financial markets and includes loan markets, bond markets, and stock markets. The real interest rate is determined in this market.

Explain why the real interest rate is the opportunity cost of loanable funds. The real interest rate is the opportunity cost of loanable funds because the real interest rate measures what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when funds are used either to buy consumption goods and services or to invest in new capital goods is the opportunity cost of not saving or not lending those funds.

* This is Chapter 24 in Economics.

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How do firms make investment decisions? To determine the quantity of investment, firms compare the expected profit rate from an investment to the real interest rate. The expected profit from an investment is the benefit from the investment. The real interest rate is the opportunity cost of investment. If the expected profit from an investment exceeds the cost of the real interest rate, then firms make the investment. If the expected profit from an investment is less than the cost of the real interest rate, then firms do not make the investment.

What determines the demand for loanable funds and what makes it change? The demand for loanable funds depends on the real interest rate and expected profit. If the real interest rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if the real interest rate rises and everything else remains the same, the quantity of loanable funds demanded decreases. Movements along the loanable funds demand curve illustrate these events. If the expected profit increases and nothing else changes, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else remains the same, the demand for loanable funds decreases and the demand for loanable funds curve shifts leftward.

How do households make saving decisions? A household’s saving depends on five factors: the real interest rate, the household’s disposable income, the household’s expected future income, wealth, and default risk. A household increases its saving if the real interest rate increases, its disposable income increases, its expected future income decreases, its wealth decreases, or if default risk decreases.

What determines the supply of loanable funds and what makes it change? The supply of loanable funds depends on the real interest rate, disposable income, expected future income, wealth, and default risk. An increase in the real interest rate increases the quantity of loanable funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An increase in disposable income increases the supply of loanable funds; a decrease in disposable income decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a decrease in wealth increases the supply of loanable funds. An increase in expected future income decreases the supply of loanable funds; a decrease in expected future income increases the supply of loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in default risk increases the supply of loanable funds.

How do changes in the demand for and supply of loanable funds change the real interest rate and quantity of loanable funds? The real interest rate is determined by the supply of loanable funds and the demand for loanable funds. The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If the demand for loanable funds increases and the supply does not change, the real interest rate rises and the quantity of loanable funds increases. If the demand for loanable funds decreases and the supply does not change, the real interest rate falls and the quantity of loanable funds decreases. If the supply of loanable funds increases and the demand does not change, the real interest rate falls and the quantity of loanable funds increases. If the supply of loanable funds decreases and the demand does not change, the real interest rate rises and the quantity of loanable funds decreases.

Page 211 1.

(page 619 in Economics)

How does a government budget surplus or deficit influence the loanable funds market? A government budget surplus adds to the supply of loanable funds. A government budget deficit adds to the demand for loanable funds.

What is the crowding-out effect and how does it work? The crowding-out effect refers to the decrease in investment that occurs when the government budget deficit increases. An increase in the government budget deficit increases the demand for loanable funds. As a result the real interest rate rises. The rise in the real interest rate decreases—“crowds out”— investment.

FINANCE, SAVING, AND INVESTMENT

What is the Ricardo-Barro effect and how does it modify the crowding-out effect? The Ricardo-Barro effect points out that the crowding out effect is less than predicted by looking only at the effect of a budget deficit on the demand for loanable funds. The Ricardo-Barro effect asserts that as a result of a government budget deficit households increase their saving to pay the higher taxes that will be needed in the future to repay the debt issued to fund the deficit. The increase in saving increases the supply of loanable funds. This increase in the supply of loanable funds offsets the rise in the real interest rate from the increase in the demand for loanable funds caused by the budget deficit. Because the real interest rate does not rise as much, the decrease in investment, that is the amount of crowding out, is less in the presence of the Ricardo-Barro effect.

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Answers to the Study Plan Problems and Applications Use the following data to work Problems 1 and 2. Michael is an Internet service provider. On December 31, 2014, he bought an existing business with servers and a building worth $400,000. During 2015, his business grew and he bought new servers for $500,000. The market value of some of his older servers fell by $100,000. 1.

What was Michael’s gross investment, depreciation, and net investment during 2015? Michael’s gross investment was $500,000, his depreciation was $100,000, and his net investment was $400,000.

What is the value of Michael’s capital at the end of 2015? Michael’s capital at the end of 2015 is equal to his capital at the beginning of 2015, $400,000, plus his net investment during the year, also $400,000, for a total of $800,000.

Lori is a student who teaches golf on Saturdays. In a year, she earns $20,000 after paying her taxes. At the beginning of 2014, Lori owned $1,000 worth of books, DVDs, and golf clubs and she had $5,000 in a savings account at the bank. During 2014, the interest on her savings account was $300 and she spent a total of $15,300 on consumption goods and services. There was no change in the market values of her books, DVDs, and golf clubs. a. How much did Lori save in 2014? Lori’s saving equals her disposable income minus her consumption expenditure. Lori’s disposable income is $20,000 plus the interest on her savings account, $300, for a total of $20,300.Her consumption expenditure is $15,300, so her saving is $5,000.

b. What was her wealth at the end of 2014? Lori’s wealth at the end of 2014 is equal to the value of her wealth at the beginning of 2014 plus her saving during the year. At the beginning of 2014 Lori’s wealth is $6,000—the value of her books, DVDs, golf clubs, and savings account. Lori saved $5,000 during 2014 so her wealth at the end of the year is $11,000.

Treasury Yields Fall to Two-Week Low Treasury bond prices rose on Monday, pushing interest rates down. The interest rate on 10-year bonds fell 4 basis points to 1.65%. Source: The Wall Street Journal, August 27, 2012 What is the relationship between the price of a treasury bond and its interest rate? Why does the interest rate move inversely to price? When the price of a treasury bond rises, its interest rate falls. This inverse relationship exists because of the definition of an interest rate. The interest rate equals the amount paid as interest divided by the price of the security, then multiplied by 100. When the price rises, mathematically the interest rate must fall.

FINANCE, SAVING, AND INVESTMENT

Use the following information to work Problems 5 and 6. First Call, Inc., a smartphone company, plans to build an assembly plant that costs $10 million if the real interest rate is 6 percent a year or a larger plant that costs $12 million if the real interest rate is 5 percent a year or a smaller plant that costs $8 million if the real interest rate is 7 percent a year. 5. Draw a graph of First Call’s demand for loanable funds curve. Figure 7.1 shows First Call’s demand for loanable funds curve.

First Call expects its profit to double next year. Explain how this increase in expected profit influences First Call’s demand for loanable funds. When First Call expects its profit to increase, First Call increases its investment. The increase in its investment leads First Call to increase its demand for loanable funds.

The table sets out data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving.

Loanable Loanable funds Real interest funds supplied rate demanded (percent per (trillions of 2009 dollars) year) The equilibrium real interest rate is 7 4 8.5 5.5 percent per year. The equilibrium quantity 5 8.0 6.0 of investment equals the quantity of 6 7.5 6.5 loanable funds demand, $7.0 trillion and 7 7.0 7.0 the equilibrium quantity of saving equals 8 6.5 7.5 the quantity of loanable funds supplied, 9 6.0 8.0 $7.0 trillion. 10 5.5 8.5 b. If planned saving increases by $0.5 trillion at each real interest rate, explain the change in the real interest rate. The increase in saving increases the supply of loanable funds. The equilibrium real interest rate falls. In the table, the new equilibrium real interest rate is 6.5 percent per year.

c. If planned investment increases by $1 trillion at each real interest rate, explain the change in the real interest rate. The increase in investment increases the demand for loanable funds. The equilibrium real interest rate rises. In the table, the new equilibrium real interest rate is 8 percent per year.

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Use the data in Problem 7 to work Problems 8 and 9. 8. If the government’s budget becomes a deficit of $1 trillion, what are the real interest rate and investment? Does crowding out occur? The equilibrium real interest rate becomes 8 percent and the equilibrium quantity of investment is $6.5 trillion. There is crowding out of $500 billion of investment.

If the government’s budget becomes a deficit of $1 trillion and the Ricardo-Barro effect occurs, what are the real interest rate and the investment? The equilibrium real interest rate remains 7 percent and the quantity of investment remains $7.0 trillion. There is no crowding out because the $1 trillion increase in the budget deficit leads to an offsetting $1 trillion increase in private saving.

Use the table in Problem 7 and the following data to work Problems 10 and 11. Suppose that the quantity of loanable funds demanded increases by $1 trillion at each real interest rate and the quantity of loanable funds supplied increases by $2 trillion at each interest rate. 10.

11.

If the government budget remains balanced, what are the real interest rate, investment, and private saving? Does any crowding out occur? The table to the right, which shows the Real interest Loanable Loanable funds new demand for loanable funds and new rate funds supplied supply of loanable funds schedules, is demanded helpful to answer the problem. The new (percent per (trillions of 2009 dollars) real interest rate is 6 percent. Investment year) and private saving are both $8.5 trillion. 4 9.5 7.5 There is no crowding out. 5 9.0 8.0 If the government’s budget becomes a 6 8.5 8.5 deficit of $1 trillion, what are the real 7 8.0 9.0 interest rate, investment, and private 8 7.5 9.5 saving? Does any crowding out occur? 9 7.0 10.0 The equilibrium real interest rate becomes 10 6.5 10.5 7 percent. The equilibrium quantity of investment is $8.0 trillion and the equilibrium quantity of private saving is $9.0 trillion. There is crowding out of $500 billion of investment.

FINANCE, SAVING, AND INVESTMENT

Answers to Additional Problems and Applications 12.

On January 1 2014, the London Taxi Company owned 5 cabs valued at £150,000. During 2014, the London Taxi Company bought 4 new cabs for a total of £200,000. At the end of 2014, the market value of all of the cabs was £300,000. Calculate the London Taxi Company’s gross investment, depreciation, and net investment. Gross investment was £200,000. Depreciation was 200,000 + 150,000 − 300,000 = £50,000. Net investment, equal to gross investment minus depreciation, was £150,000.

Use the following information to work Problems 13 and 14. The Bureau of Economic Analysis reported that the U.S. capital stock was $46.3 trillion at the end of 2010, $46.6 trillion at the end of 2011, and $47.0 trillion at the end of 2012. Depreciation in 2011 was $2.4 trillion, and gross investment during 2012 was $2.8 trillion (all in 2009 dollars). 13. Calculate U.S. net investment and gross investment during 2011. Net investment equals the change in the capital stock. In 2011, U.S. net investment was $46.6 trillion − $46.3 trillion, which is $0.3 trillion. Gross investment equals net investment plus depreciation. In 2011, U.S. gross investment was $0.3 trillion + $2.4 trillion, which is $2.7 trillion.

14.

Calculate U.S. depreciation and net investment during 2012. Net investment equals the change in the capital stock. In 2012, U.S. net investment was $47.0 trillion − $46.6 trillion, which is $0.4 trillion. Depreciation equals gross investment minus net investment. In 2012, U.S. depreciation was $2.8 trillion − $0.4 trillion, which is $2.4 trillion.

15.

Annie runs a fitness center. On December 31, 2014, she bought an existing business with exercise equipment and a building worth $300,000. During 2015, business improved and she bought some new equipment for $50,000. At the end of 2015, her equipment and buildings were worth $325,000. Calculate Annie’s gross investment, depreciation, and net investment during 2015. Annie’s net investment during 2015 is $25,000 because that is the change in her capital stock. Annie’s gross investment is $50,000 because that is her total purchase of capital equipment in 2015. Annie’s depreciation during 2015 is $25,000 because Annie’s net investment, $25,000, equals her gross investment, $50,000, minus her depreciation.

16.

John is a researcher at a university, and after he paid taxes, his income and interest from financial assets was $55,000 in 2013. At the beginning of 2013, he owned $3,000 worth of financial assets. At the end of 2013, John’s financial assets were worth $5,000. a. How much did John save during 2013? John’s wealth increased by $2,000 in 2013. So his saving in 2013 is $2,000, assuming there are no capital gains or losses on his stocks and bonds.

b. How much did John spend on consumption goods and services? John’s income after taxes was $55,000. His consumption equals his income minus his saving, which is $55,000 − $2,000 = $53,000.

17.

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In a speech at the CFA Society of Nebraska in February 2007, William Poole (former Chairman of the St. Louis Federal Reserve Bank) said: Over most of the post-World War II period, the personal saving rate averaged about 6 percent, with some higher rates from the mid-1970s to mid-1980s. The negative trend in the saving rate started in the mid-1990s, about the same time the stock market boom started. Thus it is hard to dismiss the hypothesis that the decline in the measured saving rate in the late 1990s reflected the response of consumption to large capital gains from corporate equity [stock]. Evidence from panel data of households also supports the conclusion that the decline in the personal saving rate since 1984 is largely a consequence of capital gains on corporate equities. a. Is the purchase of corporate equities part of household consumption or saving? Explain your answer. The purchase of corporate equities, that is, shares of corporate stock, is part of household saving. Consumption refers to the purchase of goods and services that are then consumed, but corporate equities are not consumable goods or services.

b. Equities reap a capital gain in the same way that houses reap a capital gain. Does this mean that the purchase of equities is investment? If not, explain why it is not. The purchase of equities is not an investment because investment refers to the purchase of physical capital. Equities are not physical capital and so they are not investment.

18.

Draw a graph to illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds. Figure 7.2 shows the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds. The demand curve for loanable funds shifts rightward from DLF0 to DLF1, and the supply curve of loanable funds shifts rightward from SLF0 to SLF1. The increase in supply is larger than the increase in demand, so the real interest rate falls (from 6 percent to 5 percent in the figure) and the quantity of loanable funds increases (from $2.3 trillion to $2.7 trillion in the figure).

FINANCE, SAVING, AND INVESTMENT

19.

Draw a graph to illustrate how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged. Figure 7.3 shows the effect of an increase in the supply of loanable funds and a decrease in the demand for loanable funds. The supply of loanable funds curve shifts rightward from SLF0 to SLF1, and the demand for loanable funds curve shifts leftward from DLF0 to DLF1. The magnitude of the increase in supply is equal to the magnitude of the decrease in demand, so the real interest rate falls (from 7 percent to 4 percent in the figure) and the quantity of loanable funds does not change (staying at $2.5 trillion in the figure).

Use the following information to work Problems 20 and 21. In 2012, the Lee family had disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year. 20.

Draw a graph of the Lee family’s supply of loanable funds curve. Figure 7.4 shows the Lee family’s supply of loanable funds curve.

21.

In 2013, suppose that the stock market crashes and the default risk increases. Explain how this increase in default risk influences the Lee family’s supply of loanable funds curve. If default risk increases the Lee family will decrease its saving. As a result, the Lee family’s supply of loanable funds decreases and its supply of loanable funds curve shifts leftward.

22.

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Gunvor Becomes Major Winner in Rosneft Oil Tender Trading house Gunvor is among the winners of a large Rosneft tender. Gunvor would lift up to 400,000 tonnes of Russian Urals crude per month from the Baltic Sea port of Primorsk in AprilSeptember. Source: Reuters, March 17, 2015 On a graph, show the effect of Gunvor going to the loanable funds market to finance its operation. Explain the effect on the real interest rate, private saving, and investment. Gunvor’s demand for financial capital to fund its operation increases the demand for loanable funds. As Figure 7.5 illustrates, the demand curve for loanable funds shifts rightward from DLF0 to DLF1. The real interest rate rises. Private saving and investment both increase.

23.

The table sets out the data for an economy when the government’s budget is balanced. a. Calculate the equilibrium real interest rate, investment, and private saving. The equilibrium real interest rate is 4 percent per year. Equilibrium investment equals the quantity of loanable funds demanded, $6.0 trillion. Equilibrium saving equals the quantity of loanable funds supplied, (also) $6.0 trillion.

Real interest rate (percent per year) 2 3 4 5 6 7 8

b. If planned saving decreases by $1 trillion at each real interest rate, explain the change in the real interest rate and investment.

Loanable Loanable funds funds supplied demanded (trillions of 2009 dollars) 8.0 7.0 6.0 5.0 4.0 3.0 2.0

4.0 5.0 6.0 7.0 8.0 9.0 10.0

If planned saving increases by $1 trillion, the supply of loanable funds increases. Consequently the equilibrium real interest falls and the equilibrium quantity of investment increases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium investment increases to $6.5 trillion.

c. If planned investment decreases by $1 trillion at each real interest rate, explain the change in saving and the real interest rate. If planned investment decreases by $1 trillion, the demand for loanable funds decreases. Consequently the equilibrium real interest falls and the equilibrium quantity of saving decreases. In the table, the equilibrium real interest rate falls to 3.5 percent and equilibrium saving decreases to $5.5 trillion.

FINANCE, SAVING, AND INVESTMENT

Use the following information to work Problems 24 and 25. India’s Economy Hits the Wall At the start of 2008, India had an annual growth of 9 percent, huge consumer demand, and increasing investment. But by July 2008, India had large government deficits and rising interest rates. Economic growth is expected to fall to 7 percent by the end of 2008. A Goldman Sachs report suggests that India needs to lower the government’s deficit and raise educational achievement. Source: Business Week, July 1, 2008 24.

If the Indian government reduces its deficit and returns to a balanced budget, how will the demand for or supply of loanable funds in India change? If the Indian government reduces its deficit, the demand for loanable funds decreases.

25.

With economic growth forecasted to slow, future incomes are expected to fall. If other things remain the same, how will the demand or supply of loanable funds in India change? If expected future incomes slow, the major effect is an increase in the supply of loanable funds as households’ increase their saving.

26.

Sovereign Debt Markets in Turbulent Times: A View of the European Crisis At the end of 2009, the share of debt held by the private sector increased and as domestic banks allocated increasing amounts of funds to the public sector, product investment declined, further deepening the recession in Greece. Source: VoxEU.org, July 23 2014 Explain how the increase in public debt would deepen the Greek crisis. The large deficits increase the demand for loanable funds and, in the absence of a Ricardo-Barro effect, raise the real interest rate and crowd out investment. The decrease in investment means that the capital stock of Greece is lower than would otherwise be the case, which will decrease economic growth, deepening the recession in Greece.

Economics in the News 27.

After you have studied Economics in the News on pp. 212–213 (620–621 in Economics), answer the following questions. a. Why does the news article say that bond prices and interest rates move in opposite directions? Is it correct? Explain. The article says that bond prices and interest rates move in opposite directions because the interest rate is the interest received as the percentage of the price of the asset. In terms of a formula, if INT is the interest received and PRICE is the price of the asset, then the interest rate is (INT ÷ PRICE) × 100. Therefore, if the price of the asset rises, the percentage of the asset price received as interest, which is the interest rate, falls.

b. How does a government budget deficit influence the loanable funds market and why does a decrease in the deficit lower the interest rate? If the government runs a deficit, the demand for loanable funds increases. If the deficit decreases, the demand for loanable funds decreases which lowers the interest rate.

c. When an economic expansion gets going, what happens to the demand for loanable funds and the interest rate? An economic expansion increases the demand for loanable funds. The increase in the demand for loanable funds raises the interest rate.

d. If an expanding economy increases government tax revenue, how will that affect the loanable funds market and the real interest rate? If the government’s tax revenue increases, the government’s budget deficit shrinks. The decrease in the government budget deficit decreases the demand for loanable funds, thereby lowering the interest rate.

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e. Looking at Fig. 1 on p. 213 (page 621 in Economics), what must have happened to either the demand for or the supply of loanable funds during 2011, 2012, and 2013? In 2011 the interest rate fell, was low in 2012, and then started to rise in 2013. In 2011, either the demand for loanable funds decreased and/or the supply of loanable funds increased. In 2012, either the demand and supply of loanable funds did not change or they both changed in the same direction by the same amount. Finally in 2013, either the demand for loanable funds increased and/or the supply of loanable funds decreased.

28.

Huge Growth in Private Students Taking State Loans Compared to £52 million for 6,574 students in 2010, around 53,000 students received about £675 million a year in 2013–14 in the form of student loans from the state. Source: BBC News, January 26, 2015 a. How do state loans influence the government’s budget? The government’s budget is equal to revenue minus spending. An increase in state loans will increase the total spending and the overall budget. There will be a budget deficit if revenues are not enough to cover the additional spending.

b. If there is a budget deficit, how would you expect it to influence the demand for loanable funds and the equilibrium real interest rate? The increase in total spending will increase the demand for loanable funds. The demand for loanable funds curve shifts upward. If there is no change in the interest rate, the demand for loanable funds will be greater than the supply of loanable funds. Hence, there is an excess in the demand of loanable funds that would push the equilibrium real interest rate upward.

C h a p t e r

MONEY, THE PRICE LEVEL, AND INFLATION**

Answers to the Review Quizzes Page 222 1.

(page 630 in Economics)

What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money? Money is anything that is generally acceptable as a means of payment. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later). Packs of chewing gum do not function as money because they are not particularly good as a store of value—gum deteriorates. Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange.

What are the problems that arise when a commodity is used as money? Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward. Prices would change simply because the commodity’s value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone.

What are the main components of money in the United States today? The main components of money in the United States today are currency and deposits at banks and other depository institutions. What are the official measures of money? Are all the measures really money? The official measures of money are M1 (the sum of currency, traveler’s checks, and checking deposits owned by individuals and businesses) and M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits). All of the components of M1 are truly money because all the components serve as a means of payment. Some of the components of M2 are not truly money because they are not a means of payment. (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money.

Why are checks and credit cards not money? Checks and credit cards are not money because they are not a means of payment. A check is an order to transfer a deposit from one person to another. The deposits are money but the checks are not. A

* This is Chapter 25 in Economics.

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credit card is an ID card that lets a person take out a loan at the instant he or she buys something. The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money.

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What are depository institutions?

Depository institutions are financial firms that take deposits from households and firms. They then make loans available to other households and firms.

What are the functions of depository institutions? Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

How do depository institutions balance risk and return? Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets such as loans. But these assets are risky. If the loans fail, then the bank might not have sufficient funds to repay their depositors. If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank must balance its search for higher return against the risk earning the return entails.

How do depository institutions create liquidity, pool risks, and lower the cost of borrowing? Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk. Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process.

How have depository institutions made innovations that have influenced the composition of money? Checking deposits at thrift institutions such as S&L’s savings banks, and credit unions are examples of deposits that were created by innovations in the 1980s and 1990s. These deposits have become an increasingly large percentage of M1. Savings deposits have decreased as a percentage of M2, while time deposits and money market mutual funds have increased, and checking deposits at commercial banks have become a decreasing percentage of M1.

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What is the central bank of the United States and what functions does it perform? The Federal Reserve System is the central bank of the United States. The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s depository institutions. The Fed provides banking services to commercial banks.

What is the monetary base and how does it relate to the Fed’s balance sheet? The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed. Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities. Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve.

What are the Fed’s three policy tools? The Federal Reserve has three policy tools: required reserve ratio, last resort loans, and open market operations.

What is the Federal Open Market Committee and what are its main functions? The Federal Open market Committee (FOMC) is the main policy-making group within the Federal

MONEY, THE PRICE LEVEL, AND INFLATION

Reserve System. It decides upon the nation’s monetary policy as conducted through open market operations. The FOMC meets approximately once every six weeks.

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How does an open market operation change the monetary base? The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Federal Reserve, that is, banks’ reserves. When the Federal Reserve conducts an open market operation, it either buys securities and pays for them with newly created reserves or it sells securities and is paid with reserves held by banks. In both cases the monetary base changes. In the first case, when the Fed buys securities, the monetary base increases. In the second case, when the Fed sells securities, the monetary base decreases.

Page 232 1.

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How do banks create money?

Banks within the banking system create money by creating deposits, which are part of the nation’s money. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank.

What limits the quantity of money that the banking system can create? The quantity of money that the banking system can create is limited by: the monetary base, desired reserves, and desired currency holdings.

A bank manager tells you that she doesn’t create money. She just lends the money that people deposit. Explain why she’s wrong. Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money. Point out to the manager that when she makes a loan, the deposits at her bank initially increase. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases. However, actions of other economic agents also affect the creation of money. For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil. But over time the quantity of money increases because banks gain more (excess) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money.

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(page 645 in Economics)

What are the main influences on the quantity of real money that people and businesses plan to hold? The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation. An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level. An increase in the nominal interest rate decreases the quantity of real money demanded, because the nominal interest rate is the opportunity cost of holding money. An increase in real GDP increases the demand for real money, because more real GDP implies more transactions and an increase in the demand for money to finance the transactions. And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money.

MONEY, THE PRICE LEVEL, AND INFLATION

Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve. An increase in the nominal interest rate decreases the quantity of real money demanded. The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate. As illustrated in Figure 8.1, a decrease in the nominal interest rate results in a movement downward along the demand for money curve. A change in real GDP changes the demand for money. An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1, as shown in Figure 8.2.

How is money market equilibrium determined in the short run? In the short run, the nominal interest rate adjusts to restore equilibrium to the money market. When the quantity of money demanded equals the quantity supplied, the nominal interest rate is at its equilibrium level.

How does a change in the quantity of money change the interest rate in the short run? In the short run an increase in the quantity of money lowers the interest rate and a decrease in the quantity of money raises the interest rate. Suppose the Federal Reserve increases the quantity of money. At the initial interest rate people hold more money than the quantity they demand. To restore the amount of money they hold to equality with the quantity demanded, people use the surplus in the loanable funds market to buy bonds. The price of a bond rises which means that the interest rate on the bond falls. When the Federal Reserve decreases the quantity of money, the reverse occurs: At the initial interest rate people have less money than the quantity they demand so they sell bonds in the loanable funds market to acquire more money. Selling bonds lowers their price which raises the interest rate.

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How does a change in the quantity of money change the interest rate in the long run? In the long run a change in the quantity of money does not change the interest rate. For example, suppose the Federal Reserve increases the quantity of money (the effects from a decrease in the quantity of money are the reverse of an increase). In the short run the nominal interest rate and the real interest rate fall. Both households and firms increase their demand for goods. The resulting shortages force prices higher and therefore the price level rises. As the price level rises, the quantity of real money decreases, which raises the nominal interest rate and real interest rate. The rise in the interest rate decreases the demand for goods. Eventually the price level rises so that the quantity of real money equals the initial amount. At this point, the nominal interest rate and real interest rate have risen to equal their initial values so there is no long-run effect on the interest rate from a change in the quantity of money.

Page 239 1.

(page 647 in Economics)

What is the quantity theory of money? The quantity theory of money is the proposition that in the long run an increase in the quantity of money creates an equal percentage increase in the price level.

How is the velocity of circulation calculated? The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation equals (nominal) GDP divided by the quantity of money.

What is the equation of exchange? The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M.

Does the quantity theory correctly predict the effects of money growth on inflation? The long-run historical and international evidence on the relationship between money growth and the inflation rate support the quantity theory. The data suggest a marked tendency for nations with high money growth rates to have high inflation rates.

MONEY, THE PRICE LEVEL, AND INFLATION

Answers to the Study Plan Problems and Applications 1.

Money in the United States today includes which of the following items? • Cash in Citibank’s cash machines

Money includes currency outside the banks. Currency inside cash machines is not money.

•

U.S. dollar bills in your wallet The dollar bills inside your wallet are money.

•

Your Visa card The Visa card is not money.

•

Your loan to pay for school fees The loan is not money.

In June 2013, currency held by individuals and businesses was $1,124 billion; traveler’s checks were $4 billion; checkable deposits owned by individuals and businesses were $1,042 billion; savings deposits were $6,884 billion; time deposits were $583 billion; and money market funds and other deposits were $647 billion. Calculate M1 and M2 in June 2011. M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses. In June, 2011 M1 equaled $1,124 billion + $4 billion + $1,042, or $2,170 billion. M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits. In June, 2011 M2 equaled $2,170 + $583 billion + $6,884 billion + $647 billion, or $10,284 billion.

Europe’s Banks Must Be Forced to Recapitalize E.U. banks must hold more capital. Where private funding is not forthcoming, recapitalization must be imposed by E.U. governments. Source: Financial Times, November 24, 2011 What is the “capital” referred to in the news clip? How might the requirement to hold more capital make banks safer? The “capital” means owners’ capital; that is, funds the owners have invested in the bank. When loans or other assets go bad, the bank incurs a loss and the bank’s capital decreases. If enough losses are incurred, the bank’s capital might be totally dissipated, in which case the bank fails because the bank has no further cushion to absorb more losses. The requirement to hold more capital makes the possibility of failure less likely.

The FOMC sells $20 million securities to Wells Fargo. Enter the transactions that take place to show the changes in the following balance sheets. The first balance sheet to the right shows the balance sheet of the Federal Reserve Bank of New York. The Fed’s assets decrease by $20 million because the Fed now has $20 million less securities. The Fed’s liabilities also decrease by $20 million because Wells Fargo pays for its purchases using the reserves that it has on deposit at the Fed.

Federal Reserve Bank of New York Assets (millions) Securities −$20

The second balance sheet to the right shows the balance sheet of Wells Fargo Bank. Wells Fargo gains assets in the form of securities of $20 million. Simultaneously it also losses reserve deposit assets of $20 million because it pays for the government securities using its reserve deposits at the Fed.

Liabilities (millions) Wells Fargo reserve deposit −$20

Wells Fargo Assets (millions) Securities +$20 Reserve deposit −$20

Liabilities (millions)

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In the economy of Nocoin, bank deposits are $300 billion, bank reserves are $15 billion of which two thirds are deposits with the central bank. Households and firms hold $30 billion in bank notes. There are no coins. Calculate a. The monetary base and the quantity of money. The monetary base is $45 billion. The monetary base is the sum of the central bank’s notes, banks’ deposits at the central bank, and coins held by households, firms, and banks. There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins. The monetary base is $45 billion. The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.

b. The banks’ desired reserve ratio and the currency drain ratio (as percentages). The banks’ reserve ratio is 5 percent. The banks’ reserve ratio is the percent of deposits that is held as reserves. In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion)  100, which is 5 percent. The currency drain is 10 percent. The currency drain is the ratio of currency to deposits. In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion) 100, which is 10 percent.

China Cuts Banks’ Reserve Ratios The People’s Bank of China announces it will cut the required reserve ratio. Source: Financial Times, February 19, 2012 Explain how lowering the required reserve ratio will impact banks’ money creation process. Lowering the required reserve ratio decreases banks’ desired reserves. When banks’ desired reserves decrease they will make more loans so the quantity of money in China increases. (The Mathematical Note shows that an decrease in the desired reserve ratio increases the money multiplier.)

The spreadsheet provides data about the demand for money in Minland. Columns A and B show the demand for money schedule when real GDP (Y0) is $10 billion and Columns A and C show the demand for money schedule when real GDP (Y1) is $20 billion. The quantity of money is $3 billion. What is the interest rate when real GDP is $10 billion? Explain what happens in the money market in the short run if real GDP increases to $20 billion.

A r

2 3 4 5 6 7 8

7 6 5 4 3 2 1

B Y0 1.0 1.5 2.0 2.5 3.0 3.5 4.0

C Y1 1.5 2.0 2.5 3.0 3.5 4.0 4.5

When real GDP is $10 billion, the equilibrium nominal interest rate is 6 percent because that is the interest rate that sets the quantity of money demanded equal to $3 billion. If real GDP increases to $20, the quantity of money demanded exceeds the quantity supplied, so people want to hold more money than is available. They try to increase the amount of money held by selling bonds. The prices of bonds fall, and the interest rate rises to its new equilibrium of 5 percent.

MONEY, THE PRICE LEVEL, AND INFLATION

In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20. In year 2, the quantity of money increases by 20 percent. If the quantity theory of money holds, calculate the quantity of money, the GDP deflator, real GDP, and the velocity of circulation in year 2. The quantity of money in year 1 is $40 million. Because the equation of exchange tells us that MV = PY, we know that M = PY/V. Then, with P = 2.0, Y = $400 million, and V = 20, M = $40 million. Then in year 2 the quantity of money is $48 million because money grows by 20 percent, which is $8 million. The GDP deflator is 240. Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the GDP deflator rises by the same percentage as the increase in the quantity of money, which is 20 percent. Real GDP is $400 million because it remains equal to potential GDP (the quantity of GDP produced at full employment). The velocity of circulation is 20. Because the factors that influence velocity have not changed, velocity is unchanged.

Mathematical Note 9.

In Problem 5, the banks have no excess reserves. Suppose that the central bank of Nocoin increases bank reserves by $0.5 billion. a. Explain what happens to the quantity of money and why the change in the quantity of money is not equal to the change in the monetary base. The quantity of money increases by $3.67 billion. The quantity of money increases by the change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33 (see part b), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion. The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect. The open market operation increases bank reserves and creates excess reserves, which banks use to make new loans. New loans are used to make payments and some of these loans are placed on deposit in banks. The increase in bank deposits increases banks’ reserves and increases desired reserves. But the banks now have excess reserves which they loan out and the process repeats until excess reserves have been eliminated.

b. Calculate the money multiplier. The money multiplier is 7.33. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1)/(0.1 + 0.05), which equals 7.33.

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Answers to Additional Problems and Applications 10.

Kristin deposits $5,000 cash into her savings account at the First National Bank. What is the immediate change in M1 and M2? The deposit of $5,000 in the savings account will decrease M1. However, M2 will not change.

11.

Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its ability to function as money. Which of the following commodities would most likely have taken the place of the cruzeiro in the Brazilian economy? Explain why. a. Tractor parts It is unlikely that tractor parts would be used as money because tractor parts are heavy and unwieldy to carry around for use as a medium of exchange.

b. Packs of cigarettes Packs of cigarettes would likely be used as a substitute for money because they are light to carry around, are durable, and can be easily divided into fractions of packs for making change.

c. Loaves of bread Loaves of bread would be unlikely to be used as a substitute for money because they would spoil too rapidly.

d. Impressionist paintings Impressionist paintings would be unlikely to be used as a substitute for money because they would be unwieldy to carry around and because their quality and value differs dramatically from one artist to another.

e. Baseball trading cards Baseball cards would be unlikely to be used as a substitute for money because most Brazilians are unfamiliar with baseball (and unlikely to value the cards per se) and because the cards are not very durable.

12.

Are You Ready to Pay by smartphone? Starbucks customers can now pay for their coffee using their smartphone. Does this mean the move to electronic payments is finally coming? Source: The Wall Street Journal, January 20, 2011 If people can use their smartphone to make payments, will currency disappear? How will the components of M1 change? People will probably carry less currency because their cell phone will substitute for currency, but currency won’t disappear because currency is used in the underground economy. As a component of M1, currency and traveler’s checks will be smaller and most of M1 will be checkable deposits.

Use the following news clip to work Problems 13 and 14. The World’s 29 Too Big to Fail Banks, JP Morgan at the Top The Financial Stability Board has released the latest list of the world’s too-big-to-fail banks. Each year, the board examines banks to decide which ones pose a threat to the global economy if they were to fail. Those on the list of too-big-to-fail must hold more capital to absorb potential losses, and therefore protect taxpayers from bailouts. In 2013, JPM and HSBC top the list. This means they must each hold an extra 2.5% of capital on top of the additional 7% that will be required down the road. Source: www.forbes.com, November 11, 2013 13.

Explain how the failure of big banks would be disastrous for the economy? A commercial bank lends its excess reserves which are the actual reserves minus required (safe) reserves. Hence, to maximize its profit, the bank minimizes these reserves to the maximum or lends all its excess reserves. If there is a run on the bank from depositors and a large number of depositors request the return of their funds, the bank might fail if it does not have adequate reserves in hand to meet these withdrawals. In this case, depositors will lose their savings and if the bank is too big and

MONEY, THE PRICE LEVEL, AND INFLATION

holds an important share of the total banking system assets this will affect the savings of a country. A fall in the savings may lead to a recession.

14.

Should such banks receive financial support from their governments to avoid failure? The world’s largest financial institutions, at least most of them, are connected. These connections would pose a systemic risk in the sense that the failure of one large bank could bring down others and threaten the stability of the financial system. In order to prevent such a default, the government may use public funds to ensure payment of a large bank’s debt. This would increase the stability of the banking system. However, the financial support by the government will encourage the bank to take more risks and might lead to a greater chance of failure than it would without the government’s financial support. Moreover, these funds could be alternatively allocated by the government to other sectors that are productive.

15.

Explain the distinction between a central bank and a commercial bank. A central bank is basically a “bank for banks.” It will conduct business with commercial banks, such as making loans to them and holding their reserves. A central bank does not accept deposits from private citizens. A central bank also regulates the nation’s depository institutions and conducts the nation’s monetary policy. A commercial bank conducts business with firms and households. It accepts deposits from individuals and then makes loans to other people or firms. Commercial banks are privately owned and have as their objective the maximization of their profit.

16.

If the Fed makes an open market sale of $1 million of securities to a bank, what initial changes occur in the economy? If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and the bank’s balance sheet change. The Fed’s holding of securities falls by $1 million and the bank’s holding of securities rises by $1 million. The bank pays for the purchase with its reserves, so the reserves held by the Fed fall by $1 million and the bank’s reserves fall by $1 million. The amount of the bank’s assets does not change, though the composition changes (more securities, fewer reserves). The Fed’s assets and liabilities both fall by an equal amount ($1 million in this case).

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Set out the transactions that the Fed undertakes to increase the quantity of money. The Fed has three procedures by which it can increase the quantity of money: • The Fed could use an open market purchase of securities from banks. When the Fed buys securities, it pays for the purchase by increasing banks’ reserves. The increase in banks’ reserves increases the monetary base and allows banks to make more loans, which then increase the quantity of money. • The Fed could make a last resort loan to a bank. When the Fed makes a loan to a bank, the bank’s reserves increase. The increase in reserves increases the monetary base and allows the bank to make more loans, which then increase the quantity of money. • The Fed could lower the required reserve ratio. By lowering the required reserve ratio, the Fed lowers the reserves banks must hold and thereby lowers their desired reserve ratio. Banks respond by increasing their loans, which then increase the quantity of money.

18.

Describe the Fed’s assets and liabilities. What is the monetary base and does it relate to the Fed’s balance sheet? The Fed has two main assets: U.S. government securities and loans to depository institutions. The Fed also has two main liabilities, Federal Reserve notes and depository institution deposits (the reserves that depository institutions hold at the Fed). The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. Coins are only a small part of the monetary base. The two largest components of the monetary base, Federal Reserve notes and depository institutions deposits at the Fed, are the Fed’s two liabilities.

19.

Fed Minutes Show Active Discussion of QE3 The FOMC discussed “a new large-scale asset purchase program” commonly called “QE3.” Some FOMC members said such a program could help the economy by lowering long-term interest rates and making financial conditions more broadly easier. They discussed whether a new program should snap up more Treasury bonds or buying mortgage-backed securities issued by the likes of Fannie Mae and Freddie Mac. Source: The Wall Street Journal, August 22, 2012 What would the Fed do to implement QE3, how would the monetary base change, and how would bank reserves change? To implement QE3 the Fed would undertake massive (“quantitative”) purchases of assets. These assets likely would be long-term securities and could include Treasury bonds and/or mortgage backed securities, such as those issued by Fannie Mae or Freddie Mac. These purchases would increase both the monetary base and banks’ reserves.

20.

Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits and no excess reserves. The currency drain ratio is 50 percent of deposits. Now suppose that the central bank increases the monetary base by $1,200 billion. a. How much do the banks lend in the first round of the money creation process? Banks loan $1,200 billion because the entire increase in reserves is excess reserves.

b. How much of the initial amount lent flows back to the banking system as new deposits? $800 billion flows back to the banks as new deposits. The currency drain, which is the percentage ratio of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited back in banks and 50 percent of the deposits, $400 billion, is kept as currency.

c. How much of the initial amount lent does not return to the banks but is held as currency? Currency increases by $400 billion. The currency drain, which is the percentage of currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as currency.

MONEY, THE PRICE LEVEL, AND INFLATION

d. Why does a second round of lending occur? A second round of lending takes place because the $800 billion flowing back to the banks as new deposits means that banks have excess reserves. Of the $800 billion flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in a second round of lending.

21.

Explain the change in the nominal interest rate in the short run if a. Real GDP increases. The nominal interest rate rises. When real GDP increases, the demand for money increases. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

b. The money supply increases. The nominal interest rate falls. When the supply of money increases, the quantity of real money increases. At the initial interest rate people are holding more money than the quantity they demand. People buy bonds to decrease the money they hold. The price of a bond rises and the nominal interest rate falls.

c. The price level rises. The nominal interest rate rises. When the price level rises, the quantity of real money decreases. The supply of money decreases. The demand for money does not change. At the initial interest rate people are holding less money than the quantity they demand. People sell bonds to increase the money they hold. The price of a bond falls and the nominal interest rate rises.

22.

Figure 8.3 shows the demand for money curve. If the Fed decreases the quantity of real money supplied from $4 trillion to $3.9 trillion, explain how the price of a bond will change. If the Fed decreases the quantity of money to $3.9 trillion, the price of a bond falls. The decrease in the quantity of money means that at the initial interest rate, 4 percent, people are holding less money than the quantity they demand. In response people sell bonds to try to increase the quantity of money they hold. As people sell bonds, the price of a bond falls and the interest rate rises, in the figure from 4 percent to 6 percent.

23.

Use the data in Problem 7 to work this problem. The interest rate is 4 percent a year. Suppose that real GDP decreases from $20 billion to $10 billion and the quantity of money remains unchanged. Do people buy bonds or sell bonds? Explain how the interest rate changes. When real GDP decreases, the demand for money decreases. At the initial interest rate of 4 percent, the quantity of money people are holding exceeds the quantity of money they want to hold. People buy bonds to decrease the quantity of money they are holding. When people demand bonds, the price of a bond rises, and the interest rate falls. When the interest rate equals 3 percent a year, people are holding exactly the quantity of money that they want to hold so 3 percent is the new equilibrium interest rate.

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The table provides some data for the United States in the first decade following the Civil War. Source of data: Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960 a. Calculate the value of X in 1869.

Quantity of money Real GDP (1929 dollars) Price level (1929 = 100) Velocity of circulation

1869 $1.3 billion $7.4 billion X 4.50

1879 $1.7 billion Z 54 4.61

Using the formula MV = PY gives ($1.3 billion  4.5) = (P  $7.4 billion) so that P equals 0.79, or, transformed to an index number, P = 79.

b. Calculate the value of Z in 1879. Using the formula MV = PY gives ($1.7 billion  4.61) = (0.54  Y) so that Y equals $14.5 billion.

c. Are the data consistent with the quantity theory of money? Explain your answer. The quantity theory holds. The quantity theory predicts that the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity minus the growth rate of real GDP. The growth rate of velocity is approximately zero, so the inflation rate equals the growth rate of the quantity of money minus the growth rate of real GDP. The quantity of money grew by approximately 27 percent, real GDP grew by approximately 65 percent and the price level fell by approximately 38 percent. (These percentages are calculated using the average of the quantity of money, the price level, and real GDP as the base for the percentage.) The inflation rate, −38 percent (deflation) equals the growth rate of the quantity of money, 27 percent, minus the growth rate of real GDP, 65 percent.

Economics in the News 25.

After you have studied Reading Economics in the News on pp. 240–241 (648–649 in Economics,) answer the following questions. a. What changes in the interest rate and the quantity of M2 occurred between 2007 and 2014? The interest rate plummeted from almost 5 percent per year to near 0 percent per year. Meanwhile the quantity of M2 soared from about $7 trillion to $10 trillion.

b. Why is the outcome feared by bankers optimistic? Bankers are concerned that the quantity of money demanded will decrease by $1 trillion if the Fed raises the interest rate to 1 percent. Because most of the decrease will be a decrease in deposits, bankers expect a $1 trillion decrease in deposits. But the demand curve for M2 shows that if the interest rate rises to 1 percent, the quantity of money demanded will decrease by $1.8 trillion. Bankers expect a decrease of only $1 trillion, so the predicted decrease is much larger than the outcome they expect.

c. By how much would the quantity of M2 demand decrease if the interest rate rose to 2 percent, 3 percent, and 4 percent? (Express your answer as a percentage of GDP.) If the interest rate rises to 2 percent, the quantity of money demanded is approximately 50 percent of GDP; if the interest rate rises to 3 percent, the quantity of money demanded is approximately 48 percent of GDP; and, if the interest rate rises to 4 percent, the quantity of money demanded is approximately 47 percent of GDP.

d. What could the banks do to prevent deposits from decreasing by as much as predicted by the demand for M2 curve in Fig. 3 on p. 241 (page 649 in Economics)? Banks can raise the interest rate they pay on deposits in order to prevent the deposits from decreasing as much as the demand for M2 curve shows.

e. What would you expect to happen to the monetary base if interest rates rise? Why? The monetary base will decrease. If interest rates rise, banks will have a greater incentive to loan the funds they are keeping as reserves at the Fed. Decreasing the quantity of reserves decreases the monetary base.

MONEY, THE PRICE LEVEL, AND INFLATION

26.

The Truth is Out: Money is Just an IOU, and the Banks Are Rolling In It The central bank can print as much money as it wants to, but it doesn’t as it was created to regulate money supply. If governments could print money, and not independent central banks, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Source: The Guardian, March 18, 2014 a. Explain how the money market will be affected if too much money is printed by the central bank. Printing money will increase money supply. The excess money supply will lower the interest rate. A change in the interest rate will bring a movement along the demand for money curve.

b. Explain using the quantity theory of money how printing money increases inflation in the long run Printing money by the central bank increases money supply (M). In the long run, with the economy at full employment, real GDP equals potential GDP, so the real GDP growth rate equals the potential GDP growth rate. If we assume a constant velocity in the long run, the inflation rate will be the money growth rate minus the real GDP growth rate. The increase in M will increase the price level proportionally if the growth rate of real GDP is assumed to be zero in the long run.

Mathematical Note 27.

In the United Kingdom, the currency drain ratio is 38 percent of deposits and the reserve ratio is 2 percent of deposits. In Australia, the quantity of money is $150 billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is 8 percent of deposits. a. Calculate the U.K. money multiplier. The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D = 38 percent and R/D = 2 percent, so the money multiplier equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45.

b. Calculate the monetary base in Australia. The monetary base equals $46.2 billion. The monetary base equals the sum of currency and depository institution deposits at the central bank. The currency drain is 33 percent, so with the quantity of money equal to $150 billion, currency is $37.2 billion and deposits are $112.8 billion. The banks’ reserve ratio is 8 percent, so reserves are ($112.8  0.08), which is $9 billion. The monetary base equals $37.2 billion + $9.0 billion, or $46.2 billion.

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THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

Answers to the Review Quizzes Page 256 1.

(page 664 in Economics)

What are the influences on the demand for U.S. dollars in the foreign exchange market? The demand for U.S. dollars depends on four main factors: the exchange rate, the world demand for U.S. exports, the interest rate in the United State and other countries, and the expected future exchange rate.

What are the influences on the supply of U.S. dollars in the foreign exchange market? The supply of U.S. dollars depends on four main factors: the exchange rate, the U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate.

How is the equilibrium exchange rate determined? The equilibrium exchange rate is the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied. At the equilibrium exchange rate there is neither a shortage nor a surplus of U.S. dollars.

What happens if there is a shortage or a surplus of U.S. dollars in the foreign exchange market? If there is a shortage of U.S. dollars, the quantity of U.S. dollars demanded exceeds the quantity supplied. As long as there is a shortage, this upward pressure on the price automatically forces the price higher to its equilibrium. If there is a surplus of U.S. dollars, the quantity of U.S. dollars demanded is less than the quantity supplied. As long as there is a surplus, this downward pressure on the price automatically forces the price lower to its equilibrium.

What makes the demand for U.S. dollars change? Three factors change the demand for U.S. dollars: the world demand for U.S. exports, the interest rate in the United States and other countries, and the expected future exchange rate. If world demand for U.S. exports increases, the demand for U.S. dollars increases. If the interest rate in the United States rises relative to interest rates in other countries, the demand for U.S. dollars increases. And if the expected future exchange rate rises, the demand for U.S. dollars increases.

* This is Chapter 26 in Economics.

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What makes the supply of U.S. dollars change? Three factors change the supply of U.S. dollars: U.S. demand for imports, the interest rate in the United States and other countries, and the expected future exchange rate. If U.S. demand for imports increases, the supply of U.S. dollars increases. If the interest rate in the United States falls relative to interest rates in other countries, the supply of U.S. dollars increases. And if the expected future exchange rate falls, the supply of U.S. dollars increases.

What makes the U.S. dollar exchange rate fluctuate? Changes in the demand for U.S. dollars and the supply of U.S. dollars lead to fluctuations in the U.S. dollar exchange rate. Because the demand for dollars and the supply of dollars generally change at the same time and in opposite directions, exchange rate fluctuations are frequently large.

Page 260 1.

(page 668 in Economics)

What is arbitrage and what are its effects in the foreign exchange market? Arbitrage is seeking to profit by buying in one market and selling for a higher price in another market. Arbitrage has several effects: • Law of one price: At any one time, an exchange rate is the same in all markets. • No round-trip profit: It is impossible to make a profit by using currency A to buy currency B and then selling currency B to buy currency A. It is impossible to make a profit if even longer chains of currency are used. • Interest rate parity: For risk-free transactions, the rate of return earned by a unit of currency is the same in different nations. • Purchasing power parity: Purchasing power parity occurs when a unit of money buys the same amount of goods and services in different nations.

What is interest rate parity and what happens when this condition doesn’t hold? Interest rate parity occurs when, for risk-free transactions, the rate of return earned by a unit of currency is the same in different nations. If the rate of return for the U.S. dollar is higher than that for, say, the Japanese yen, interest rate parity does not hold. In this case people will expect the value of the dollar to fall against the yen (that is, the U.S. dollar is expected to depreciate over time) so that interest rate parity is restored because the rate of return earned by a unit of currency is the same in both nations.

What makes an exchange rate hard to predict? The exchange rate depends on the expected future exchange rate. The expected future is volatile. For example, the U.S. expected future exchange rate changes when news occurs that changes the future demand and/or supply of U.S. dollars. Consequently the current demand and supply of U.S. dollars changes, thereby changing the U.S. exchange rate.

What is purchasing power parity and what happens when this condition doesn’t hold? Purchasing power parity means equal value of money. If prices of goods and services are higher in the United States than the (exchange rate adjusted) prices of goods and services in, say, Japan, purchasing power parity does not occur because a unit of currency buys less in the United States than in Japan. The demand for U.S. dollars decreases and the supply of U.S. dollars increases so that the value of the dollar falls against the yen to restore purchasing power parity.

What determines the real exchange rate and the nominal exchange rate in the short run? The real exchange between the United States and Japan, RER, equals E  P/P* where P is the U.S. price level, P* is the Japanese price level, and E is the nominal exchange rate in yen per dollar. In the short run, changes in the nominal exchange rate bring an equal change in the real exchange rate because the price levels in Japan and the United States do not adjust instantly to a change in the nominal exchange rate. In the short run, the nominal U.S. exchange rate is determined in the foreign exchange market as the exchange rate that sets the quantity of U.S. dollars demanded equal to the quantity of U.S. dollars supplied.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

What determines the real exchange rate and the nominal exchange rate in the long run? In the long run, the real exchange rate is determined by demand and supply in the goods market. Identical goods in the United States and Japan sell for the same price once adjusted for the (nominal) exchange rate. The relative prices of goods that are not identical are determined by the supply and demand for them and so the relative price levels in different countries are determined by supply and demand. These relative price levels determine the real exchange rate. In the long run, changes in the real exchange rate and changes in the price levels change the nominal exchange rate. In the long run, the price level is determined by the quantity of money. So changes in the U.S. or the Japanese quantity of money change the price level and also bring an offsetting change in the nominal exchange rate.

Page 263 1.

(page 671 in Economics)

What is a flexible exchange rate and how does it work? A flexible exchange rate policy is an exchange rate that is determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. In this arrangement, the forces of supply and demand with no direct central bank intervention are the only factors that influence the exchange rate.

What is a fixed exchange rate and how is its value fixed? A fixed exchange rate policy is an exchange rate that is pegged at a value decided by the government or central bank. The central bank directly intervenes in the foreign exchange market to block the unregulated forces of supply and demand from changing the exchange rate away from its pegged value. For instance, if a central bank wanted to hold the exchange rate steady in the presence of diminished demand for its currency, the central bank props up demand by buying its currency in the foreign exchange market to keep the exchange rate from falling. If the demand for its currency increases, the central bank increases the supply by selling its currency and keeps the exchange rate from rising.

What is a crawling peg and how does it work? A crawling peg exchange rate policy selects a target path for the exchange rate and then uses direct central bank intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate except that the central bank changes the target value of the exchange rate in accord with its target path.

How has China operated in the foreign exchange market, why, and with what effect? From 1997 until 2005, the People’s Bank of China fixed the Chinese yuan exchange rate. Over this time, the demand for the yuan increased, so the People’s Bank of China supplied additional yuan to keep the exchange rate constant. By supplying yuan, the People’s Bank acquired large amounts of foreign currency. In addition, by fixing its exchange rate China essentially pegged its inflation rate to equal the U.S. inflation rate. Since 2005 the yuan has been allowed to appreciate slightly as the People’s Bank moved to a crawling peg exchange rate policy. The exchange rate has not been allowed to change much, so over the long run the Chinese inflation rate remains closely tied to U.S. inflation.

Page 269 1.

(page 677 in Economics)

What are the transactions that the balance of payments accounts record? The current account records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest income paid abroad, and net transfers abroad (such as foreign aid payments). The capital and financial account records foreign investment in the U.S. minus U.S. investment abroad. Any statistical discrepancy is also recorded in the capital account. The official settlements account records the change in U.S. official reserves.

Is the United States a net borrower or a net lender? Is it a debtor or a creditor nation? The United States is a net borrower and is a debtor nation.

How are net exports and the government sector balance linked? Net exports is the value of exports of goods and services minus the value of imports of goods and services. Net exports is equal to the sum of government sector surplus or deficit plus the private sector surplus or deficit. The government sector balance is equal to net taxes minus government expenditure on

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goods and services. If the government sector balance is negative, then the government sector has a deficit, that is, a budget deficit. Because net exports equals the sum of the government sector balance plus private sector balance, if the government budget deficit increases and the private sector balance does not change, the value of net exports becomes more negative.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

Answers to the Study Plan Problems and Applications

Use the following data to work Problems 1 to 3. The U.S. dollar exchange rate increased from $0.96 Canadian in June 2011 to $1.03 Canadian in June 2012, and it decreased from 81 Japanese yen in June 2011 to 78 yen in June 2012. 1. Did the U.S. dollar appreciate or depreciate against the Canadian dollar? Did the U.S. dollar appreciate or depreciate against the yen? The U.S. dollar appreciated against the Canadian dollar and it depreciated against the yen.

What was the value of the Canadian dollar in terms of U.S. dollars in June 2011 and June 2012? Did the Canadian dollar appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012? One Canadian dollar was worth 104 U.S. cents in June 2011 and 97 U.S. cents in June 2012. The Canadian dollar depreciated against the U.S. dollar.

What was the value of 100 yen in terms of U.S. dollars in June 2011 and June 2012? Did the yen appreciate or depreciate against the U.S. dollar over the year June 2011 to June 2012? One hundred yen was worth 123 U.S. cents in June 2011 and 128 U.S. cents in June 2012. The yen appreciated against the U.S. dollar.

On March 30, 2012, the U.S. dollar was trading at 82 yen per U.S. dollar on the foreign exchange market. On August 30, 2012, the U.S. dollar was trading at 79 yen per U.S. dollar. a. What events in the foreign exchange market could have brought this fall in the value of the U.S. dollar? The fall in the U.S. exchange rate is the result of a decrease in the demand for U.S. dollars and/or an increase in the supply of U.S. dollars. Factors that decrease the demand for U.S. dollars include a decrease in the Japanese demand for U.S. exports; a fall in the U.S. interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate. Factors that increase the supply of U.S. dollars include an increase in the U.S. demand for Japanese imports; a fall in the U.S. interest rate relative to the Japanese interest rate; and, a fall in the expected future exchange rate.

b. Did the events you’ve described change the demand for U.S. dollars, the supply of U.S. dollars, or both demand and supply in the foreign exchange market? A decrease in the Japanese demand for U.S. exports leads to only a decrease in the demand for U.S. dollars. An increase in the U.S. demand for Japanese imports leads only to an increase in the supply of U.S. dollars. The other factors, a fall in the U.S. interest rate relative to the Japanese interest rate and a fall in the expected future exchange rate, change both the demand for U.S. dollars and the supply of U.S. dollars.

Colombia is the world’s biggest producer of roses. The global demand for roses increases and at the same time Colombia’s central bank increases the interest rate. In the foreign exchange market for Colombian pesos, what happens to a. The demand for pesos? The demand for the peso increases because the Colombian interest rate differential increases and because the demand for Colombia’s export, roses, increases.

b. The supply of pesos? The supply of the pesos decreases because the Colombian interest rate differential increases.

c. The quantity of pesos demanded? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new demand curve, so along the new demand curve for pesos, the quantity of pesos demanded decreases.

d. The quantity of pesos supplied? The Colombian exchange rate rises. The rise in the exchange rate creates a movement upward along the new supply curve, so along the new supply curve of pesos, the quantity of pesos supplied increases.

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e. The peso-U.S. dollar exchange rate? The U.S. exchange rate depreciates (and the Columbian exchange rate appreciates) because the demand for Colombian pesos increases and the supply decreases.

If a euro deposit in a bank in France earns interest of 4 percent a year and a yen deposit in Japan earns 0.5 percent a year, other things remaining the same and adjusted for risk, what is the exchange rate expectation of the Japanese yen? For interest rate parity to hold, the Japanese yen must be expected to appreciate by the difference in the interest rates. So the Japanese yen must be expected to appreciate by 4.0 percent minus 0.5 percent, or 3.5 percent.

The U.K. pound is trading at 1.50 U.S. dollars per U.K. pound and purchasing power parity holds. The U.S. interest rate is 1 percent a year and the U.K. interest rate is 3 percent a year. a. Calculate the U.S. interest rate differential. The U.S. interest rate differential equals 1 percent minus 3 percent, or −2 percent per year.

b. What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now? For interest rate parity to hold, the U.K. pound must be expected to depreciate 2 percent per year. Therefore next year the U.K. pound is expected to be equal to 0.98  1.50 U.S. dollars per U.K. pound, which is 1.47 U.S. dollars per U.K. pound.

c. Which country more likely has the lower inflation rate? How can you tell? Because the U.K. pound is expected to depreciate, the United Kingdom likely has the higher inflation rate, which means that the United States is expected to have the lower inflation rate.

The U.S. price level is 115, the Japanese price level is 92, and the real exchange rate is 98.75 Japanese real GDP per unit of U.S. real GDP. What is the nominal exchange rate? The real exchange rate equals (E × P)/P* in which E is the nominal exchange rate, P is the U.S. price level, and P* is the Japanese price level. Rearranging this formula gives E = (real exchange rate × P*)/P. Using the rearranged formula, the nominal exchange rate equals (98.75 × 92)/115 = 79.0 yen per dollar.

With the strengthening of the yen against the U.S. dollar in 2012, Japan’s central bank did not take any action. A Japanese politician called on the central bank to take actions to weaken the yen, saying it will help exporters in the short run and have no long-run effects. a. What is Japan’s current exchange rate policy? Japan’s current exchange rate policy is a flexible exchange.

b. What does the politician want the exchange rate policy to be in the short run? Why would such a policy have no effect on the exchange rate in the long run? The politician wants the exchange rate to be a crawling peg by lowering it over a period of time. This policy has no effect on the exchange rate in the long run because in the long run the real exchange rate is determined by supply and demand for the nation’s goods. In addition, the nominal exchange rate adjusts to make the ratio of the nations’ price levels equal to the real exchange rate.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

10.

The table gives some information about the U.S. international transactions. a. Calculate the balance on the three balance of payments accounts.

Item Imports of goods and services Foreign investment in the United States Exports of goods and services U.S. investment abroad Net interest income Net transfers Statistical discrepancy

Billions of U.S. dollars 2,215 1,408

The current account balance equals exports of goods and services ($1,754 billion) minus 1,754 imports of goods and services ($2,215 billion) 1,200 plus net interest income ($167 billion) plus 167 net transfers (−$142 billion). So the current −142 account balance is −$436 billion. 231 The capital and financial account balance equals foreign investment in the United States ($1,408 billion) minus U.S. investment abroad ($1,200 billion) plus the statistical discrepancy ($231 billion). So the capital and financial account balance is $439 billion. The official settlements account balance equals − current account balance ($436 billion) − capital and financial account balance ($439 billion). So the official settlements account balance is −$3 billion. Because the official settlements account is negative, U.S. official reserves are increasing.

b. Was the United States a net borrower or a net lender? Explain your answer. The United States was a net borrower because foreign investment in the United States exceeded U.S. investment abroad.

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Answers to Additional Problems and Applications 11.

Suppose that yesterday, the U.S. dollar was trading on the foreign exchange market at 0.75 euros per U.S. dollar and today the U.S. dollar is trading at 0.80 euros per U.S. dollar. Which of the two currencies (the U.S. dollar or the euro) has appreciated and which has depreciated today? The U.S. dollar appreciated because its exchange rate rose. The euro depreciated because its exchange rate fell (from 1.33 U.S. dollars per euro to 1.25 U.S. dollars per euro).

12.

Suppose that the exchange rate rose from 80 yen per U.S. dollar to 90 yen per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to sell in the foreign exchange market? The rise in the exchange rate increases the quantity of U.S. dollars that people plan to sell in the foreign exchange market.

13.

Suppose that the exchange rate for the Mexican peso fell from 15 pesos per U.S. dollar to 10 pesos per U.S. dollar. What is the effect of this change on the quantity of U.S. dollars that people plan to buy in the foreign exchange market? The fall in the exchange rate increases the quantity of U.S. dollars that people plan to buy in the foreign exchange market.

14.

Today’s exchange rate between the Lebanese pound and the U.S. dollar is 1,500 LBP per dollar and the central bank of Lebanon is buying U.S. dollars in the foreign exchange market. If the central bank of Lebanon did not purchase U.S. dollars would there be excess demand or excess supply of U.S. dollars in the foreign exchange market? Would the exchange rate remain at 1,500 LBP per U.S. dollar? If not, which currency would appreciate? In the absence of the purchases by the central bank of Lebanon, there would be an excess supply of U.S. dollars in the foreign exchange market. Without these purchases, the exchange rate would fall from 1,500 LBP per dollar to something lower. The Lebanese pound would appreciate (and the U.S. dollar would depreciate).

15.

On October 25, 2000, the exchange rate was 0.8307 U.S. dollar per euro. It increased to 1.588 U.S. dollars per euro on July 16, 2008, and then decreased to 1.0557 U.S. dollar per euro on March 16, 2015. If the euro is expected to bounce back to its 2008 exchange rate, explain how this would affect the demand for and the supply of euros in the foreign exchange market? If the euro is expected to bounce back to its 2008 exchange rate, it raises the expected profit from holding euros and thereby affects both the demand for and the supply of euros. The rise in the expected profit from holding euros increases the demand for euros because people would rather hold more profitable currencies. But the supply of euros will decrease.

16.

The exchange rate changed from 1.0557 U.S. dollar per euro on July 16, 2008 to 1.588 U.S. dollars per euro on March 16, 2015. Which factors caused these changes in the exchange rate? Which factors would change both demand and supply? The factors that influenced the exchange rate for the euro include (i) the Eurozone debt crisis which caused the investors to invest less in Eurozone sovereign bonds. The investors preferred to invest in bonds of other countries such as the U.S. (ii) The European Central Bank kept interest rates low and started pumping euros into the money market to boost the economy (iii) The demand for U.S. exports and European imports dropped because of the U.S. subprime mortgage crisis that caused a recession in the U.S. and the Eurozone. Because of these reasons, there is a high supply of and a lower demand for euros, pushing the euro down. Changes in the interest rate differential and expected future exchange rate between the U.S. and the Eurozone can change both demand and supply.

17.

Australia produces natural resources (coal, iron ore, natural gas, and others), the demand for which has increased rapidly as China and other emerging economies expand. a. Explain how growth in the demand for Australia’s natural resources would affect the demand for Australian dollars in the foreign exchange market. The growth in demand for Australia’s natural resources increases the demand for Australian dollars.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

b. Explain how the supply of Australian dollars would change. Absent any change in the expected future exchange rate, the supply of Australian dollars does not change (there is a change in the quantity supplied).

c. Explain how the value of the Australian dollar would change. The increase in demand for Australian dollars raises the value of the Australian dollar.

d. Illustrate your answer with a graphical analysis. Figure 9.1 illustrates the effect of the increase in demand for Australian dollars. The demand curve for Australian dollars shifts rightward, from D0 to D1. The supply curve does not shift. The exchange rate rises from 90 yen per Australian dollar to 95 yen per Australian dollar.

Use the following news clip to work Problems 18 and 19. Indian Entrepreneur Seeks Opportunities Rahul Reddy, an Indian real estate entrepreneur, believes that “The United States is good for speculative higher-risk investments.” He profited from earlier investment in Australia and a strong Australian dollar provided him with the funds to enter the U.S. real estate market at prices that he believed “we will probably not see for a long time.” He said, “The United States is an economic powerhouse that I think will recover, and if the exchange rate goes back to what it was a few years ago, we will benefit.” Based on an article in Forbes, July 10, 2008 18.

Explain why Mr. Reddy is investing in the U.S. real estate market. At the time of the news article, the U.S. dollar had depreciated. The short-run effect of this depreciation was to make U.S. goods and services and U.S. properties less expensive for foreigners. Mr. Reddy, among others, was trying to take advantage of the lower price by purchasing investment properties and development opportunities in the United States.

19.

Explain what would happen if the speculation made by Mr. Reddy became widespread. Would expectations become self-fulfilling? Mr. Reddy’s actions increase the demand for U.S. dollars. If others take similar actions, the demand for U.S. dollars increases. If U.S. residents also begin to believe that buying U.S. investment properties offers a profitable opportunity, the supply of U.S. dollars decreases as U.S. residents purchase U.S. properties rather than foreign properties. In addition, Mr. Reddy is expecting that the dollar will appreciate back to its previous level. If others have the same expectation, once again the demand for dollars increases and the supply of dollars decreases. On both counts, the dollar appreciates. This change in the exchange rate resembles a self-fulfilling prophecy because market participants expect the dollar to appreciate and, as a result, it does so. Of course, the fundamental reason for the change is the shift in people’s beliefs.

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Use the following information to work Problems 20 and 21. Brazil’s Overvalued Real The Brazilian real has appreciated 33 percent against the U.S. dollar and has pushed up the price of a Big Mac in Sao Paulo to $4.60, higher than the New York price of $3.99. Despite Brazil’s interest rate being at 8.75 percent a year compared to the U.S. interest rate at near zero, foreign funds flowing into Brazil surged in October. Source: Bloomberg News, October 27, 2009 20.

Does purchasing power parity hold? If not, does PPP predict that the Brazilian real will appreciate or depreciate against the U.S. dollar? Explain. Purchasing power parity (PPP) does not hold because a Big Mac is significantly more expensive in Brazil than in New York. PPP predicts that the Brazilian real will depreciate against the U.S. dollar. Depreciation will reduce the number of U.S. dollars it takes to buy a Brazilian real and thereby decrease the number of U.S, dollars it takes to purchase a Big Mac in Brazil back to equality with the number of dollars it takes to purchase a Big Mac in New York.

21.

Does interest rate parity hold? If not, why not? Will the Brazilian real appreciate further or depreciate against the U.S. dollar if the Fed raises the interest rate while the Brazilian interest rate remains at 8.75 percent a year? Interest rate parity holds. The difference in the interest rates is offset by the expected depreciation of the Brazilian real, so the real is expected to depreciate by 8.75 percent a year. If the Fed raises the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now higher, the real depreciates. The higher U.S. interest rate means that the U.S. interest rate differential increases. The demand for dollars increases and the supply decreases, so the dollar immediately appreciates which means the real immediately depreciates. The real is still expected to depreciate in the future, but the expected future depreciation is less than 8.75 percent a year because the interest rate differential is smaller.

22.

When the Chips Are Down The Economist magazine uses the price of a Big Mac to determine whether a currency is undervalued or overvalued. In July 2012, the price of a Big Mac was $4.33 in New York, 15.65 yuan in Beijing, and 6.50 Swiss francs in Geneva. The exchanges rates were 6.37 yuan per U.S. dollar and 0.98 Swiss francs per U.S. dollar. Source: The Economist, July 25, 2012 a. Was the yuan undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in China into U.S. prices shows that the Chinese Big Mac has a dollar price of 15.65 yuan ÷ 6.37 yuan per dollar which is $2.46. The yuan was undervalued relative to purchasing power parity.

b. Was the Swiss franc undervalued or overvalued relative to purchasing power parity? Changing the price of a Big Mac in Switzerland into U.S. prices shows that the Swiss Big Mac has a dollar price of 6.50 francs ÷ 0.98 francs per dollar which is $6.63. The Swiss franc was overvalued relative to purchasing power parity.

c. Do you think the price of a Big Mac in different countries provides a valid test of purchasing power parity? The price of a Big Mac is the price of only one good. Purchasing power parity applies to national price levels not to the price of an individual good. Using an individual good means that local supply and demand conditions might lead the price to diverge from purchasing power parity.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

Use the following news clip to work Problems 23 to 25. U.S. Declines to Cite China as Currency Manipulator In 2007, the U.S. trade deficit with China hit an all-time high of $256.3 billion, the largest deficit ever recorded with a single country. Chinese currency, the yuan, has risen in value by 18.4 percent against the U.S. dollar since the Chinese government loosened its currency system in July 2005. However, U.S. manufacturers contend the yuan is still undervalued by as much as 40 percent, making Chinese products more competitive in this country and U.S. goods more expensive in China. China buys U.S. dollardenominated securities to maintain the value of the yuan in terms of the U.S. dollar. Source: MSN, May 15, 2008 23.

What was the exchange rate policy adopted by China until July 2005? Explain how it worked. Draw a graph to illustrate your answer. The actions in the foreign exchange market of the People’s Bank allowed China to maintain a fixed exchange rate with the United States. If, at the fixed exchange, there was surplus of dollars (which implies there is a shortage of yuan), the People’s Bank bought the dollars using yuan. Without this action by the People’s Bank, the surplus of dollars would have depreciated the dollar and appreciated the yuan; with this action by the People’s Bank, the exchange rate stayed fixed. Figure 9.2 shows the foreign exchange market. At the fixed exchange of 7.00 yuan per dollar, there is a surplus of $0.2 trillion U.S. dollars. If the market is allowed to reach its equilibrium exchange rate, the dollar would depreciate to 5.00 yuan per dollar, which means that the yuan would appreciate. But the People’s Bank purchased the $0.2 trillion U.S. dollar surplus and thereby kept the exchange rate pegged at 7.00 yuan per dollar. By fixing its exchange rate in order to keep the yuan from appreciating, the People’s Bank accumulated U.S. dollars.

24.

What was the exchange rate policy adopted by China after July 2005? Explain how it works. After July 2005 China has not allowed a truly flexible exchange rate. Instead China uses a crawling peg policy, in which the exchange rate is allowed to make small changes.

25.

Explain how fixed and crawling peg exchange rates can be used to manipulate trade balances in the short run, but not the long run. Changes in fixed and crawling peg exchange rates can affect the trade balance in the short run because these changes affect the relative price of the domestically-produced good and the foreign good. But changes in fixed and crawling peg exchange rates cannot affect the trade balance in the long run because the trade balance is (ultimately) determined by the real exchange rate. In the long run, the price levels will adjust to create a real exchange rate that balances trade.

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Aussie Dollar Hit by Interest Rate Talk The Australian dollar fell against the U.S. dollar to its lowest value in the past two weeks. The CPI inflation rate was reported to be generally as expected, but not high enough to justify expectations for an aggressive interest rate rise by Australia’s central bank next week. Source: Reuters, October 28, 2009 a. What is Australia’s exchange rate policy? Explain why expectations about the Australian interest rate lowered the value of the Australian dollar against the U.S. dollar. Because the Australian dollar was allowed to fall, the central bank must be following a flexible exchange rate policy. When Australia’s central bank raises the interest rate, the demand for Australian dollars increases and the supply decreases, so the Australian exchange rate rises. Before the report, traders expected the Australian central bank would raise the interest rate at some point in the future, which meant that the (expected) future exchange rate would rise. But the report indicated that the interest rate would not rise, which thereby decreased the expected future exchange rate. The fall in the expected future exchange rate decreases the demand for Australian dollars and increases the supply of Australian dollars, thereby lowering the Australian exchange rate.

b. To avoid the fall in the value of the Australian dollar against the U.S. dollar, what action could the central bank of Australia have taken? Would such an action signal a change in Australia’s exchange rate policy? To avoid a fall in the Australian exchange rate, the central bank of Australia could have entered the foreign exchange market to purchase Australian dollars or it could have immediately raised the exchange rate. If the central bank prevented 100 percent of the change in the exchange rate, then the central bank would be pegging the exchange rate. If it prevented some of the change in the exchange rate, then the central bank might be allowing the exchange rate to crawl. In either case, however, the exchange rate regime would no longer be flexible.

Use the table to work Problems 27 and 28. The table gives some data about the U.K. economy: 27.

Calculate the private sector and government sector balances.

Item Consumption expenditure Exports of goods and services Government expenditure Net taxes Investment Saving

The private sector balance equals saving (£162 billion) minus investment (£181 billion), which is −£19 billion. The government sector balance is equal to net taxes (£217 billion) minus government expenditures on goods and services (£230 billion), which is −£13 billion.

28.

Billions of U.K. pounds 721 277 230 217 181 162

What is the relationship between the government sector balance and net exports? The government sector balance plus the private sector balance equals net exports. Therefore the net exports equals the private sector balance (−£19 billion) plus the government sector balance (−£13 billion), which is −£32 billion. The U.K. had a net export deficit of £32 billion.

Economics in the News 29.

After you have studied Economics in the News on pp. 270–271 (678–679 in Economics), answer the following questions. a. What happened to the foreign exchange value of the U.S. dollar in July and August 2014? The dollar rose against the euro, the pound, and the yen.

b. What could the Fed have done to stop the rise in the dollar? The Fed could have sold U.S. dollars in the foreign exchange market by purchasing foreign reserves. The Fed’s actions would have increased the supply of dollars and thereby lessened the dollar’s rise.

c. What could the European Central Bank have done that might have stopped the fall in the Euro? The European Central Bank could have purchased euros by selling foreign reserves. The European Central Bank’s actions would have increased the demand for euros and thereby lessened the euro’s fall.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

d. What can you infer about the changes in U.K. pound–euro exchange rate during July and August 2014? Can you think of a reason for the behavior of that exchange rate? Stating on Jul 2, the U.K. pound and the European euro depreciated an almost identical amount against the U.S. dollar. Therefore there was very little to no change in the U.K. pound-euro exchange rate. This exchange might have remained constant because there was no change in the expected future U.K. pound-euro exchange rate because there was no change in the future expected U.K or European interest rates and other relevant U.K. or and European factors. The two exchange rates depreciated against the U.S. dollar because there were changes in the future expected U.S. interest rate and/or other relevant factors.

If the dollar continues its upward path against the euro, what do you predict will be the consequences for U.S. and European relative inflation rates? Purchasing power parity implies that if the U.S. dollar continues to rise, it is likely that the U.S. inflation rate will fall relative to European inflation. Similarly, if the euro continues to fall, it is likely that the European inflation rate will rise relative to U.S. inflation.

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AGGREGATE SUPPLY AND AGGREGATE DEMAND**

Answers to the Review Quizzes Page 283 1.

(page 691 in Economics)

If the price level and the money wage rate rise by the same percentage, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level and the money wage rate rise by the same percentage, there is no change in the quantity of real GDP supplied and a movement occurs up along the LAS curve.

If the price level rises and the money wage rate remains constant, what happens to the quantity of real GDP supplied? Along which aggregate supply curve does the economy move? If the price level rises and the money wage rate remains constant the quantity of real GDP supplied increases and the economy moves along the SAS curve.

If potential GDP increases, what happens to aggregate supply? Does the LAS curve shift or is there a movement along the LAS curve? Does the SAS curve shift or is there a movement along the SAS curve? If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase and the LAS curve and SAS curve shift rightward.

If the money wage rate rises and potential GDP remains the same, does the LAS curve or the SAS curve shift or is there a movement along the LAS curve or the SAS curve? If the money wage rate rises and potential GDP remains the same there is a decrease in short-run aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and the LAS curve is unchanged.

Page 287 1.

(page 695 in Economics)

What does the aggregate demand curve show? What factors change and what factors remain the same when there is a movement along the aggregate demand curve? The aggregate demand curve shows the relationship between the quantity of real GDP demanded and the price level when other influences on expenditure plans remain the same. When there is a movement along the aggregate demand curve, the price level changes and other factors such as expectations, fiscal and monetary policy, and the world economy remain the same.

2. *

Why does the aggregate demand curve slope downward?

* This is Chapter 27 in Economics.

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The aggregate demand curve slopes downward because of the wealth effect and two substitution effects. First, a rise in the price level decreases real wealth, which brings an increase in saving and a decrease in spending—the wealth effect. Second, a rise in the price level raises the interest rate, which decreases borrowing and spending—an intertemporal substitution effect as people decrease current spending in favor of future spending—and increases the price of domestic goods and services relative to foreign goods and services, which decreases exports and increases imports—an international substitution effect.

How do changes in expectations, fiscal policy and monetary policy, and the world economy change aggregate demand and the aggregate demand curve? Aggregate demand increases and the AD curve shifts rightward if: expected future income, expected future inflation, or expected future profits increase; government expenditure increases or taxes are cut; the quantity of money increases and the interest rate is cut; the exchange rate falls; or foreigners’ income increases. The reverse changes decrease aggregate demand and shift the AD curve leftward.

Page 293 1.

(page 701 in Economics)

Does economic growth result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Economic growth results from increases in long-run aggregate supply. Economic growth occurs because the quantity of labor increases, capital is accumulated and there are technological advances over time. All three of these factors increase potential GDP and shift the LAS curve rightward.

Does inflation result from increases in aggregate demand, short-run aggregate supply, or long-run aggregate supply? Inflation results from increases in aggregate demand that exceed the increase in long-run aggregate supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that exceed increases in LAS produce inflation.

Describe three types of short-run macroeconomic equilibrium. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. There are three types of short-run equilibrium: below full-employment equilibrium where a recessionary gap exists with real GDP less than potential GDP; above fullemployment equilibrium where an inflationary gap exists with real GDP greater than potential GDP; full-employment equilibrium where no gap exists and real GDP equals potential GDP.

How do fluctuations in aggregate demand and short-run aggregate supply bring fluctuations in real GDP around potential GDP? Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations in real GDP around potential GDP. For instance, starting from full employment, a decrease in aggregate demand decreases the price level and real GDP and creates a recessionary gap. In the long run the money wage rate (and the money prices of other resources) falls so that short-run aggregate supply increases and the economy returns to its full employment equilibrium. Starting from full employment, a decrease in short-run aggregate supply decreases real GDP and raises the price level. The fall in real GDP combined with a rise in the price level is a phenomenon called stagflation.

Page 295 1.

(page 703 in Economics)

What are the defining features of classical macroeconomics and what policies do classical macroeconomists recommend? Classical macroeconomists believe that the economy is self-regulating and always at full employment. Classical macroeconomists assert that the proper government policy is to minimize the disincentive effects of taxes on employment, investment, and technological change.

What are the defining features of Keynesian macroeconomics and what policies do Keynesian macroeconomists recommend? Keynesian macroeconomists believe that if the economy was left alone, it would rarely operate at full employment. To achieve and maintain full employment the economy needs active help from fiscal and monetary policy. Aggregate demand fluctuations combined with a very sticky money wage rate are the

AGGREGATE SUPPLY AND AGGREGATE DEMAND

major sources of the business cycle. Keynesian macroeconomists assert that active fiscal and monetary policy, designed to offset fluctuations in aggregate demand, are the proper government policies.

What are the defining features of monetarist macroeconomics and what policies do monetarist macroeconomists recommend? Monetarists believe that the economy is self-regulating and will typically operate at full employment if monetary policy is not erratic and the money growth rate is kept steady. The major source of business cycle fluctuations are similar to the Keynesian view, that is, changes in aggregate demand combined with a sticky money wage rate. However, according to monetarists, the changes in aggregate demand are the result of fluctuations in the growth rate of money caused by the Federal Reserve. Monetarists assert that the proper government policies are low taxes, to avoid the disincentive effects stressed by classical macroeconomists, and steady monetary growth.

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Answers to the Study Plan Problems and Applications 1.

Explain the influence of each of the following events on the quantity of real GDP supplied and aggregate supply in India and use a graph to illustrate. • U.S. firms move their call handling, IT, and data functions to India. Moving call-handling, IT, and data functions to India increases short-run and long-run aggregate supply because it increases the amount of employment at full employment and (probably) also increases the capital stock. As Figure 10.1 shows, both the short run aggregate supply curve and long-run aggregate supply curve shift rightward, from SAS0 to SAS1 and from LAS0 to LAS1.

•

Fuel prices rise. The rise in fuel prices raises firms’ costs. Short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Long-run aggregate supply does not change. Figure 10.2 shows the leftward shift of the short-run aggregate supply curve from SAS0 to SAS1.

•

Wal-Mart and Starbucks open in India. When Starbucks and Wal-mart open in India, short-run and long-run aggregate supply increase. When these stores open, employment at full employment increases and India’s capital stock increases. Both the short-run and long-run aggregate supply curves shift rightward, as illustrated in Figure 10.1.

•

Universities in India increase the number of engineering graduates. Increasing the number of engineering graduates increases India’s human capital. Both the short-run and long-run aggregate supply increases, as shown in Figure 10.1 by the rightward shifts in the short-run and long-run aggregate supply curves.

•

The money wage rate rises. An increase in the money wage rate increases firms’ costs. Short-run aggregate supply decreases but long-run aggregate supply does not change. Long-run aggregate supply does not change because in the long run the price level rises by the same percentage the money age rate increased, so in the long run

AGGREGATE SUPPLY AND AGGREGATE DEMAND

employment does not change. This situation is illustrated in Figure 10.2, in which the short-run aggregate supply curve shifts leftward and the long-run aggregate supply curve does not change.

•

The price level in India increases. In the short run, an increase in the price level increases the quantity of real GDP supplied. In the long run, the money wage rate rises by the same percentage so in the long run there is no change in the quantity of real GDP supplied. These results are illustrated in Figure 10.3 by the grey arrows showing the movement along the short-run aggregate supply curve, SAS, and the movement along the long-run aggregate supply curve, LAS.

Labor productivity is rising at a rapid rate in China and wages are rising at a similar rate. Explain how a rise in labor productivity and wages in China will influence the quantity of real GDP supplied and aggregate supply in China. The rise in labor productivity increases potential GDP and increases aggregate supply. The short-run and long-run aggregate supply curves shift rightward. The rise in the money wage rate in China decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward. It has no effect on potential GDP or on the long-run aggregate supply curve.

Canada trades with the United States. Explain the effect of each of the following events on Canada’s aggregate demand. • The government of Canada cuts income taxes. Cutting income taxes increases aggregate demand because it increases people’s disposable incomes.

•

The United States experiences strong economic growth. Strong growth in the United States increases U.S. demand for Canadian exports. Canadian exports are a component of Canada’s aggregate demand so the increase in demand for Canada’s exports means that Canada’s aggregate demand increases.

•

Canada sets new environmental standards that require power utilities to upgrade their production facilities. To upgrade their facilities, power utilities must increase their investment. Investment is a component of aggregate demand so an increase in investment means that Canada’s aggregate demand increases.

The Fed cuts the quantity of money and all other things remain the same. Explain the effect of the cut in the quantity of money on aggregate demand in the short run. A decrease in the quantity of money decreases aggregate demand and shifts the AD curve leftward. By cutting the quantity of money, the interest rate rises, so firms decrease their investment and households cut back their expenditure on new homes, new cars, and other big-ticket items. The decrease in consumption expenditure and investment both decrease aggregate demand.

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Gross Domestic Product for the Second Quarter of 2012 The increase in real GDP in the second quarter primarily reflected increases in personal consumption expenditures, exports, and investment. Government spending decreased. Source: Bureau of Economic Analysis, August 29, 2012 Explain how the items in the news clip influence U.S. aggregate demand. The increase in consumption expenditures, exports, and investment all increase U.S. aggregate demand. The decrease in government spending decreases U.S. aggregate demand.

Use Figure 10.4 to work Problems 6 to 8. Initially, the short-run aggregate supply curve is SAS0 and the aggregate demand curve is AD0. 6.

Some events change aggregate demand from AD0 to AD1. Describe two events that could have created this change in aggregate demand. What is the equilibrium after aggregate demand changed? If potential GDP is $1 trillion, the economy is at what the type of macroeconomic equilibrium? Aggregate demand increases when the aggregate demand curve shifts from AD0 to AD1. Aggregate demand increases if expected future income, expected future inflation, or expected future profit increases; if the government cuts taxes, increases its expenditure on goods and services, or increases its transfer payments; if the Fed lowers the interest rate; or if the U.S. exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium is at point C: real GDP is $1.1 trillion and the price level is 105. The economy is at an above full-employment equilibrium with an inflationary gap.

Some events change aggregate supply from SAS0 to SAS1. Describe two events that could have created this change in aggregate supply. What is the equilibrium after aggregate supply changed? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no output gap? Aggregate supply decreases when the aggregate supply curve shifts from SAS0 to SAS1. Aggregate supply decreases if potential GDP decreases; if the money wage rate rises; or if the money prices of other resources rise. After the change, equilibrium is at point A: real GDP is $0.9 trillion and the price level is 105. The economy is at a below full-employment equilibrium with a recessionary gap.

Some events change aggregate demand from AD0 to AD1 and aggregate supply from SAS0 to SAS1. What is the new macroeconomic equilibrium? After the changes, equilibrium is at point D: real GDP is $1.0 trillion and the price level is 110. The economy is at a full-employment equilibrium.

Describe the policy change that a classical macroeconomist, a Keynesian, and a monetarist would recommend for U.S. policymakers to adopt in response to each of the following events: a. Growth in the world economy slows. Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

b. The world price of oil rises. Classical and monetarist economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

c. U.S. labor productivity declines. Classical economists probably would recommend no policy action. If they suggested any policy at all, the policy would involve cutting taxes. Monetarist economists would recommend an increase in the quantity of money, which lowers the interest rate. Keynesian economists likely would suggest several policies, such as the U.S. government should increase aggregate demand by increasing its expenditure on goods and services or by cutting taxes. Keynesian economists also would suggest that the Fed should increase the quantity of money and lower interest rates.

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Answers to Additional Problems and Applications 10.

Explain for each event whether it changes the quantity of real GDP supplied, short-run aggregate supply, long-run aggregate supply, or a combination of them. • Hong Kong firms switch to lower-cost 3D printing technology. New technology raises productivity, which increases both short-run and long-run aggregate supply.

•

An ageing population is expected to shrink Hong Kong’s labor force.

•

Foreign students in Hong Kong universities get temporary work permits.

•

Firms from mainland China open offices in Hong Kong.

•

Shrinking labor force decreases short-run and long-run aggregate supply. Increase in labor force increases short-run and long-run aggregate supply. An increase in the quantity of capital increases short-run and long-run aggregate supply.

The Hong Kong price level rises. A rise in the price level might result from an increase in aggregate demand, which causes an increase in the quantity of real GDP supplied, or from a decrease in short-run aggregate supply, which causes a decrease in the quantity of real GDP demanded.

11.

Examine for each event whether it changes the quantity of real GDP demanded or aggregate demand in Japan. • Japanese price level rises. A rise in the Japanese price level leads to a decrease in the quantity of real GDP demanded.

•

Depreciation of yen attracts more tourists to Japan.

•

Japan’s coal consumption rises due to a prolonged shut down of nuclear plants.

•

Exports of services increase which increases aggregate demand. The increase in consumption expenditure increases aggregate demand.

Japan’s sales tax rises. Higher sales tax lowers consumption expenditure, which decreases aggregate demand.

12.

Changes in Inventory Investment When real GDP increased in the first quarter of 2015, personal consumption expenditure, private inventory investment, and imports increased while exports, nonresidential fixed investment, and government spending decreased. Source: Bureau of Economic Analysis, April 29, 2015 Explain how the increase in private inventory investment affected U.S. aggregate demand. Private inventory investment is the change in value of firms’ stocks of unfinished or finished but unsold goods. It is a type of investment expenditure. The increase in inventory investment increased aggregate demand.

13.

Exports and Imports Increase Real exports of goods and services increased 6.0 percent in the second quarter, compared with an increase of 4.4 percent in the first. Real imports of goods and services increased 2.9 percent, compared with an increase of 3.1 percent. Source: Bureau of Economic Analysis, August 29, 2012 Explain how the changes in exports and imports reported here influence the quantity of real GDP demanded and aggregate demand. In which of the two quarters reported did exports and imports make the greater contribution to aggregate demand growth? Net exports is part of aggregate demand, which means that an increase in net exports increases aggregate demand. Net exports equals exports minus imports, so an increase in exports increases aggregate demand while an increase in imports decreases aggregate demand. In both quarters, exports increased so in both quarters exports increased aggregate demand. In both quarters, imports increased, so in both quarters imports decreased aggregate demand. The biggest contribution to economic growth was in the second quarter, because export growth rose significantly from 4.4 percent to 6.0 percent while import growth fell, from 3.1 percent to 2.9 percent.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

Use the following information to work Problems 14 to 16. According to the East Asia and Pacific Economic Update published by the World Bank in April 2015, the following factors have affected China’s real GDP in 2015. • Global economic recovery supports a moderate increase in China’s exports. • China benefits from a fall in the world price of oil. • Chinese government to cut excess capacity in heavy industry. • U.S. firms to relocate their labor-intensive manufacturing industries to low-cost countries. 14.

Explain how each of the above factors changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them. The global economic recovery increases China’s exports, which increases aggregate demand. As the world price of oil is prone to fluctuations in the long run, a fall in the world price of oil leads to an increase in short-run aggregate supply. The cut back in the excess capacity of production in heavy industry does not change short-run aggregate supply and long-run aggregate supply. As the excess capacity is reduced, the expected returns to new investment (in capacity) increase, leading to an increase in aggregate demand. The relocation of labor-intensive manufacturing industries from the U.S. to low-cost countries such as China increases production, increasing both the short-run aggregate supply and the long-run aggregate supply.

15.

Explain how each factor separately affect China’s real GDP and the price level, starting from a position of long-run equilibrium. The increase in China’s exports raises the price level and increases real GDP. The fall in the world price of oil increases short-run aggregate supply, which decreases the price level and real GDP. The reduction in excess capacity of production in heavy industry does not change short-run aggregate supply and long-run aggregate supply. Due to an increase in expected returns from new investment, aggregate demand increases, which raises the price level and increases real GDP. The relocation of labor-intensive manufacturing industries to China increases short-run aggregate supply and long-run aggregate supply, which decreases the price level and increases real GDP.

16.

Explain the combined effects of these factors on China’s real GDP and the price level, starting from a position of long-run equilibrium. The combined effect is that real GDP increases but the effect on the price level is uncertain. All factors (except global economic recovery which increases China’s exports) lower the price level. The increase in China’s exports raises the price level.

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Use the following information to work Problems 17 and 18. In Japan, potential GDP is 600 trillion yen. The table shows the aggregate demand and shortrun aggregate supply schedules. Price level 17. a. Draw a graph of the aggregate demand 75 curve and the short-run aggregate 85 supply curve. 95 Figure 10.5 shows the aggregate demand 105 curve and the short-run aggregate supply 115 curve. 125 b. What is the short-run equilibrium real 135 GDP and price level?

Real GDP Real GDP supplied in demanded the short run (trillions of 2005 yen) 600 400 550 450 500 500 450 550 400 600 350 650 300 700

Equilibrium real GDP is ¥500 trillion and the price level is 95. Short-run macroeconomic equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate supply curve.

18.

Does Japan have an inflationary gap or a recessionary gap and what is its magnitude? Equilibrium real GDP is less than potential GDP, so Japan has a recessionary gap. The recessionary gap equals the difference between potential GDP and real GDP, which is ¥100 trillion.

Use the following information to work Problems 19 and 20. Spending by Women Jumps The magazine Women of China reported that Chinese women in big cities spent 63% of their income on consumer goods last year, up from 26% in 2007. Clothing accounted for the biggest chunk of that spending, at nearly 30%, followed by digital products such as cellphones (11%) and travel (10%). Chinese consumption as a whole grew faster than the overall economy and is expected to reach 42% of GDP by 2020, up from the current 36%. Source: The Wall Street Journal, August 27, 2010 19. Explain the effect of a rise in consumption expenditure on real GDP and the price level in the short run. Figure 10.6 (on the next page) shows the effect from the increase in consumption expenditure. Consumption expenditure is one of the components of aggregate demand, so an increase in consumption expenditure increases aggregate demand and shifts the aggregate demand curve rightward. In the figure the aggregate demand curve shifts from AD0 to AD1. Because aggregate demand increased, equilibrium real GDP increases (in Figure 10.6 from 33.0 trillion yuan to 33.2 trillion yuan) and the price level rises (in the figure from 117 to 119).

AGGREGATE SUPPLY AND AGGREGATE DEMAND

20.

If the economy had been operating at a full-employment equilibrium, a. Describe the macroeconomic equilibrium after the rise in consumer spending. If the economy had been operating at a full-employment equilibrium before the increase in consumer expenditure, after the increase equilibrium real GDP exceeds potential GDP. The economy is at an above full-employment equilibrium with an inflationary gap.

b. Explain and draw a graph to illustrate how the economy can adjust in the long run to restore a full-employment equilibrium. Figure 10.7 shows how the economy can adjust to its long-run equilibrium. In the short run, real GDP exceeds potential GDP. Employment exceeds full employment. The tight labor market means that the money wage rate starts to rise. As the money wage rate rises short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Real GDP and employment decrease. Even though employment is decreasing, as long as employment exceeds full employment, the money wage rate continues to rise and the short-run aggregate supply continues to decrease. The process ultimately ends when real GDP has decreased back to equal potential GDP and employment equals full employment. Short-run aggregate supply has decreased and the short-run aggregate supply curve has shifted from SAS0 to SAS1. At this point the price level has risen (to 121 in Figure 10.7) and real GDP has returned to potential GDP (33.0 trillion yuan).

21.

Suppose that the E.U. economy goes into an expansion. Explain the effect of the expansion on U.S. real GDP and unemployment in the short run. When the E.U. economy moves into an expansion, U.S. exports to the E.U. increase. The increase in U.S. exports increases U.S. aggregate demand, thereby increasing U.S. real GDP and lowering U.S. unemployment.

22.

Explain why changes in consumer spending and business investment play a large role in the business cycle. Changes in consumer spending play a large role in business cycles because consumption expenditure is by far the largest part of GDP. A small percentage change in consumption expenditure is a large change in aggregate demand which can lead to a large change in real GDP. Changes in investment spending are also important because investment spending is quite volatile and subject to large changes. Consequently a decrease in investment often leads to a large decrease in aggregate demand and a recession while an increase frequently results in a large increase in aggregate demand and an expansion.

23.

How to Avoid Recession? Let the Fed Do Its Work Greg Mankiw wrote in 2007 on the eve of the Global Financial Crisis, “Congress made its most important contribution to taming the business cycle back in 1913, when it created the Federal Reserve System. Today, the Fed remains the first line of defense against recession.” Source: The New York Times, December 23, 2007 a. Describe the process by which action by the Fed in times of recession flows through the economy. An increase in the quantity of money lowers interest rates and makes it easier to get a loan. The lower interest rate leads businesses to increase their investment and households to increase spending on new homes and other consumer durables. Banks, eager to lend, lower their lending standards and more

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people and firms qualify for loans. All these effects increase aggregate demand and thereby raise real GDP.

b. Draw a graph to illustrate the Fed’s action and its effect. Figure 10.8 shows how the Fed’s action increases aggregate demand, shifting the aggregate demand curve rightward from AD0 to AD1. Real GDP increases from $16.0 trillion to $16.2 trillion.

24.

Cut Taxes and Boost Spending? Raise Taxes and Cut Spending? Cut Taxes and Cut Spending This headline expresses three views about what to do to get the U.S. economy growing more rapidly and contribute to closing a large recessionary gap. Economists from which macroeconomic school of thought would recommend pursuing policies described by each of these views? The first policy, cut taxes and boost spending, would be endorsed by the Keynesian and new Keynesian schools. The second policy, raise taxes and cut spending, is endorsed by no school of thought. The third policy, cut taxes and cut spending, would be endorsed by the classical and new classical schools.

Economics in the News 25.

After you have studied Economics in the News on pp. 296–297 (704–705 in Economics), answer the following questions. a. What are the main features of the U.S. economy in the second quarter of 2014? The main feature of the U.S. economy in the second quarter of 2014 was rapid growth. The economy grew at a faster than average rate of 4.2 percent in that quarter. The growth rate was significantly more rapid than in the first quarter when the U.S. economy grew at only 2.1 percent.

b. Did the United States have a recessionary gap or an inflationary gap in 2014? How do you know? The U.S. economy had a recessionary gap. Unemployment was high and actual GDP was below potential GDP.

c. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that occurred in 2013 and 2014 that brought the economy to its situation in mid-2014. Figure 10.9 shows the changes between 2013 and 2014. There was a recessionary gap so in the figure the aggregate demand curve, AD13, and the short-run aggregate supply curve, SAS13, intersect to the left of the longrun aggregate supply curve, LAS13. Potential GDP was $16.5 trillion in 2013 and actual real GDP was only $15.6 trillion. The economy had a large recessionary gap though it would shrink in 2014. In 2013 and 2014 fiscal and

AGGREGATE SUPPLY AND AGGREGATE DEMAND

monetary policy as well as an expanding world economy increased aggregate demand. Short-run aggregate supply did not change because the increase in potential GDP (which increases short-run aggregate supply) was small and probably offset by a higher money wage rate (which decreases shortrun aggregate supply). The aggregate demand curve shifted rightward, to AD14 in Figure 10.9. The economy remained below full employment because the long-run aggregate supply curve had shifted rightward to LAS14. Real GDP was $16.0 trillion but potential GDP was $16.7 trillion.

d. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that will have occurred when full employment is restored. Figure 10.10 shows this result. In it the aggregate demand curve has shifted rightward from AD14 to ADpolicy. Equilibrium real GDP is $16.7 trillion, the same as potential GDP. The price level has risen, from 108 to a little less than 112.

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e. Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the federal government increased its expenditure on goods and services or cut taxes by enough to restore full employment. Fiscal policy of increasing government expenditure on goods and services or cutting taxes increases aggregate demand and shifts the aggregate demand curve rightward. Figure 10.10 shows this policy. In it the aggregate demand curve has shifted rightward from AD14 to ADpolicy. Equilibrium real GDP is $16.7 trillion, the same as potential GDP. The price level has risen, from 108 to 112.

Use the AS-AD model to show the changes in aggregate demand and aggregate supply that would occur if the economy moved into an inflationary gap. Show the short-run and the long-run effects. If government policy leads to an inflationary gap, the aggregate demand curve will have shifted rightward so that it intersects the short-run aggregate supply curve at a point to the right of potential GDP. In Figure 10.11, the government policy would shift the aggregate demand curve to AD. The price level is 112.5 and equilibrium real GDP is $16.9 trillion while potential GDP is only $16.7 trillion. The economy has an inflationary gap. In the long run, the inflationary gap will be eliminated. For simplicity, presuming that neither potential GDP nor aggregate demand increase, the tight labor market will lead to increases in the money wage rate. As the money wage rate rises, firms’ costs increase. The short-run aggregate supply decreases and the short-run aggregate supply curve shifts leftward. Eventually aggregate supply decreases so that the short-run aggregate supply curve has shifted to SAS in Figure 10.11. At that moment, the economy is back to full employment: Equilibrium real GDP, $16.7 trillion, equals potential GDP, also $16.7 trillion. The price level, of course, has risen, in the figure from 112.5 to 114.0.

26.

Brazil Falls into Recession A decade ago, Brazil had rapid growth but now its economy is experiencing a slowdown with investment falling, and inventories increasing. Potential GDP growth rate has slowed. Business and consumer confidence has fallen. Source: BBC News, August 29, 2014 a. Explain the effect of a decrease in investment on real GDP and potential GDP. The first effect of a decrease in investment is a decrease in aggregate demand. The decrease in aggregate demand decreases real GDP. As investment remains depressed, the capital stock grows more slowly, which decreases the growth rate of potential GDP.

b. Explain how business and consumer confidence influences aggregate expenditure. The decrease in business confidence leads businesses to decrease their investment. The decrease in investment decreases the Brazil’s aggregate expenditure. Similarly, the decrease in consumer confidence lowers consumer expenditure, thereby again decreasing Brazil’s aggregate expenditure.

C h a p t e r

EXPENDITURE MULTIPLIERS**

Answers to the Review Quizzes Page 307 1.

(page 715 in Economics)

Which components of aggregate expenditure are influenced by real GDP? Consumption expenditure and imports are influenced by real GDP. Both increase when real GDP increases.

Define and explain how we calculate the marginal propensity to consume and the marginal propensity to save. The marginal propensity to consume is the proportion of an increase in disposable income that is consumed. In terms of a formula, the marginal propensity to consume, or MPC, can be calculated as C/YD, where  means “change in.” The marginal propensity to save is the proportion of an increase in disposable income that is saved. In terms of a formula, the marginal propensity to save, or MPS, can be calculated as S/YD.

How do we calculate the effects of real GDP on consumption expenditure and imports by using the marginal propensity to consume and the marginal propensity to import? The effects of real GDP on consumption expenditure and imports are determined respectively by the marginal propensity to consume and the marginal propensity to import. In particular, the effect of a change in real GDP on consumption expenditure equals the marginal propensity to consume multiplied by the change in disposable income. Similarly, the effect of a change in real GDP on imports equals the marginal propensity to import multiplied by the change in real GDP.

Page 311

(page 719 in Economics)

What is the relationship between aggregate planned expenditure and real GDP at equilibrium expenditure?

How does equilibrium expenditure come about? What adjusts to achieve equilibrium?

Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP. Equilibrium expenditure results from adjustments in real GDP. For instance, if aggregate planned expenditure exceeds real GDP, firms find that their inventories are below their targets. In response, firms increase production to meet their inventory targets, As production increases, real GDP increases. The increase in real GDP increases aggregate planned expenditure but by less than the increase in real GDP. Eventually real GDP increases sufficiently so that it equals aggregate planned expenditure and, at that point, equilibrium expenditure occurs.

* This is Chapter 28 in Economics.

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If real GDP and aggregate expenditure are less than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are less than their equilibrium levels, an unplanned decrease in inventories occurs. The unplanned decrease in inventories leads firms to increase production to restore inventories to their planned levels. The increase in production increases real GDP.

If real GDP and aggregate expenditure are greater than equilibrium expenditure, what happens to firms’ inventories? How do firms change their production? And what happens to real GDP? If real GDP and aggregate expenditure are greater than their equilibrium levels, an unplanned increase in inventories occurs. The unplanned increase in inventories leads firms to decrease production to restore inventories to their planned levels. The decrease in production decreases real GDP.

Page 316 1.

(page 724 in Economics)

What is the multiplier? What does it determine? Why does it matter? The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure and real GDP. A change in autonomous expenditure changes real GDP by an amount determined by the multiplier. The multiplier matters because it tells us how much a change in autonomous expenditure changes equilibrium expenditure and real GDP.

How do the marginal propensity to consume, the marginal propensity to import, and the income tax rate influence the multiplier? The marginal propensity to consume, the marginal propensity to import, and the income tax rate all influence the magnitude of the multiplier. The multiplier is smaller when the marginal propensity to consume is smaller, when the marginal propensity to import is larger, and when the income tax rate is larger.

How do fluctuations in autonomous expenditure influence real GDP? Fluctuations in autonomous expenditure bring business cycle turning points. When autonomous expenditure changes, the economy moves from one phase of the business cycle to the next. For example, if autonomous expenditure decreases, equilibrium expenditure and real GDP decrease and, as a result, the economy enters the recession phase of the business cycle.

Page 321

(page 729 in Economics)

How does a change in the price level influence the AE curve and the AD curve?

If autonomous expenditure increases with no change in the price level, what happens to the AE curve and the AD curve? Which curve shifts by an amount that is determined by the multiplier and why?

A change in the price level shifts the AE curve and creates a movement along the AD curve.

A change in autonomous expenditure with no change in the price level shifts both the AE curve and the AD curve. The AE curve shifts by an amount equal to the change in autonomous expenditure. The multiplier determines the magnitude of the shift in the AD curve. The AD curve shifts by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

How does an increase in autonomous expenditure change real GDP in the short run? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the short run, an increase in aggregate expenditure increases real GDP. However, the increase in real GDP is less than the increase in aggregate demand because the price level rises. The more the price level rises (the steeper the SAS curve) the smaller the increase in real GDP.

How does real GDP change in the long run when autonomous expenditure increases? Does real GDP change by the same amount as the change in aggregate demand? Why or why not? In the long run, an increase in aggregate expenditure has no effect on real GDP, that is, real GDP does not change. The change in real GDP—zero—is less than the change in aggregate demand. The change in real GDP is nil because, in the long run, the economy returns to its full-employment equilibrium. In the long run, an increase in aggregate expenditure raises the price level but has no effect on real GDP.

EXPENDITURE MULTIPLIERS

Page 327

(page 735 in Economics)

In an economy, autonomous consumption expenditure is $50 billion, investment is $200 billion, and government expenditure is $250 billion. The marginal propensity to consume is 0.7 and net taxes are $250 billion. Exports are $500 billion and imports are $450 billion. Assume that net taxes and imports are autonomous and the price level is fixed. a. What is the consumption function? The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same. In this case the consumption function is C = 50 + 0.7(Y – 250) where the “50” is $50 billion and the “250” is $250 billion.

b. What is the equation of the AE curve? The equation of the AE curve is AE = 375 + 0.7Y, where Y is real GDP and the 375 is $375 billion. Aggregate planned expenditure is the sum of consumption expenditure, investment, government purchases, and net exports. Using the symbol AE for aggregate planned expenditure, aggregate planned expenditure is AE = 50 + 0.7(Y – 250) + 200 +250+ 50 AE = 50 + 0.7Y – 175 + 200 + 250 + 50 AE = 375 + 0.7Y

c. Calculate equilibrium expenditure. Equilibrium expenditure is $1,250 billion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 375 + 0.7Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $1,250 billion.

d. Calculate the multiplier. The multiplier equals 1/(1 − the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.7. So the multiplier is 1/(1 − 0.7), which is 3.333.

e. If investment decreases to $150 billion, what is the change in equilibrium expenditure? Equilibrium real expenditure decreases by $166.67 billion. From part d the multiplier is 3.333. The change in equilibrium expenditure equals the change in investment, $50 billion, multiplied by 3.333.

Describe the process in part (e) that moves the economy to its new equilibrium expenditure. When investment decreases by $50 billion, aggregate planned expenditure is less than real GDP. Firms find that their inventories are accumulating above target levels. As a result, they decrease production to reduce inventories. Real GDP decreases. The decrease in real GDP decreases disposable income so that consumption expenditure falls. In turn, the decrease in consumption expenditure leads to a further decrease in aggregate planned expenditure. Real GDP still exceeds aggregate planned expenditure though by less than was initially the case. Nonetheless unwanted inventories are still accumulating and firms continue to cut production, further reducing real GDP. This process continues until eventually real GDP will decrease enough to equal aggregate planned expenditure.

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Answers to the Study Plan Problems and Applications 1.

In an economy, when income increases from $400 billion to $500 billion, consumption expenditure changes from $420 billion to $500 billion. Calculate the marginal propensity to consume, the change in saving, and the marginal propensity to save. The marginal propensity to consume is the fraction of a change in disposable income that is consumed. In this economy, when income increases by $100 billion per year, consumption expenditure increases by $80 billion per year. The marginal propensity to consume equals $80 billion ÷ $100 billion, or 0.8. Saving equals disposable income minus consumption expenditure. Therefore from the $100 billion increase in income, consumption expenditure increased by $80 billion, leaving a $20 billion increase in saving. The marginal propensity to save is the fraction of a change in disposable income that is saved. In this economy, for the increase in income of $100 billion, saving increases by $20 billion, so the marginal propensity to save is $20 billion ÷ $100 billion, which is 0.2.

Use Figure 11.1 to work Problems 2 and 3. Figure 11.1 illustrates the components of aggregate planned expenditure on Turtle Island. Turtle Island has no imports or exports, no incomes taxes, and the price level is fixed. 2. Calculate autonomous expenditure and the marginal propensity to consume. Autonomous expenditure is $2 billion. Autonomous expenditure is expenditure that does not depend on real GDP. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. The marginal propensity to consume is 0.6. When the country has no imports or exports and no income taxes, the slope of the AE curve equals the marginal propensity to consume. When income increases from zero to $6 billion, aggregate planned expenditure increases from $2 billion to $5.6 billion. That is, when real GDP increases by $6 billion, aggregate planned expenditure increases by $3.6 billion. The marginal propensity to consume is $3.6 billion ÷ $6 billion, which is 0.6.

3. a. What is aggregate planned expenditure when real GDP is $6 billion? Figure 11.1 shows that aggregate planned expenditure is $5.6 billion when real GDP is $6 billion.

b. If real GDP is $4 billion, what is happening to inventories? Firms’ inventories are decreasing. When real GDP is $4 billion, aggregate planned expenditure exceeds real GDP, so firms sell all that they produce and more. As a result, inventories decrease.

c. If real GDP is $6 billion, what is happening to inventories? Firms are accumulating inventories. That is, unplanned inventory investment is positive. When real GDP is $6 billion, aggregate planned expenditure is less than real GDP. Firms cannot sell all that they produce and inventories pile up.

Explain the difference between induced consumption expenditure and autonomous consumption expenditure. Why isn’t all consumption expenditure induced expenditure? Induced consumption expenditure is consumption expenditure that changes when disposable income changes. Autonomous consumption expenditure is consumption expenditure that would occur in the short run even if disposable income was zero. Not all consumption expenditure is induced consumption expenditure because, in the short run, even if someone has no income they still will have some (autonomous) consumption expenditure, if for nothing else, for food.

EXPENDITURE MULTIPLIERS

Explain how an increase in business investment at a constant price level changes equilibrium expenditure. Investment is a component of autonomous aggregate expenditure. An increase in investment increases aggregate expenditure so the AE curve shifts upward. Equilibrium expenditure increases.

Use the following data to work Problems 6 and 7. An economy has a fixed price level, no imports, and no income taxes. MPC is 0.80, and real GDP is $150 billion. Businesses increase investment by $5 billion. 6.

Calculate the multiplier and the change in real GDP. With no imports and no income taxes, the multiplier equals 1/(1 − MPC). So the multiplier is 1/(1 − 0.8), which is 5.0 Then the $5 billion increase in investment increases real GDP by 5.0 × $5 billion, which is $25 billion.

Calculate the new real GDP and explain why real GDP increases by more than $5 billion. Real GDP was initially $150 billion. The increase in investment increased real GDP by $25 billion, so real GDP increases to $175 billion. Real GDP increases by more than the initial increase in investment because the increase in investment increases disposable income which induces additional increases in consumption expenditure. So real GDP increases both because investment increases and also because of induced increases in consumption expenditure.

An economy has a fixed price level, no imports, and no income taxes. An increase in autonomous expenditure of $2 trillion increases equilibrium expenditure by $8 trillion. Calculate the multiplier and explain what happens to the multiplier if an income tax is introduced. The multiplier is defined as the change in equilibrium expenditure divided by the change in autonomous expenditure. In this problem the multiplier equals $8 trillion ÷ $2 trillion which is 4.0. If an income tax is introduced, the multiplier decreases in value. With an income tax, at each spending round less disposable income is created leading to smaller increases in induced expenditure.

Use the following data to work Problems 9 to 13. Suppose that the economy is at full employment, the price level is 100, and the multiplier is 2. Investment increases by $100 billion. 9. What is the change in equilibrium expenditure if the price level remains at 100? The initial change in equilibrium expenditure is $200. The initial effect of the increase in investment increases equilibrium expenditure by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the initial change in equilibrium expenditure is $200 billion.

10. a. What is the immediate change in the quantity of real GDP demanded? The quantity of real GDP demanded increases by $200 billion. The increase in investment shifts the aggregate demand curve rightward by the change in investment times the multiplier. The multiplier is 2 and the change in investment is $100 billion, so the aggregate demand curve shifts rightward by $200 billion.

b. In the short run, does real GDP increase by more than, less than, or the same amount as the immediate change in the quantity of real GDP demanded? In the short run, real GDP increases by less than $200 billion. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the price level will rise and real GDP will increase but by an amount less than the shift of the AD curve.

11.

In the short run, does the price level remain at 100? Explain why or why not. In the short run, the price level rises. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the short run, the increase in aggregate demand means that the price level will rise as the economy moves along its upward-sloping SAS curve.

12. a. In the long run, does real GDP increase by more than, less than, or the same amount as the immediate increase in the quantity of real GDP demanded? In the long run, real GDP equals potential GDP, so real GDP does not increase. Real GDP is determined at the intersection of the AD curve and the SAS curve. After the initial increase in

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investment, money wages increase, the SAS curve shifts leftward, and in the long run, real GDP moves back to potential GDP.

b. Explain how the price level changes in the long run. Real GDP is determined at the intersection of the AD curve and the SAS curve. In the long run, money wages increase so the SAS curve shifts leftward, raising the price level by more than it rose in the short run.

13.

Are the values of the multipliers in the short run and the long run larger or smaller than 2? The multiplier in the short run is less than the multiplier of 2 because the short-run increase in real GDP is less than $200 billion. The long-run multiplier is even smaller. It equals zero.

14.

Use the data in the Worked Problem on p. 325 (page 737 in Economics). Calculate the change in equilibrium expenditure when investment decreases by $150 billion. The multiplier equals 4. Consequently the change in equilibrium expenditure equals (4) × (−$150 billion), or a decrease of $600 billion.

EXPENDITURE MULTIPLIERS

Answers to Additional Problems and Applications Use the following data to work Problems 15 and 16. You are given the information in the table about the economy of Australia. 15.

Calculate the marginal propensity to save. The marginal propensity to save is the fraction of a change in disposable income that is saved. In Australia, when disposable income increases by $100 billion per year, saving increases by $25 billion per year. The marginal propensity to save is $25 billion ÷ $100 billion, which is 0.25.

16.

Disposable income Saving (billions of dollars per year) 0 0 100 25 200 50 300 75 400 100

Calculate consumption at each level of disposable income. Calculate the marginal propensity to consume. The table to the right shows Australia’s consumption expenditure schedule. Consumption expenditure equals disposable income minus saving. For each increase in disposable income of $100 billion, consumption expenditure increases by $75 billion. The marginal propensity to consume is 0.75. The marginal propensity to consume plus the marginal propensity to save equals 1. Because the marginal propensity to save equals 0.25, the marginal propensity to consume equals 0.75.

Disposable Consumption income expenditure (billions of dollars per year) 0 0 100 75 200 150 300 225 400 300

Use the following news clip to work Problems 17 to 19. Americans $2.4 trillion Poorer The Federal Reserve reported that household wealth decreased by $2.4 trillion or $21,000 per household in the third quarter of 2011. This drop is the steepest since 2008 and the second consecutive quarterly drop. Foreclosures lowered household debt slightly but credit card debt increased. Many households are struggling to buy the essentials and spending on food has decreased. Separately, the Bureau of Economic Analysis reported that consumption expenditure increased by $39 billion in the third quarter of 2011. Sources: The New American, December 11, 2011 and the Bureau of Economic Analysis 17.

Explain and draw a graph to illustrate how a fall in household wealth would be expected to influence the consumption function and saving function.

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Figure 11.2a shows the effect of a decrease in wealth on the consumption function and Figure 11.2b shows the effect on the saving function. Consumption expenditure decreases so the consumption function shifts downward from CF0 to CF1 while saving increases so the saving function shifts upward from SF0 to SF1.

18.

What factors might explain the actual changes in consumption expenditure and wealth that occurred in the third quarter of 2011? According to the article, consumption increased. At least two other factors could explain the discrepancy between the “predicted” decrease in consumption in part a and the increase that actually occurred. First, disposable income might have increased. This change would lead to a movement upward along the (downward-shifted) consumption function so that consumption expenditure increased. Alternatively people’s expected future incomes might have risen. The upward revision in expected future income would lead to an upward shift of the consumption function which would offset the fall from the decrease in wealth.

19.

Draw a graph of a consumption function and show at what points consumers were actually operating in the second and third quarters. Make any necessary assumptions and explain your answer. Regardless of any increase in future expected income, it is likely the case that the decrease in wealth led to a net downward shift of the consumption function because the decrease in wealth was so large. In Figure 11.2a the consumption function shifts downward from CF0 to CF1. Equally likely, however, disposable income increased. So the economy moves from disposable income of $10.5 trillion and consuming at point A on consumption function CF0 to disposable income of $11.0 trillion and consuming at point B on consumption function CF1.

1 2 3 4 5 6 7

A A B C D E F

B Y 100 200 300 400 500 600

C C 110 170 230 290 350 410

D I 50 50 50 50 50 50

E G 60 60 60 60 60 60

F X 60 60 60 60 60 60

G M 15 30 45 60 75 90

Use the spreadsheet above, which lists real GDP (Y ) and the components of aggregate planned expenditure in billions of dollars, to work Problems 20 and 21. 20.

Calculate autonomous expenditure. Calculate the marginal propensity to consume. Autonomous expenditure equals the value of aggregate planned expenditure when real GDP is zero. Because the spreadsheet does not list GDP of zero, we must extrapolate to calculate the value of consumption expenditure and imports when GDP equals zero. From the spreadsheet, consumption expenditure falls by $60 billion for every $100 billion decrease in GDP. So when GDP equals zero, autonomous consumption expenditure is $50 billion. Similarly, from the spreadsheet, imports decrease by $15 billion for every $100 billion decrease in GDP. So when GDP equals zero, imports equal zero. Autonomous expenditure is $50 billion (consumption expenditure) plus $50 billion (investment) plus $60 billion (government expenditure) plus $60 billion (exports), which equals $220 billion. The marginal propensity to consume is 0.6. When income increases from $100 billion to $200 billion, consumption expenditure increases from $110 billion to $170 billion. A $100 billion increase in GDP increases consumption expenditure by $60 billion. So the marginal propensity to consume is $60 billion ÷ $100 billion, which is 0.6.

EXPENDITURE MULTIPLIERS

21. a. What is aggregate planned expenditure when real GDP is $200 billion? Aggregate planned expenditure is $310 billion. Aggregate planned expenditure is the sum of consumption expenditure ($170 billion) plus planned investment ($50 billion) plus government expenditure ($60 billion) plus exports ($60 billion) minus imports ($30 billion), which is $310 billion.

b. If real GDP is $200 billion, explain the process that moves the economy toward equilibrium expenditure. Inventories are decreasing so that the unplanned inventory change is negative. When real GDP is $200 billion, aggregate planned expenditure is $310 billion. Because aggregate planned expenditure exceeds real GDP, firms sell all that they produce and even more so that inventories are decreasing. Firms then increase their production, to restore their inventories, and real GDP increases.

c. If real GDP is $500 billion, explain the process that moves the economy toward equilibrium expenditure. Firms are accumulating inventories so that the unplanned inventory change is positive. When real GDP is $500 billion, aggregate planned expenditure is $445 billion. Firms cannot sell all that they produce so that unplanned inventories increase. Firms respond by decreasing their production, to lower their inventories, and real GDP decreases.

22.

Maruti Looks to Job, Production Cuts as Sales Decline As a result of slower economic growth and higher loan rates, local sales of Maruti Suzuki India Limited fell 7.8 percent in June from last year. Consequently, the largest car maker in India has asked as many as 450 contract workers to go on “long leave”, or leave without pay, as an effort to cut production and reduce inventory levels at its dealerships. Source: Mint, July 9, 2013 Explain how a rise in unplanned inventory causes firms to change their production. A fall in demand or sales leads to piling up of inventories. Inventories are part of investment. If the rise in inventory is unplanned, firms will be forced to cut production in order to avoid further piling up of stocks, which then decreases aggregate expenditure and real GDP. In the news clip, a rise in unplanned inventories depresses the firm’s production.

23.

In India, Focus Shifts To Deploying Fiscal Stimulus In an attempt to stimulate the economy, the Union Government announced a $23.9 billion increase in its planned expenditure in the annual budget. Source: CNBC, March 19, 2015 If the slope of the AE curve is 0.6, calculate the immediate change in aggregate planned expenditure and the change in real GDP in the short run if the price level remains unchanged. The increase in government expenditure will have a multiplier effect on aggregate expenditure and real GDP. The multiplier equals 1/(1 – slope of AE curve). The slope of the AE curve is 0.6 so the multiplier is 1/(1 – 0.6), which is 2.5. With this multiplier, the $23.9 billion increase in planned government expenditure increases aggregate expenditure by 2.5 × $23.9 billion, or $59.75 billion. In the short run, when the price level is constant, real GDP increases by the same amount, $59.75 billion.

24.

Obama’s Economic Recovery Plan President Obama's proposal to jolt a listless recovery with $180 billion worth of tax breaks and transportation projects left economists largely unimpressed Tuesday. Source: USA Today, September 10, 2010 If taxes fall by $90 billion and the spending on transport projects increases by $90 billion, which component of Obama’s recovery plan would have the larger effect on equilibrium expenditure, other things remaining the same? The spending on transportation projects will have the larger effect because the expenditure multiplier is larger than the tax multiplier. The expenditure multiplier is larger because in the first round all of the increased government expenditure increases aggregate expenditure whereas part of a tax cut is saved and hence does not increase aggregate expenditure.

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Use the following news item to work Problems 25 to 27. The BEA reported that in the third quarter of 2014 U.S. exports increased by $40 billion. 25.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium expenditure in the short run. The increase in exports increases aggregate expenditure because exports is a component of aggregate expenditure. As shown in Figure 11.3, the aggregate expenditure curve shifts upward from AE0 to AE1. Because aggregate expenditure has increased, real GDP increases, In Figure 11.3 the increase in aggregate expenditure increases real GDP from $15.8 trillion to $16.0 trillion.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the short run. The increase in exports increases aggregate expenditure and creates an increase in the aggregate demanded. Figure 11.4 illustrates the effect on real GDP. The aggregate demand curve shifts rightward, from AD0 to AD1. The price level rises and equilibrium real GDP increases from $15.8 trillion to $15.9 trillion. The economy is in an above full-employment equilibrium.

EXPENDITURE MULTIPLIERS

27.

Explain and draw a graph to illustrate the effect of an increase in exports on equilibrium real GDP in the long run. In the short run, the economy is in an above fullemployment equilibrium. As time passes, the money wage rate rises, which decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward. Eventually the short-run aggregate supply decreases enough so that the economy returns to full employment. In Figure 11.5, this analysis means that the short-run aggregate supply curve eventually shifts from SAS0 to SAS1 and the economy returns to full employment, with real GDP of $15.8 trillion and a price level of 122.

28.

Compare the multiplier in the short run and the long run and explain why they are not identical. The long-run multiplier is zero, which means that the short-run multiplier is larger than the long-run multiplier. The long-run multiplier equals zero because in the long run the economy returns to full employment. For example, in the short run an increase in aggregate demand increases real GDP, which means that the short-run multiplier is positive. But the economy is at a greater than full-employment equilibrium. Therefore the money wage rate starts to rise. The rise in the money wage rate decreases short-run aggregate supply and thereby decreases real GDP. The short-run aggregate supply continues to decrease until the economy reaches full employment, at which point it stops decreasing. But the ultimate change in real GDP is zero, which means the long-run multiplier is zero.

Use the following news clip to work Problems 29 to 31. Japan's Economy Grows Faster Than Expected Japanese economy has staged an encouraging comeback in the first quarter. The growth in GDP has been driven by private consumption that had remained long an obstacle in the country’s economic recovery whereas capital expenditure has risen for the first time in four quarters. Source: CNBC, May 19, 2015 29.

Is capital expenditure part of induced expenditure or autonomous expenditure? Explain. Induced consumption expenditure is the expenditure that varies with real GDP while autonomous expenditure does not vary with real GDP. Under the Keynesian model, government spending is assumed to be constant and hence it does not vary with income. Capital expenditure is, therefore, part of autonomous expenditure.

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Examine how Japan’s real GDP increases due to a movement along the aggregate demand curve and a shift in the aggregate demand curve. Illustrate your answer using a graph. Keeping the price level fixed, an increase in private consumption and capital expenditure leads to a rightward shift in the aggregate demand curve. Figure 11.6 illustrates these differences. The change from point A to point B reflects a change in aggregate demand. If the increase in consumption and capital expenditure results from lower prices, it creates a change in the quantity of real GDP demanded. The movement from point B to point C reflects a change in the quantity of real GDP demanded.

31.

Explain using a graph how in the Keynesian model, keeping the price level fixed, an increase in private consumption influences aggregate expenditure and aggregate demand.

In the Keynesian model, keeping the price level unchanged, an increase in private consumption increases the aggregate expenditure and aggregate demand. As illustrated in Figure 11.7a, the increase in private consumption shifts the aggregate expenditure curve upward, from AE0 to AE1 and in Figure 11.7b the aggregate demand curve shifts rightward, from AD0 to AD1.

EXPENDITURE MULTIPLIERS

32.

Japan Slides Into Recession In Japan, consumer prices slid at a faster pace in July and industrial production unexpectedly slumped. Source: Bloomberg, September 1, 2012 Contrast what the news clip says is happening in Japan with what is happening in the United States in Problem 29 and provide a graphical analysis of the differences.

The news clip suggests that in Japan aggregate demand is decreasing so that both the price level and real GDP are decreasing. Figure 11.8a shows this situation. The information in Problem 29 suggests that consumption expenditure is increasing and, while investment (capital spending) is decreasing. However it seems that the change in consumption expenditure exceeds the change in investment so U.S. aggregate demand is increasing. Figure 11.8b shows this situation.

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Economics in the News 33.

After you have studied Economics in the News on pp. 322–323 (730–731 in Economics), answer the following questions. a. If the 2014 changes in inventories were mainly planned changes, what role did they play in shifting the AE curve and changing equilibrium expenditure? Use a two-part figure (similar to that on p. 310 (p. 718 in Economics)) to answer this question.

Figure 11.9a shows aggregate planned expenditure; Figure 11.9b shows unplanned inventory change. When aggregate planned expenditure is given by AE0, unplanned inventory change is equal to zero when real GDP is $16.0 trillion, so unplanned inventory change is given by the top line in Figure 11.9b. If the change in inventories was planned, then planned investment increased and with it aggregate planned expenditure also increased. The increase in aggregate planned expenditure shifts the aggregate expenditure curve upward, as illustrated by the shift from AE0 to AE1 in Figure 11.9a. It shifts the unplanned inventory change line downward to the lower curve, Unplanned inventory change 1, in Figure 11.9b. The increase in aggregate expenditure increases equilibrium real GDP. In figure 11.9a, real GDP increases from $16.0 trillion to $16.1 trillion. In Figure 11.9b, at real GDP of $16.1 trillion, along the new unplanned inventory change curve line, unplanned inventory change is zero.

b. The BEA news release reports that exports of goods and services were up 10.1 percent and imports of goods and services were up 11.0 percent. Were these increases in expenditure increases in autonomous expenditure or increases in induced expenditure, and how do they influence the magnitude of the multiplier? Changes in exports are autonomous expenditure and changes in imports are induced expenditure. Changes in exports have no effect on the magnitude of the multiplier. Changes in imports do affect the size of the multiplier. The larger the quantity of imports that are induced by a change in income, the smaller the multiplier.

c. Using the assumptions made in Figure 2 on p. 323 (p. 731 in Economics), what is the value of the autonomous expenditure multiplier? The autonomous expenditure multiplier equals 1/(1 – slope of AE line). In the figure, the slope along the top red line is equal to ($15.99 trillion − $15.91 trillion)/($15.99 trillion − $15.83 trillion) = ($0.08 trillion)/(($0.16 trillion) = 0.5. So the autonomous expenditure multiplier equals 1/(1 – 0.5) = 2.0.

EXPENDITURE MULTIPLIERS

34.

In an economy with a fixed price level, autonomous spending is $20 trillion and the slope of the AE curve is 0.6. a. What is the equation of the AE curve? The equation of the AE curve is AE = 20 + 0.6Y, where Y is real GDP and the 20 is $20 trillion.

b. Calculate equilibrium expenditure. Equilibrium expenditure is $50 trillion. Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. That is, AE = 20 + 0.6Y and AE = Y. Solving these two equations for Y gives equilibrium expenditure of $50 trillion.

c. Calculate the multiplier. The multiplier equals 1/(1 − the slope of the AE curve). The equation of the AE curve tells us that the slope of the AE curve is 0.6. So the multiplier is 1/(1 − 0.6), which is 2.5.

d. Calculate the shift of the aggregate demand curve if investment increases by $1 billion. The shift of the aggregate demand curve equals the multiplier multiplied by the change in investment, or 2.5 × $1 billion, which is $2.5 billion.

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THE BUSINESS CYCLE, INFLATION, AND DEFLATION**

Answers to the Review Quizzes Page 338 1.

(page 746 in Economics)

Explain the mainstream theory of the business cycle. Mainstream business cycle theory attributes business cycles to fluctuations in aggregate demand growth. According to the mainstream view, potential GDP grows steadily and aggregate demand, while generally growing slightly faster that potential GDP, at times grows more slowly than potential GDP and at other times grows significantly more rapidly than potential GDP. When aggregate demand grows more slowly than potential GDP, the inflation rate is low and, because money wages are sticky and do not adjust to the lower the inflation rate, the economy slides into a recessionary gap so that real GDP is less than potential GDP. When aggregate demand grows more rapidly than potential GDP, the inflation rate is high and the economy moves into a strong expansion accompanied by inflation.

What are the four special forms of the mainstream theory of the business cycle and how do they differ? The four special forms of the mainstream theory are the Keynesian cycle theory, the monetarist cycle theory, the new classical cycle theory, and the new Keynesian cycle theory. These theories differ according to the factors they believe are the most responsible for causing fluctuations in the growth of aggregate demand. Keynesian cycle theory asserts that fluctuations in aggregate demand growth are the result of fluctuations in investment driven by fluctuations in business confidence. The monetarist cycle theory says that fluctuations in both investment and consumption expenditure lead to fluctuations in aggregate demand growth and that the basic source of the fluctuations in investment and consumption expenditure is fluctuations in the growth rate of the quantity of money. New classical cycle theory claims that the money wage rate and the position of the short-run aggregate supply curve are determined by the rational expectation of the price level, which in turn is determined by potential GDP and the expected aggregate demand. As a result, only unexpected changes in aggregate demand growth lead to business cycles. Finally, new Keynesian cycle theory says that money wage rates and the position of the short-run aggregate supply are determined by rational expectations of the price level from the past. As a result, both expected and unexpected fluctuations in aggregate demand growth lead to business cycles.

According to RBC theory, what is the source of the business cycle? What is the role of fluctuations in the rate of technological change? Real business cycle (RBC) theory says that economic fluctuations are caused by technological change that makes productivity growth fluctuate. Fluctuations in the rate of technological change are the impulse that creates the business cycle.

* This is Chapter 29 in Economics.

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According to RBC theory, how does a fall in productivity growth influence investment demand, the market for loanable funds, the real interest rate, the demand for labor, the supply of labor, employment, and the real wage rate? According to real business cycle theory, a fall in productivity growth decreases investment demand and the demand for labor. The decrease in investment demand decreases the demand for loanable funds and lowers the real interest rate. Via the intertemporal substitution effect, the lower real interest rate decreases the supply of labor. Because both the demand for labor and the supply of labor decrease, employment decreases. The real wage rate also falls because the decrease in the demand for labor exceeds the decrease in the supply of labor.

What are the main criticisms of RBC theory and how do its supporters defend it? Critics of the real business cycle theory level three criticisms at it: 1) the money wage rate is sticky; 2) the intertemporal substitution effect is small so that the small changes in the real wage rate cannot account for large changes in employment; and, 3) measured productivity shocks are likely to be caused by changes in aggregate demand so that business cycle fluctuations cause the measured productivity shocks. Real business cycle supporters respond that 1) the real business cycle theory is consistent with the facts about economic growth and it explains the facts about business cycles; and 2) real business cycle theory is consistent with a wide range of microeconomic evidence about labor supply, labor demand, investment demand, and the distribution of income between labor and capital.

Page 344 1.

(page 752 in Economics)

How does demand-pull inflation begin? Demand-pull inflation begins with an increase in aggregate demand. The increase in aggregate demand increases real GDP and the price level.

What must happen to create a demand-pull inflation spiral? When the economy is at an above full-employment equilibrium, the money wage rate rises which decreases the short-run aggregate supply. The decrease in the short-run aggregate supply decreases real GDP and raises the price level. If nothing else changes, the price level eventually stops rising. To create a demand-pull inflation spiral, aggregate demand must persistently increase, and the only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.

How does cost-push inflation begin? Cost-push inflation begins with an increase in the money wage rate or an increase in the money prices of raw materials, which decreases short-run aggregate supply. The decrease in short-run aggregate supply raises the price level and decreases real GDP.

What must happen to create a cost-push inflation spiral? If the Fed responds to each decrease in short-run aggregate supply by increasing the quantity of money, aggregate demand increases and freewheeling cost-push inflation ensues.

What is stagflation and why does cost-push inflation cause stagflation? Stagflation occurs when real GDP decreases and the price level rises. Cost-push inflation causes stagflation when short-run aggregate supply decreases because a decrease in short-run aggregate supply raises the price level and decreases real GDP.

How does expected inflation occur? Expected increases in aggregate demand or expected decreases in short-run aggregate supply create expected inflation because they change the expected price level. For example, in anticipation of an increase in aggregate demand, the money wage rate rises by the same percentage as the price level is expected to rise. With the correct expectation, real GDP remains equal to potential GDP and unemployment remains at its natural rate.

How do real GDP and the price level change if the forecast of inflation is incorrect? If the actual inflation rate exceeds the forecasted inflation rate, the price level rises by more than expected and real GDP exceeds potential GDP. If the actual inflation rate falls short of the expected inflation rate, the price level rises by less than expected and real GDP is less than potential GDP.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

Page 347 1.

(page 755 in Economics)

What is deflation?

Deflation is a persistently falling price level.

What is the distinction between deflation and a one-time fall in the price level? Deflation is a persistently falling price level; that is, the price level continually falls. A one-time fall in the price level occurs when the price level falls but thereafter starts to grow once again.

What causes deflation? Deflation occurs if aggregate demand increases at a persistently slower rate than aggregate supply. This situation typically occurs when the quantity of money grows slowly so that aggregate demand also grows slowly.

How does the quantity theory of money help us to understand the process of deflation? The equation of exchange shows that the growth rate of the price level equals the money growth rate plus the rate of change of velocity minus the growth rate of real GDP. The quantity theory adds two assumptions to the equation of exchange: The trend rate of change of velocity does not depend on the money growth rate and the trend growth rate of real GDP equals the growth rate of potential GDP, which also does not depend on the money growth rate. With these assumptions, the quantity theory predicts that a nation’s deflation (or inflation) rate equals the money growth rate plus the trend growth in velocity minus the trend growth in real GDP. The situation in Japan illustrates that this prediction is close to what actually occurred.

What are the consequences of deflation? Unanticipated deflation means that workers who have long-term wage contracts receive a higher real wage rate. But firms respond to the higher real wage by hiring fewer workers, so employment and output fall. The reduction in output decreases profits. Firms respond by decreasing investment, which reduces the growth rate of the capital stock, thereby slowing growth in potential GDP. The deflation also lowers the nominal interest rate, which increases the quantity of money people hold, which decreases the velocity of circulation, further adding to deflation.

How can deflation be ended? Deflation can be ended by increasing the money growth rate. In particular, the money growth rate must be changed to equal the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation.

Page 349 1.

(page 757 in Economics)

How would you use the Phillips curve to illustrate an unexpected change in inflation? An unexpected change in inflation results in a movement along the short-run Phillips curve. In particular, an unexpected increase in the inflation rate lowers the unemployment rate and an unexpected decrease in the inflation rate raises the unemployment rate.

If the expected inflation rate increases by 10 percentage points, how do the short-run Phillips curve and the long-run Phillips curve change? A 10 percentage point increase in the expected inflation rate shifts the short-run Phillips curve vertically upward by 10 percentage points. (Each point on the new short-run Phillips curve lies 10 percentage points above the point on the old Phillips curve directly below it). A 10 percentage point increase in the expected inflation rate does not change the long-run Phillips curve.

If the natural unemployment rate increases, what happens to the short-run Phillips curve and the long-run Phillips curve? An increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward by an amount equal to the increase in the natural unemployment rate.

Does the United States have a stable short-run Phillips curve? Explain why or why not. The United States does not have a stable short-run Phillips curve. The U.S. short-run Phillips curve shifts with changes in the expected inflation rate and the natural unemployment rate, so it is not stable.

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Answers to the Study Plan Problems and Applications 1.

Debate on Causes of Joblessness Grows What is the cause of the high unemployment rate? One side says there is not enough government spending. The other says it’s a structural problem—people who can’t move to take new jobs because they are tied down to burdensome mortgages or firms that can’t find workers with the requisite skills to fill job openings. Source: The Wall Street Journal, September 4, 2010 Which business cycle theory would say that the rise in unemployment is cyclical? Which would say it is an increase in the natural rate? Why? It is likely that most of the mainstream business cycle theories say that the rise in the unemployment rate is cyclical in nature. Definitely the Keynesian cycle theory and new Keynesian cycle theory agree that the rise is cyclical. It is also likely that the monetarist cycle theory and new classical cycle theory agree. The real business cycle theory, however, disagrees. It regards all unemployment as natural and so it would assert that the rise in the unemployment rate reflects a rise in the natural rate.

High Food and Energy Prices Here to Stay On top of rising energy prices, a severe drought, bad harvests, and a poor monsoon season in Asia have sent grain prices soaring. Globally, this is the third major food price shock in five years. Source: The Telegraph, August 29, 2012 Explain what type of inflation the news clip is describing and provide a graphical analysis of it. The news clip is describing a cost-push inflation. The costs of important inputs, such as oil, as well as the cost of other raw materials, such as grain, have all risen. Figure 12.1 illustrates a cost-push inflation. In it the short-run aggregate supply curve has shifted leftward, from SAS0 to SAS1 and the price level has risen from 122 to 124.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

Use Figure 12.2 to answer Problems 3 to 5. The economy starts out on the curves labeled AD0 and SAS0. 3. Some events occur and the economy experiences a demand-pull inflation. What might those events have been? Describe their initial effects and explain how a demand-pull inflation spiral results. Anything that increases aggregate demand can be the factor that starts a demand-pull inflation. For instance, an increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of a demand-pull inflation. To sustain the inflation, the quantity of money must keep increasing. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases and the AD curve shifts rightward to AD1. The new equilibrium is at the intersection of AD1 and SAS0, so the price level rises and real GDP increases. There is an inflationary gap. Starting at the intersection of AD1 and SAS0, there is an inflationary gap so the money wage rate rises and short-run aggregate supply decreases. The SAS curve starts to shift leftward toward SAS1. The price level keeps rising, but real GDP now decreases. If the central bank responds with persistent increases in the quantity of money, the process repeats: AD shifts to AD2, an inflationary gap opens again, the money wage rate rises again, and the SAS curve shifts toward SAS2.

Some events occur and the economy experiences a cost-push inflation. What might those events have been? Describe their initial effects and explain how a cost-push inflation spiral results. Anything that decreases short-run aggregate supply can set off a cost-push inflation. For instance, an increase in the money wage rate or an increase in the money price of raw materials could be the start of a cost-push inflation. But to sustain such an inflation, the quantity of money must keep increasing. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Short-run aggregate supply decreases and the SAS curve shifts leftward to SAS1. The price level rises and real GDP decreases. There is now a recessionary gap. Starting out at the intersection of AD0 and SAS1, there is a recessionary gap so real GDP is below potential GDP and unemployment is above the natural rate. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD1. Real GDP returns to $16 trillion and the price level rises to 160. A further cost increase occurs, which shifts the short-run aggregate supply curve to SAS2 and a recessionary gap opens up again. The economy is again below potential GDP. In an attempt to restore full employment, the central bank increases the quantity of money. The aggregate demand curve shifts rightward to AD2. Real GDP returns to $16 trillion and the price level rises to 200.

Some events occur and the economy is expected to experience inflation. What might those events have been? Describe their initial effects and what happens as an expected inflation proceeds. Anything that increases aggregate demand can set off an expected inflation as long as the event is expected. For instance, an expected increase in the quantity of money, an increase in government expenditure, a tax cut, or an increase in exports could all be the start of an expected inflation. But to sustain such an expected inflation, the quantity of money must keep increasing along its expected path. Starting at the intersection of AD0 and SAS0, the price level is 120 and real GDP is at potential GDP of $16 trillion. Aggregate demand increases, and the AD curve shifts rightward to AD1. The increase in

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aggregate demand is expected so the money wage rate rises and the SAS curve shifts to SAS1. The price level rises, and real GDP remains equal to potential GDP. Starting at the intersection of AD1 and SAS1, a further expected increase in aggregate demand occurs. The AD curve shifts to AD2, and because the increase in aggregate demand is expected, the money wage rate rises again and the SAS curve shifts to SAS2. Again, the price level rises and real GDP remains equal to potential GDP.

Suppose that the velocity of circulation of money is constant and real GDP is growing at 3 percent a year. a. To achieve an inflation target of 2 percent a year, at what rate would the central bank grow the quantity of money? To achieve a target inflation rate, the growth rate of the quantity of money must equal the inflation target plus real GDP growth minus growth in velocity. In the situation at hand, the growth in the quantity of money should equal 2 percent a year plus 3 percent a year minus 0 percent, or 5 percent a year.

b. At what growth rate of the quantity of money would deflation be created? Deflation occurs if the inflation rate is less than zero. Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate. The rate of velocity change is zero and the real GDP growth rate is 3 percent a year. So the inflation rate is negative when the money growth rate is less than the real GDP growth rate, which is 3 percent a year.

Eurozone Unemployment Hits Record High As Inflation Rises Unexpectedly Eurozone unemployment rose to 10.7 percent. At the same time, eurozone inflation unexpectedly rose to 2.7 percent a year, up from the previous month’s 2.6 percent a year. Source: Huffington Post, March 1, 2012 a. How does the Phillips curve model account for a very high unemployment rate? The Phillips curve can account for very high unemployment either by a very low inflation rate, which creates a movement along a stationary short-run Phillips curve, or by a very high natural unemployment rate, which shifts both the short-run and long-run Phillips curves rightward.

b. Explain the change in unemployment and inflation in the eurozone in terms of what is happening to the short-run and long-run Phillips curves.

The small burst of unexpected inflation mentioned in the news clip brought a movement up along the short-run Phillips curve. But a large increase in the natural unemployment rate shifts both the short-run and long-run Phillips curves rightward. So in the Eurozone, the trade-off between inflation and unemployment worsened as the short-run Phillips curve shifted rightward. From the Fed’s Minutes

Members expected real GDP growth to be moderate over coming quarters and then to pick up very gradually, with the unemployment rate declining only slowly. With longer-term inflation expectations stable, members anticipated that inflation over the medium run would be at or below 2 percent a year. Source: FOMC Minutes, June 2012 Are FOMC members predicting that the U.S. economy will move along a short-run Phillips curve or that the short-run Phillips curve will shift through 2012 and 2013? Explain. The Fed is predicting that the U.S. economy will move leftward along a generally flat short-run Phillips curve. The Fed expects that the unemployment rate will fall. Because the Fed thinks longer-term inflation expectations are stable, it does not expect the short-run Phillips curve to shift.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

Answers to Additional Problems and Applications Use the following information to work Problems 9 to 11. Suppose that the business cycle in the United States is best described by RBC theory and that a new technology increases productivity. 9.

Draw a graph to show the effect of the new technology in the market for loanable funds. The advance in technology makes investment in industries that can utilize the new technology more profitable. Investment demand increases, which increases the demand for loanable funds. As Figure 12.3 shows, the increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The increase in the demand for loanable funds raises the equilibrium real interest rate and increases the equilibrium quantity of loanable funds. In Figure 12.3 the real interest rate rises from 4 percent a year to 5 percent a year and the quantity of loanable funds increases from $2.5 trillion to $2.7 trillion.

10.

Draw a graph to show the effect of the new technology in the labor market. The advance in technology directly increases the demand for labor as firms look to hire more workers to exploit the technology. In addition, the supply of labor increases as workers respond to the higher real interest rate. The increase in the supply of labor, however, is less than the increase in the demand for labor. As Figure 12.4 shows, the demand for labor curve shifts rightward from LD0 to LD1 and the supply of labor curve shifts rightward from LS0 to LS1. Both changes increase the equilibrium quantity of employment. In Figure 12.4 employment increases from 300 billion hours to 330 billion hours. The effect on the real wage rate is ambiguous, but if, as illustrated in the figure, the increase in demand exceeds the increase in supply, then the net effect raises the real wage rate. In Figure 12.4 the real wage rate rises from $20 per hour to $30 per hour.

11.

Explain the when-to-work decision when technology advances. The when-to-work decision is an important part of the real business cycle theory. The increase in technology raises the real interest rate. Changes in the real interest rate create an “intertemporal substitution effect,” which is the “when-to-work” decision. If the real interest rate rises, the return to current work increases because any funds saved reap a higher real interest rate. (The effect is called “intertemporal” because in the future the increased saving influences people to work less.) As a result, a higher real interest rate increases the current supply of labor, which shifts the supply of labor curve rightward and increases equilibrium employment.

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U.K. Treasury Chief Zeros In on Productivity In 2013, U.K. productivity, measured in terms of output per hour worked, was 17 percent lower than the average of the G7. In response, U.K. Treasury Chief said the government will invest in new infrastructure, including roads and airports, boost worker skills through education reforms, and publish a more detailed productivity plan. Source: The Wall Street Journal, May 20, 2015 Explain the relationship between real wages and productivity in this news clip in terms of real business cycle theory. The article suggests that “the government will invest in new infrastructure, including roads and airports, and boost worker skills through education reforms.” On the one hand, increase in investment will increase the demand for loanable funds, resulting in a lower real interest rate. On the other hand, increases in productivity will increase the demand for labor. Due to intertemporal substitution effect, the higher real interest rate increases the supply of labor. RBC theorists believe that the effect of intertemporal substitution is large. If the effect is so large that the increase in the supply of labor is greater than the demand for labor, then the real wage rate will be lower. If the demand for labor is greater than the supply of labor, then the real wage rate will increase.

Use the following news clip to work Problems 13 and 14. Food Costs Are Stoking Asia Inflation Prices for foodstuffs, including essential items such as rice and milk, have risen in recent months, causing higher inflation rates in Asian countries, such as India, China, Thailand, and Indonesia. Food-price increases have significantly pushed inflation rates across the region. A 20 percent increase in rice prices regionally is estimated to add 1.5 percentage points to inflation. Shortage in supply is seen as the major reason for the price hike. In Indonesia, the central bank has called the inflation “temporary” and expects the next harvest season to increase the supply. Therefore, the central bank has kept its benchmark interest rate constant. In fact, akin to Indonesia, policy makers across Asia are banking on a good harvest to fight inflation over the short term. A bad harvest, on the other hand, will spur governments to react seriously. Source: The Wall Street Journal, Feb 11, 2010 13. What type of inflation process is referred to in this news clip? Explain how the central bank’s decision to keep the benchmark interest-rate constant could be effective in curbing the inflation. The inflation process referred to in the news clip is a cost-push inflation. There is a shortage in supply of foodstuffs causing the prices to rise. Therefore, aggregate supply decreases, the short-run aggregate supply curve shifts leftward, the price level rises and real GDP decreases. If Indonesia’s central bank keeps the benchmark interest rate unchanged, there will be no shift in the aggregate demand curve. Also, a temporary inflation implies that there are no strong inflationary expectations, and the aggregate supply curve will return to its original position shortly. Finally, the price will return to its initial level and the economy will go back to its initial equilibrium. Thus, the central bank’s decision to keep the benchmark interest rate constant can be effective in curbing temporary cost-push inflation.

14.

Explain what would happen to the economy if inflationary expectations are formed on the basis of a prolonged shortage in supply and increasing food-prices? Once higher inflationary expectations are formed, workers will demand for higher wages, and the short-run aggregate supply curve will shift leftward. Therefore, the price level will rise, real GDP will fall and the unemployment rate will rise, ushering in stagflation.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

15. Europe’s Deflation Risk The United States is planning to push Europe toward new and more aggressive efforts to boost aggregate demand given a renewed risk of deflation in the euro zone. Source: Reuters, September 12, 2014 a. Explain the process by which deflation occurs. Deflation occurs when aggregate demand persistently grows more slowly than aggregate supply. This situation occurs when the money growth rate grows too slowly, which leads to slower growth in aggregate demand.

b. How might Europe boost its aggregate demand? Might the boost to aggregate demand create demand-pull inflation? Europe can persistently boost aggregate demand by persistently increasing the growth rate of the quantity of money. If this growth rate is raised too high, then the boost to aggregate demand runs the risk of creating a demand-pull inflation.

Use the following data to work Problems 16 and 17. An economy has an unemployment rate of 4 percent and an inflation rate of 5 percent a year at point A in Figure 12.5. Then some events occur that move the economy from A to B to D to C and back to A. 16.

Describe the events that could create this sequence. Has the economy experienced demandpull inflation, cost-push inflation, expected inflation, or none of these? First the inflation rate increases from 5 percent a year to 15 percent a year and the unemployment rate does not change. Then the unemployment rate increases from 4 percent to 8 percent and the inflation rate does not change. Next the inflation rate falls from 15 percent a year to 5 percent a year and the unemployment rate does not change. Finally the unemployment rate falls from 8 percent to 4 percent and the inflation rate does not change. This set of changes could be the result of an expected increase in the inflation rate from 5 percent to 15 percent, followed by an increase in the natural unemployment rate from 4 percent to 8 percent, followed by an expected fall in the inflation rate from 15 percent to 5 percent, finally followed by a decrease in the natural unemployment rate from 8 percent to 4 percent.

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Draw in the figure the sequence of the economy’s short-run and long-run Phillips curves. Figure 12.6 shows these short-run and long-run Phillips curves. The initial increase in the expected inflation rate moves the economy up its (stationary) long-run Phillips curve LRPC0 from point A to point B. The short-run Phillips curve shifts upward from SRPC0 to SRPC1 and intersects the long-run Phillips curve at point B. Then the increase in the natural unemployment rate shifts both the long-run and short-run Phillips curves rightward to LRPC1 and SRPC2 so that they intersect at point D. Next the fall in the expected inflation rate moves the economy along its (stationary) new long-run Phillips curve LRPC1 from point D to point C. The short-run Phillips curve shifts downward from SRPC2 to SRPC3 and intersects the long-run Phillips curve at point C. Finally, the fall in the natural unemployment rate shifts both the long-run and short-run Phillips curves leftward back to LRPC0 and SRPC0 so that they intersect at point A.

Use the following information to work Problems 18 and 19. The Reserve Bank of New Zealand signed an agreement with the New Zealand government in which the Bank agreed to maintain inflation inside a low target range. Failure to achieve the target would result in the governor of the Bank (the equivalent of the chairman of the Fed) losing his job. 18. Explain how this arrangement might have influenced New Zealand’s short-run Phillips curve. The Reserve Bank of New Zealand’s arrangement with New Zealand’s government affected the shortrun Phillips curve because it affected people’s expectations of the inflation rate. In particular, since the agreement was credible and had significant sanctions for the governor of the Reserve Bank of New Zealand, the public likely kept their expected inflation rates lower than might otherwise have been the case. As a result, the short-run Phillips curve was lower than it otherwise would have been and, in addition, was probably less likely to shift higher if the inflation rate temporarily rose.

19.

Explain how this arrangement might have influenced New Zealand’s long-run Phillips curve. The long-run Phillips curve is independent of the inflation rate and of people’s inflationary expectations, so the arrangement probably had little direct effect on the long-run Phillips curve. The only way in which the long-run Phillips curve could have been affected was if the arrangement affected the natural unemployment rate. If the agreement lowered the natural unemployment rate, the long-run Phillips curve shifted leftward.

20.

Fed Pause Promises Financial Disaster The indication is that inflationary expectations have become entrenched and strongly rooted in world markets. As a result, the risk of global stagflation has become significant. A drawn-out inflationary process always precedes stagflation. Following the attritional effect of inflation, the economy starts to grow below its potential. It experiences a persistent output gap, rising unemployment, and increasingly entrenched inflationary expectations. Source: Asia Times Online, May 20, 2008 Evaluate the claim made in the news clip that if “inflationary expectations” become strongly “entrenched” an economy will experience “a persistent output gap.” The comment that inflationary expectations become strongly entrenched likely means that the expected inflation rate becomes high. The Phillips curve model, however, shows that even with high expected inflation the economy will eventually return to the long-run Phillips curve and the natural rate

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

of unemployment. Hence the assertion that high expected inflation means that the economy will experience a “persistent output gap” is incorrect.

Use the following information to work Problems 21 and 22. Because the Fed doubled the monetary base in 2008 and the government spent billions of dollars bailing out troubled banks, insurance companies, and auto producers, some people are concerned that a serious upturn in the inflation rate will occur, not immediately but in a few years time. At the same time, massive changes in the global economy might bring the need for structural change in the United States. 21.

Explain how the Fed’s doubling of the monetary base and government bailouts might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? The doubling of the monetary base might lead to significant inflation at some point in the future. If the inflation is unexpected, it will not change either the short-run Phillips curve or the long-run Phillips curve. But if at some point the inflation becomes expected, the short-run Phillips curve will shift upward. In either case, however, the long-run Phillips curve is not affected. The government bailouts probably decreased the amount of cyclical unemployment that otherwise would have occurred. In this case they forestalled a movement downward along the short-run Phillips curve. As long as the bailed out companies operate efficiently, the bailouts by themselves did not affect the natural unemployment rate and thereby did not change the long-run Phillips curve.

22.

Explain how large scale structural change might influence the short-run and long-run Phillips curves. Will the influence come from changes in the expected inflation rate, the natural unemployment rate, or both? Large-scale structural changes increase structural unemployment, thereby increasing the natural unemployment rate. The long-run and short-run Phillips curves shift rightward, worsening the tradeoff between unemployment and inflation.

Economics in the News 23.

After you have studied Economics in the news on pp. 350–351 (758–759 in Economics), answer the following questions. a. What are the macroeconomic problems in the Eurozone economy that the ECB is seeking to address? The Eurozone economy has slow growth a high unemployment rate. It also runs the risk of deflation.

b. Is the European unemployment problem structural, cyclical, or both and how can we determine its type? The European unemployment problem has both structural and cyclical components. The Eurozone unemployment rate has been persistently higher than the U.S. unemployment rate. This difference represents structural unemployment, the result of high European minimum wages, generous unemployment and welfare payments, and massive regulation of the labor market. But the faltering economic growth rate in Europe has also lead to cyclical unemployment.

c. Explain which type of unemployment the ECB can help with. The ECB can use its monetary policy to increase aggregate demand and lower cyclical unemployment.

d. Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that

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created the Eurozone’s macroeconomic problems. Figure 12.7 shows the situation in the Eurozone. Starting at point A, equilibrium real GDP is €14.5 trillion and potential GDP is €15 trillion. Real GDP is less than potential GDP by €0.5 trillion. Over time potential GDP increased by €3 trillion, from €15 trillion to €18 trillion. But the aggregate demand increased by less. The aggregate demand curve shifted from AD0 to AD1, an increase of only €2.5 at every price level. The equilibrium moved to point B. At point B equilibrium real GDP is €17 trillion and potential GDP is €18 trillion. Equilibrium real GDP is now less than potential GDP by €1 trillion. The recession has worsened and Eurozone unemployment has risen.

e. Use the AS-AD model to show the changes in aggregate demand and/or aggregate supply that the ECB must bring about to achieve its goal. The ECB’s goal is to increase the quantity of money sufficiently so that aggregate demand increases enough to restore the economy to full employment at potential GDP. Figure 12.8 shows the ECB’s goal. Starting from point B, with a recessionary gap of €1 trillion, potential GDP will increase by €3 trillion from €18 trillion to €21 trillion. The ECB’s goal is to increase aggregate demand by even more. If the ECB can increase aggregate demand from AD1 to AD2, an increase of €4.5 at every price level, the new equilibrium point will be at point C. At this equilibrium the Eurozone will have returned to potential GDP and employment will equal full employment.

24.

Germany Leads Slowdown in Eurozone The pace of German economic growth has weakened “markedly,” but the reason is the weaker global prospects. Although German policymakers worry about the country’s exposure to a fall in demand for its export goods, evidence is growing that the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending. Source: The Financial Times, September 23, 2010 a. How does “exposure to a fall in demand for its export goods” influence Germany’s aggregate demand, aggregate supply, unemployment and inflation? If there is a severe decrease in demand for Germany’s exports, Germany’s aggregate demand decreases. There is no impact on aggregate supply. The decrease in aggregate demand lowers the price level and decreases real GDP. The fall in the price level means that the inflation rate falls; the decrease in real GDP means that unemployment rises.

b. Use the AS-AD model to illustrate your answer to part (a). Figure 12.9 illustrates this situation. Aggregate demand decreases and the aggregate demand curve shifts leftward, from AD0 to AD1. The economy moves from point A to point B. Real GDP decreases and the price level falls.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

c. Use the Phillips curve model to illustrate your answer to part (a). In part (a) the inflation rate fell and the unemployment rate increased. People’s inflation expectations likely did not change so the German economy moved along its short-run Phillips curve. In 2010, the German inflation rate was 1 percent and the unemployment rate was 7 percent. Figure 12.10 shows the effect of the decrease in demand for exports as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate falls and the unemployment rate rises. d.

What do you think the news clip means by “the recovery is broadening with real wage rates rising and unemployment falling, which will lead into stronger consumer spending”? The clip is implicitly talking about the multiplier effect. It is predicting that aggregate demand will increase as a result of the increase in consumption expenditure. Aggregate supply might also change but the emphasis in the news clip is on aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. The increase in real GDP lowers the unemployment rate and the increase in the price level raises the inflation rate.

e. Use the AS-AD model to illustrate your answer to part (d). Figure 12.11 illustrates this situation. Aggregate demand increases because of the higher consumption expenditure and the aggregate demand curve shifts rightward, from AD0 to AD1. The economy moves from point A to point B. Real GDP increases and the price level rises. f.

Use the Phillips curve model to illustrate your answer to part (d). In part e the inflation rate rose and the unemployment rate decreased. People’s inflation expectations likely did not change so the German economy moved along its short-run Phillips curve. In 2010, the German inflation rate was 1 percent and the unemployment rate was 7 percent. Figure 12.12 shows the effect of the increase in consumption expenditure as the movement from point A on the short-run Phillips curve SRPC to point B on the same short-run Phillips curve. The inflation rate rises and the unemployment rate decreases.

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FISCAL POLICY**

Answers to the Review Quizzes Page 366 1.

(page 774 in Economics)

What is fiscal policy, who makes it, and what is it designed to influence? Fiscal policy is the use of the federal budget to achieve macroeconomic objectives. Fiscal policy is made by the president and Congress. It is designed to influence employment, economic growth, and price level stability.

What special role does the president play in creating fiscal policy? Each year the president proposes the budget that Congress amends and enacts.

What special roles do the Budget Committees of the House of Representatives and the Senate play in creating fiscal policy? Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified. Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed.

What is the timeline for the U.S. federal budget each year? When does a fiscal year begin and end? Consider the budget for 2015 as an example in answering this question. In February 2014 the president proposes a budget to Congress. Then, from February until October 1, 2014, the Congress debates the budget, amends it, and eventually passes the necessary budget bills. The president then signs or vetoes the budget bills that were presented to him. When the president vetoes bills, the Congress may override the veto or pass other bills acceptable to the president. Fiscal year 2015 begins on October 1, 2014 and runs until September 30, 2015. During this year the Congress may pass—and the president may sign—supplementary bills. Then, after the fiscal year ends, accounts are prepared and the “official” amounts of outlays, receipts, and budget deficit or surplus are reported.

Is the federal government budget today in surplus or deficit? Currently, the U.S. federal government is running a (large) budget deficit.

Page 371 1.

(page 779 in Economics)

How does a tax on labor income influence the equilibrium quantity of employment? A tax on labor income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms. The tax on labor income decreases the supply of labor. That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers

* This is Chapter 30 in Economics.

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their after-tax wage. The decrease in labor supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls. The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls.

FISCAL POLICY

How does the tax wedge influence potential GDP? By decreasing employment, the tax wedge lowers potential GDP.

Why are consumption taxes relevant for measuring the tax wedge? A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers.

Why are income taxes on capital income more powerful than those on labor income? Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans. In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy.

What is the Laffer curve and why is it unlikely that the United States is on the “wrong” side of it? The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected. The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall. When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve. It is unlikely that the United States is on the wrong side of the Laffer curve because U.S. tax rates are among the lowest in the industrial world and past changes in U.S. tax rates have produced changes in tax revenues in the same direction.

Page 374 1.

(page 782 in Economics)

What is a present value?

A present value is the amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account.

Distinguish between fiscal imbalance and generational imbalance. Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation continues to enjoy the current levels of taxes and benefits.

How large was the estimated U.S. fiscal imbalance in 2014 and how did it divide between current and future generations? In 2014, the fiscal imbalance was estimated to be $68 trillion. The generational imbalance estimates suggest that the current generation will pay 83 percent and future generations will pay 17 percent of the fiscal imbalance.

What is the source of the U.S. fiscal imbalance and what are the painful choices that we face? The source of the fiscal imbalance is the social security and, especially, the Medicare obligations made under current law. The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending.

How much of U.S. government debt is held by the rest of the world? U.S. government debt held by the rest of the world is about $5.8 trillion.

Page 379 1.

(page 787 in Economics)

What is the distinction between automatic and discretionary fiscal policy? Automatic fiscal policy is triggered by the state of the economy with no need for any government action. Discretionary fiscal policy, however, requires an act of Congress to either change government spending and/or change taxes.

How do taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle? Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure. For instance, when income decreases, consumption expenditure and aggregate expenditure decrease. But with the fall in

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income, income taxes decrease and needs-tested spending increase so that disposable income does not fall as much as does income. The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so that the fall in aggregate expenditure is likewise smaller.

How do we tell whether a budget deficit needs discretionary action to remove it? A budget deficit needs discretionary government action to remove it when the deficit is a structural deficit. If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain. However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear.

How can the federal government use discretionary fiscal policy to stimulate the economy? If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP.

Why might fiscal stimulus crowd out investment? Fiscal stimulus, such as an increase in government expenditure or a decrease in taxes, increases the budget deficit. The increase in the budget deficit increases the (government’s) demand for loanable funds, thereby raising the real interest. The higher real interest rate decreases—crowds out— investment.

FISCAL POLICY

Answers to the Study Plan Problems and Applications

Use the following news clip to work Problems 1 and 2. Economy Needs Treatment It’s the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound. Source: The Wall Street Journal, October 7, 2010 1. How has the U.S. government debt changed since 2008? What are the sources of the change in U.S. government debt? Since 2008 the U.S. government debt has skyrocketed. The debt dramatically rose because federal government taxes fell (as a percent of GDP) while federal government expenditures and transfer payments, shot upwards. Federal government expenditures on goods and services rose but not nearly as much as transfer payments.

What would be a “credible business plan” for the government to adopt? A “credible business plan” would be a plan for the government that shrinks the deficit and thereby stops the rapid increase in the government debt. This plan likely would involve cutting government outlays and increasing government receipts.

The government is considering raising the tax rate on labor income. Explain the supply-side effects of such an action and use appropriate graphs to show the directions of change, not exact magnitudes. What will happen to: a. The supply of labor and why? The supply of labor will decrease. As shown in Figure 13.1, the supply of labor curve shifts leftward from LS0 to LS1. The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the after-tax wage rate received by workers.

b. The demand for labor and why? The demand for labor will remain the same so in Figure 13.1 the demand for labor curve remains LD. The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income.

c. Equilibrium employment and why? As Figure 13.1 shows, the equilibrium level of employment decreases. In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year.

d. The equilibrium before-tax wage rate and why? As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $34 per hour to $35 per hour. The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve.

e. The equilibrium after-tax wage rate and why? The equilibrium after-tax wage rate decreases. The tax wedge in the figure is $2 per hour, so the aftertax wage rate falls from $34 per hour to $33 per hour. The increase in the tax rate on labor income increases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate increases but not by as much as the increase in tax. So the after-tax wage rate decreases.

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Potential GDP? Potential GDP decreases. The equilibrium level of employment is full employment. So as full employment decreases, potential GDP decreases along the aggregate production function. Figure 13.2 shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $16.2 trillion, to point B, with 300 billion hours of employment and potential GDP $16.1 trillion.

What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the tax on capital income will increase investment and thereby increase economic growth. A decrease in the tax on capital income increases the supply of loanable funds. The real interest rate falls and investment increases. The increase in investment increases economic growth.

Suppose that instead of taxing nominal capital income, the government taxed real capital income. Use appropriate graphs to explain and illustrate the effect that this change would have on: a. The tax rate on capital income. The nominal interest rate is the (nominal) income from capital. If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax rate on capital income falls because the part of the capital income—the inflation rate—that is received in compensation for inflation is no longer taxed.

b. The supply of and demand for loanable funds. With a lower tax rate on capital income, the supply of loanable funds increases as the after-tax real interest rate rises. This change is illustrated in Figure 13.3 by the rightward shift of the supply of loanable funds curve from the initial supply of loanable funds curve, SLF0, to SLF1. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes. In Figure 13.3, the demand for loanable funds curve does not shift.

FISCAL POLICY

c. Investment and the real interest rate. As shown in Figure 13.3, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward. This change leads to a lower real interest rate and a higher amount of loanable funds and investment.

Under current policies, a plausible projection is that U.S. public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years. a. What is a fiscal imbalance? How might the U.S. government reduce the fiscal imbalance? The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. To reduce the fiscal imbalance, the government needs to decrease its benefit payments—both its present payments and those promised in the future—and increase its tax revenue—both its current tax revenue and tax revenue in the future. While the annual government budget deficit is not the fiscal imbalance, it is related because, in general, the larger the budget deficit the larger the fiscal imbalance. Additionally, the larger the budget deficit, the larger the accumulated public debt becomes.

b. How would your answer to part (a) influence the generational imbalance? The generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits. The changes in part (a) of cutting benefits and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation. In that case the generational imbalance would change so that more of the fiscal imbalance is paid by the current generation and less by future generations.

The economy is in a recession, and the recessionary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that increases government expenditure or decreases taxes would boost aggregate demand. In terms of automatic fiscal policy, needs-tested spending increases in recessions and tax revenue falls. Congress might also use discretionary policy by passing a new spending bill or a cut in tax rates.

b. Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit. An increase in government expenditure with an offsetting increase in tax rates to boost tax revenue would not bring a budget deficit and would increase aggregate demand because the increase in government expenditure increases aggregate demand by more than the increase in taxes decreases aggregate demand.

c. Explain the risks of discretionary fiscal policy in this situation. The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP.

An economy is in a recession with a large recessionary gap and a government budget deficit. a. Do we know whether the budget deficit is a structural deficit or a cyclical deficit? Explain. We know that at least some of the budget deficit in a recession is a cyclical deficit as needs-tested spending is higher and tax revenue is lower than at potential GDP. However, some of the budget deficit might be a structural deficit. The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment.

b. Explain how automatic fiscal policy is changing the output gap? Automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what it would be otherwise in a recession. That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in tax revenue that produce the cyclical deficit.

c. If the government increases its discretionary expenditure, explain how the structural deficit might change. A discretionary increase in government expenditure, if not reversed following the end of the recession, moves the budget balance toward a structural deficit.

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Use the following news clip and fact to work Problems 9 to 11. Senate Approves Obama Tax Cut Plan The U.S. Senate has passed legislation extending Bush-era tax cuts for high-income earners to middleclass Americans earning up to $250,000 per year. Source: Financial Times, July 26, 2012 Fact: Middle and low-income earners spend almost all their disposable incomes. High-income earners save a significant part of their disposable incomes. 9. a. Explain the intended effect of extending tax cuts for middle-class Americans but not for high-income families. Draw a graph to illustrate the intended effect. The goal of extending the tax cuts for middleclass Americans has an intended effect of increasing consumption expenditure, which increases aggregate demand. Figure 13.4 shows the intended effect of this policy where, including the multiplier effect, the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $15.7 trillion to $15.9 trillion. In the figure real GDP remains below potential GDP but the recessionary gap becomes smaller.

b. Explain why the effect of tax cuts depends on who receives them. The effect of this fiscal policy depends on the size of the impact on aggregate demand. The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand. If the tax rebates go to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger.

10.

What would have a larger effect on aggregate demand: extending the Bush-era tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only? How would each alternative compare with no tax cuts but an equivalent increase in government expenditure? Extending the income tax cuts to everyone will have the largest effect on aggregate demand. Middleincome tax payers will spend most of the tax cut and high-income tax payers, while spending only a small fraction of their income, still spend some. In general, tax cuts have a larger effect on real GDP than do increases in government expenditure because the tax cuts have stronger supply-side effects. So whichever tax cut policy—extending the tax cuts to everyone, to only middle-class taxpayers, or to only high-income tax payers—has the largest supply-side effect also has the largest effect on real GDP.

11.

Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services. According to the aggregate demand/aggregate supply model, the government expenditure multiplier exceeds the tax multiplier, so government expenditure has a larger impact on real GDP. Some economists, such as Robert Barro and Harald Uhlig disagree and assert that the tax multiplier exceeds the government expenditure multiplier because taxes affect aggregate demand and aggregate supply. In this case the decrease in taxes has a larger impact on real GDP.

FISCAL POLICY

Answers to Additional Problems and Applications 12.

2012 Deficit: Smaller, But Still Big The Congressional Budget Office said the budget deficit was about $1.1 trillion in fiscal year 2012. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II. Source: The Congressional Budget Office, October 5, 2012 Of the components of government outlays and receipts, which have changed most to contribute to the huge budget deficits in 2011 and 2012? In general, since 2008 outlays have increased substantially while receipts have risen slightly. The major factor leading to the massive rise in the budget deficit is an increase in transfer payments. An increase in government expenditure on goods and services also has lead to increasing the budget deficit but the effect from this factor is dwarfed by the rise in transfer payments.

Use the following information to work Problems 13 and 14. Suppose that investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion. 13.

Calculate the amount of tax revenue and the government budget balance. Tax revenue equals $1,200 billion. From the circular flow of expenditure and income, we know that I = S + T – G + M – X. Rearranging the equation gives T = I– S + G + X – M, which equals $1,200 billion.

14. a. Explain the impact of the government budget balance on investment. The government has a budget deficit. It is exerting a negative influence on investment by increasing the demand for loanable funds, which increases the real interest rate and crowds out investment.

b. What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work. A decrease in the budget deficit by increasing taxes or decreasing government expenditure decreases the demand for loanable funds, which lowers the real interest rate and increases investment. The increase in investment increases economic growth.

15.

Suppose that capital income taxes are based (as they are in the United States) on nominal interest rates. If the inflation rate increases by 5 percent a year, explain and use appropriate graphs to illustrate the effect of the rise in inflation on: a. The tax rate on capital income. The increase in the inflation rate increases the true tax rate on capital income because the interest income that is received in compensation for inflation is larger so that the tax paid on capital income increases.

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b. The supply of loanable funds. With a higher tax rate on capital income, the supply of loanable funds decreases and the aftertax real interest rate falls. This change is illustrated in Figure 13.5 by the leftward shift of the supply of loanable funds curve from the initial supply of loanable funds curve SLF0 to the new supply, SLF1, when the inflation rate is higher.

c. The demand for loanable funds. The demand for loanable funds generally remains the same because it depends in large part on investment demand. Firms’ investment demand depends on how productive capital is and the productivity of capital does not change when the tax code changes.

d. Equilibrium investment. As illustrated in Figure 13.5, when the supply of loanable funds decreases, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. The real interest rate rises from 4 percent a year to 5 percent a year, and the equilibrium quantity of loanable funds deceases from $2.5 trillion to $2.4 trillion. Investment decreases.

e. The equilibrium real interest rate. The decrease in the supply of loanable funds leads to a higher equilibrium real interest rate. In the figure the real interest rate rises from 4 percent to 5 percent.

Use the following news clip to work Problems 16 and 17. Singapore Budget 2015: Parliament Passes Record $79.9 Billion Budget New schemes announced by the budget statement include ten new hawker centers by 2027, a third desalination plant, SkillsFuture initiative to support lifelong learning for adults, and a second edition of Construction Productivity Roadmap to boost the industry’s capabilities. Source: The Straits Times, March 13, 2015 16.

Explain the supply-side effects of building ten new hawker centers and a third desalination plant. The construction of ten new hawker centers and a third desalination plant creates more job opportunities, thereby boosting employment.

17. a. Explain the potential supply-side and demand-side effects of SkillsFuture initiative. The SkillsFuture initiative will give adult Singaporeans the opportunity to develop new skills and respond to the constantly evolving needs of industry. This will help many employees to keep their jobs or make progress in their career. The initiative, thus, may not necessarily create more employment. Therefore, aggregate supply may or may not increase. However, as employees’ real wages increase due to better skills and better employment opportunities, consumption expenditure rises, so aggregate demand increases from what it would be otherwise.

b. Explain the potential supply-side and demand-side effects of adopting new technologies to boost productivity in the construction industry. Use of new technologies increases both short-run and long-run aggregate supply. More capital investment by construction companies will increase aggregate demand as well.

FISCAL POLICY

c. Draw a graph to illustrate the combined demand-side and supply-side effect of the fiscal policy measures in part (a). Figure 13.6 shows the combined effects of the policy compared to what the situation would be if the policies not implemented. Aggregate demand increases, so the aggregate demand curve shifts rightward from AD0 to AD1. The effect on aggregate supply is ambiguous. Implementing the initiative may or may not increase aggregate supply. If aggregate supply does not change, the aggregate supply curve does not shift. In Figure 13.6 the shift of the aggregate demand curve increases real GDP, and the price level rises.

Use the following news clip to work Problems 18 and 19. China pulls back tax breaks for foreign companies Incentives such as lower land prices and tax breaks have helped Chinese cities attract multinational firms in the recent years. In 2014 alone, it secured foreign investment worth $120 billion. Now, the central government is ordering municipalities to pull back the incentives to curb the country’s growing debt and local spending. Source: CNN Money, March 27, 2015 18.

Explain the potential supply-side effects of China’s plan to pull back tax breaks? When there are no more tax breaks, foreign firms in China will expect decreased profits. Investment in the country’s capital stock decreases. Aggregate supply and potential GDP both decrease.

19.

How does withdrawing tax breaks that were granted to foreign firms curb the country’s debt? Explain your answer with the aid of the Laffer curve. After tax breaks are pulled back, foreign firms will have to pay more tax. The tax rate imposed on foreign firms lies on the upward-sloping portion of the Laffer curve, which indicates that an increase in the tax rate increases the tax revenue. The budget deficit decreases, exerting less pressure on the accumulating debt of the country.

20. Hong Kong Launches Rainy-day Fund Despite of HK$950b Reserves by 2020 By 2019–20, the fiscal reserves are predicted to reach HK$950 billion, enough to cover 22 months of the government’s projected expenditure. However, Finance Secretary John Tsang’s working group on long-term fiscal planning has warned that HK could face a structural deficit by 2022–23 due to an ageing population. The group proposes to set up a “future fund” for a rainy day, to be used if HK’s reserves drops to a critical level. Source: South China Morning Post, Feb 26, 2015 What is the difference between structural deficit and cyclical deficit? Explain how an ageing population may lead to a structural deficit. If the source of the future fund is the existing fiscal reserves, who would benefit from the establishment of the fund and who would pay? A structural deficit is the budget deficit at the potential GDP, while a cyclical deficit is the actual deficit minus structural deficit. As more people retire, the workforce shrinks, fewer people pay taxes and the income tax revenue decreases. On the other hand, the social expenditure on the elderly grows. The fiscal deficit eventually turns into a structural deficit while the ageing population continues to age. For the future fund, if the government broadens the tax base, the current generation would pay but the future generation would benefit because they do not have to pay higher taxes to cover the fiscal deficit.

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The economy is in a boom and the inflationary gap is large. a. Describe the discretionary and automatic fiscal policy actions that might occur. Fiscal policy that decreases expenditure or increases taxes would decrease aggregate demand. In terms of automatic fiscal policy, need-tested spending decreases in expansions and tax revenue increases. Congress might also use discretionary policy by cutting spending programs or increasing tax rates.

b. Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects. A decrease in government expenditure with an offsetting decrease in autonomous taxes would not bring a change in government saving and so would not change investment and the growth of real GDP.

22.

The economy is growing slowly, the inflationary gap is large, and there is a budget deficit. a. Do we know whether the budget deficit is structural or cyclical? Explain your answer. The economy is at an above full-employment equilibrium because there is an inflationary gap. Real GDP exceeds potential GDP. There is a budget deficit, but with potential GDP greater than real GDP there is a cyclical surplus. The structural deficit is larger than the total budget deficit because the cyclical surplus offsets some of structural deficit. So the budget deficit is composed of a structural deficit and a cyclical surplus.

b. Do we know whether automatic stabilizers are increasing or decreasing aggregate demand? Explain your answer. We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap.

c. If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance? Explain your answer. A discretionary decrease in government expenditure decreases the structural deficit. Following the change in fiscal policy, government outlays would be smaller even when the economy returned to full employment.

Use the following news clip to work Problems 23 to 25. Is Fiscal Stimulus Necessary? China’s economy is slowing from its normal 9 percent or higher rate to just below 9 percent. The source of the slowdown is the global economic slowdown that is restricting exports growth and the government’s deliberate decision to discourage unproductive investment. The situation now is not like that in 2008 when real GDP growth dropped from 9 percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed. Source: China Daily, June 8, 2012 23.

Explain why fiscal stimulus was needed in 2008 but not in 2012. Fiscal stimulus was needed in 2008 because the growth rate of the Chinese economy significantly slowed. The slowdown in the growth rate in 2012 is much milder and hence fiscal stimulus is not needed.

24.

Would you expect automatic stabilizers to be operating in 2012 and if so, what effects might they have? China’s automatic stabilizers will operate in 2012. China has fewer automatic stabilizers than the United States because China has fewer unemployment benefit programs and fewer welfare programs. China’s income tax, however, will operate as an automatic stabilizer as fewer people rise into higher tax brackets and some fall into lower tax brackets.

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25.

Why might a stimulus come too late? What are the potential consequences of a stimulus coming too late? Stimulus might come too late because forecasters’ predictions that the slowdown in China’s growth will be slight might prove incorrect. So stimulus might be delayed until the economy was actually in a recession. If this outcome occurred, the unemployment rate would already have risen and real GDP already have decreased because of the delay in implementing the program. Additionally, if the program is implemented too late, then GDP might already be rising and unemployment falling when the program’s impacts occur, which could result in a significantly higher price level.

Economics in the News 26.

After you have studied Reading Between the Lines on pp. 380–381 (788–789 in Economics), answer the following questions. a. What was the state of the Japanese economy in 2013? After a long period of slow economic growth, in 2013 Japan’s economy was in a recessionary gap. Gross government debt was 250 percent of GDP. The nation’s population as ageing and its Social Security payments had skyrocketed to about a third of the government’s total budget.

b. Explain the effects of Japan’s high level of government spending and debt the level of employment and potential GDP. The high level of government debt and deficit had crowded out private investment, thereby decreasing potential GDP. The decrease in potential GDP decreased employment.

c. Explain how inflation and faster growth might lower Japan’s government debt ratio and why neither is an attractive option. Increasing either inflation or faster growth reduces the ratio of debt to nominal GDP. Faster growth is hard to achieve and increasing inflation would adversely affect workers with long-term labor contracts (because higher inflation reduces their real wage rates) and savers (because higher, unanticipated inflation reduces the real value of the savings).

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d. Explain how monetary policy might be used to offset a fiscal-policy induced decrease in aggregate demand and draw a graph to illustrate your answer. Monetary policy can be used to increase aggregate demand, thereby offsetting the decrease brought about by fiscal policy. This offset prevents real GDP and employment from decreasing. In Figure 13.7, the initial aggregate demand curve is AD0 so that real GDP is ¥540 trillion and the price level is 122. Fiscal policy designed to decrease the deficit decreases aggregate demand to AD1 so that real GDP decreases to ¥520 trillion yen. But the expansionary monetary policy could increase aggregate demand, shifting it from AD1 back to AD0. Real GDP remains at ¥540 trillion. .

27. More Fiscal Stimulus Needed? In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries. a. Do you agree with Krugman and Stiglitz? Why? Students who agree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy will not return to full employment rapidly without further government stimulus. Students who disagree with Mr. Krugman and Mr. Stiglitz likely believe that the U.S. economy is on track to return to full employment.

b. What are the dangers of not engaging in further fiscal stimulus? If the economy is not returning to full employment, fiscal stimulus might be necessary. In this situation, if there is no fiscal stimulus, the economy will remain mired in a recessionary gap and unemployment will exceed natural unemployment.

c. What are the dangers of embarking on further fiscal stimulus when the budget is in deficit? The fiscal stimulus will further increase the budget deficit. The rise in the deficit increases the government’s demand for loanable funds and thereby raises the real interest rate. The higher real interest rate decreases—crowds out—investment. The net effect on aggregate demand is uncertain: The fiscal stimulus increases aggregate demand; however, the decrease in investment expenditure decreases aggregate demand. If aggregate demand does not change, there is no immediate effect on real GDP. But the decrease in investment lowers the future capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S. economic growth will be slower.

28. Payroll Tax Cut Is Unlikely to Survive Into Next Year The payroll tax holiday in 2012 reduced workers’ tax by $700 for an income of $35,000 a year and by $2,202 for incomes of $110,100 and over. If the tax holiday ends, the Economic Policy Institute recommends replacing the payroll tax cut with infrastructure spending. Source: The New York Times, September 30, 2012 a. Explain how a payroll tax affects the before-tax and after-tax wage rate and employment and unemployment. The payroll tax places a wedge between the before-tax wage rate and the after-tax wage rate. The payroll tax raises the before-tax wage rate (though by less than the amount of the tax) and lowers the after-tax wage rate. Employment decreases and unemployment increases.

b. Explain the effects of an increase in infrastructure spending on employment and unemployment. In the short-run, an increase in infrastructure increases aggregate demand, which increases real GDP and thereby increases employment and decreases unemployment. In the longer-run, an increase in

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infrastructure spending increases the nation’s productive resources, which increases potential GDP and short-run aggregate supply. The increase in short-run aggregate supply increases employment and decreases unemployment.

c. Which fiscal policy action would have the bigger effect on employment: continuing the payroll tax cut or new infrastructure spending? The payroll tax cut has only an aggregate supply effect; the infrastructure spending increases both aggregate supply and aggregate demand. Because the increase in infrastructure spending affects both aggregate demand and aggregate supply, it might have a larger effect on employment.

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MONETARY POLICY**

Answers to the Review Quizzes Page 390 1.

(page 798 in Economics)

What are the objectives of monetary policy? As set out in law, the objectives of monetary policy are to achieve “maximum employment, stable prices, and moderate long-term interest rates.”

Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run? The monetary policy goals are essentially in harmony for the long run. In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible. In the short run, however, the monetary policy goals might conflict with each other. In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession. The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate.

What is the core inflation rate and how does it differ from the overall CPI inflation rate? The core inflation rate is the rate of increase in the core PCE deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is smoother, that is, less volatile than the actual inflation rate.

Who is responsible for U.S. monetary policy? The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S. monetary policy.

Page 392 1.

(page 800 in Economics)

What is the Fed’s monetary policy instrument? While the Fed could use the quantity of money, the exchange rate, or a short-term interest rate, the Fed chooses to use a short-term interest rate, in particular, the federal funds rate. The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other.

2. *

How is the federal funds rate determined in the market for reserves?

* This is Chapter 31 in Economics.

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The federal funds rate is determined by equilibrium in the reserve markets. The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied.

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What are the main influences on the FOMC federal funds rate decision? Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed seems to respond to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate.

Page 401 1.

(page 809 in Economics)

Describe the channels by which monetary policy ripples through the economy and explain how each channel operates. When the Federal Reserve lowers the federal funds rate, other short-term interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for U.S. dollars since the interest yield on dollars is lower. When the Federal Reserve lowers the federal funds rate it does so by buying securities in the open market. Bank reserves increase so that banks have excess reserves. Because banks have excess reserves, they loan the excess. Loans increase and a multiple expansion of the quantity of money results. The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase.

Do interest rates fluctuate in response to the Fed’s actions? Yes, interest rates fluctuate in response to the Fed’s actions. Indeed, the first effect of a change in monetary policy is a change in the federal funds interest rate.

How do the Fed’s actions change the exchange rate? A change in the U.S. interest rate changes the U.S. interest rate differential. For example, a rise in the U.S. interest rate, other things remaining the same, means that the U.S. interest rate differential increases. When the U.S. interest rate differential increases people want to move funds from other countries into the United States to obtain the relatively higher returns on U.S. assets. To move funds into the United States, people buy dollars and sell other currencies, driving the price of the dollar up. A higher dollar means that foreigners must pay more for U.S.-made goods and services and Americans pay less for foreign goods and services. So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports.

How do the Fed’s actions influence real GDP and how long does it take for real GDP to respond to the Fed’s policy changes? The Fed’s actions affect real GDP by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that real GDP growth increases. The effect on real GDP is far from immediate because there are time lags in the process. Real GDP initially responds about two years after the policy is initiated.

How do the Fed’s actions influence the inflation rate and how long does it take for inflation to respond to the Fed’s policy changes? The Fed’s actions affect the inflation rate and the price level by changing expenditure plans. For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports. All three of these changes boost aggregate demand so that the price level rises and the inflation rate increases. The effect on the price level and inflation rate is far from immediate because there are time lags in the process. The change in inflation is slower than the change in real GDP.

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Page 405 1.

(page 813 in Economics)

What are the three ingredients of a financial and banking crisis? A financial and banking crisis occurs when there is a widespread fall in assets prices, a significant currency drain, and a run on banks. When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities.

What are the policy actions taken by the Fed and the U.S. Treasury in response to the financial crisis? The Fed and the U.S. Treasury have undertaken eight policies designed to combat the financial crisis. The Fed conducted massive open market operations to provide liquidity to banks. To provide liquidity to money market funds, the Fed also created an asset-backed commercial paper money market mutual fund liquidity facility. To provide liquidity to other financial institutions, the Fed allowed created programs that allowed term auction credit and also primary dealer and other broker credit. The U.S. Treasury engaged in two Troubled Asset relief Programs, TARP 1 and TARP 2. TARP 1 was designed to give banks more liquidity. Under it banks were to sell troubled assets to the U.S. Treasury in exchange for U.S. government assets. This program did not work well and was replaced by TARP 2. Under TARP 2 the U.S. Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely. Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets. This change also increased their solvency and made failure less likely.

Why was the recovery from the 2008–2009 recession so slow? The recovery from the recession has been slow because investment has not rebounded. Investment has remained low because of uncertainty about the future.

How might inflation targeting improve the Fed’s monetary policy? Inflation targeting, under which the Fed would make public its inflation target and face penalties if the target was missed, would improve the Fed’s monetary policy because it would remove uncertainty. The public would know what the Fed’s policy was and would not need to guess at what the inflation rate would be the future. This certainty would improve people’s decision making about saving and investment and thereby improve economic performance.

How might using the Taylor rule improve the Fed’s monetary policy? The Taylor rules is a formula that sets the federal funds rate according to the inflation rate and the output gap. This rule has worked well in computer simulations when it comes to avoiding excessive inflation or recessions. Given this track record, it might improve the Fed’s monetary policy and make the Fed better able to avoid high inflation and recessions. It also has the advantage of inflation targeting insofar as it removes uncertainty about what will be the Fed’s policy.

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Answers to the Study Plan Problems and Applications 1.

“Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed’s monetary policy.” Evaluate this statement and explain why the Fed’s primary policy goal is price stability. The Fed’s primary goal is price stability because price stability helps the Fed reach all three of its goals of maximum employment, stable prices, and moderate long-term interest rates. Price stability directly meets the second goal of price stability. And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate. Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate.

“Monetary policy is too important to be left to the Fed. The President should be responsible for it.” How is responsibility for monetary policy allocated among the Fed, the Congress, and the President? The Fed has primary responsibility for the nation’s monetary policy. It is the FOMC that decides upon monetary policy. The Congress plays, at best, a minor role. Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times. The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions.

Fed’s Easing Has Little Impact So Far The Federal Reserve’s latest easing program may be nicknamed “QE Infinity” on Wall Street, but it’s having a limited effect on the economy so far. Source: cnbc.com, October 3, 2012 a. What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money? The Federal Reserve Act of 2000 says that the Fed “shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

b. How can the massive increase in the monetary base resulting from “quantitative easing” or QE be reconciled with the Federal Reserve Act of 2000?

The Fed is charged with setting monetary growth to “promote effectively the goal(s) of maximum employment.” The massive increase in the monetary base attempts to decrease the unemployment rate from its level at the time, near 9.5 percent, to something closer to the natural unemployment rate, thereby helping to achieve its goal of maximum employment.

What are the two possible monetary policy instruments, which one does the Fed use, and how has its value behaved since 2000? The Fed could use either the monetary base or the federal funds rate as its monetary policy instrument. The Fed has chosen to use the federal funds rate. Since 2000 the federal funds rate has been on a roller coaster. Starting from about 6.5 percent in early 2000, the federal funds rate fell for the next four years until it reached 1 percent in the second quarter of 2004. From that time the federal funds rate rose to slightly more that 5 percent in 2006 and 2007. After 2007 the federal funds rate fell until it hit its historic low, 0.2 percent in 2008. From 2008 until 2015, the federal funds rate has stayed at or below this historic low.

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How does the Fed hit its federal funds rate target? Illustrate your answer with an appropriate graph. To hit its federal funds rate target, the Fed uses open market operations to change the quantity of reserves. Figure 14.1 illustrates this process. Initially the federal funds rate target is 5.25 percent. The quantity of reserves is $100 billion, as indicated by RS0. If the Fed wants to lower the federal funds rate to 2 percent, the Fed will use open market purchases of government securities to increase reserves to $200 billion. These open market operations will shift the supply of reserves curve to RS1 and thereby lower the equilibrium federal funds rate to the targeted value, 2.00 percent.

What does the Fed do to determine whether the federal funds rate should be raised, lowered, or left unchanged? The Fed changes in the federal funds rate based on its forecasts of the three economic variables: the inflation rate, the unemployment rate, and the output gap. If the inflation rate is forecasted to rise, the unemployment rate is forecasted to fall, or the output gap is forecasted to fall and perhaps become an inflationary gap, the Fed might be concerned about inflation and push the federal funds rate up. If the inflation rate is forecasted to fall, the unemployment rate is forecasted to rise, or the output gap is forecasted to rise, the Fed might be concerned about unemployment and push the federal funds rate down.

Use the following news clip to work Problems 7 and 8. Fed Sees Unemployment and Inflation Rising It is May 2008 and the Fed is confronted with a rising unemployment rate and rising inflation. Source: CNN, May 21, 2008 7. Explain the dilemma faced by the Fed in May 2008. Rising unemployment calls for expansionary monetary policy, that is, a cut in the interest rate to lower the unemployment rate. This policy, however, raises the inflation rate. Rising inflation calls for a contractionary monetary policy, that is, a hike in the interest rate to lower the inflation rate. This policy, however, raises the unemployment rate. So if the Fed combats unemployment, it worsens the inflation problem. But if the Fed combats inflation, it worsens the unemployment problem.

8. a. Why might the Fed decide to cut the interest rate in the months after May 2008? The Fed might have decided to cut the interest rate after May 2008 if unemployment worsened and became a more severe problem than inflation.

b. Why might the Fed have decided to raise the interest rate in the months after May 2008?

The Fed might have decided to raise the interest rate after May 2008 if inflation worsened and became a more severe problem than unemployment.

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Use the following data to work Problems 9 to 11. The Bureau of Economic Analysis reported that business investment in the second quarter of 2012 was $1,483 billion, $97 billion less than in 2008. 9. Explain the effects of the Fed’s low interest rates on business investment and use a graph to illustrate your explanation. The low interest rates are achieved by increasing banks’ reserves, which leads to an increase in the supply of loanable funds. Then, as illustrated in Figure 14.2, the increase in the supply of loanable funds lowers the real interest rate, in the figure from 5 percent per year to 3 percent per year. The fall in the real interest rate increases firms’ purchase of investment items, such as factories, plants, machine tools, and so forth, because it makes their purchase less expensive.

10.

Explain the effects of business investment on aggregate demand. Would you expect it to have a multiplier effect? Why or why not? The increase in investment increases aggregate demand as illustrated in Figure 14.3. It is likely that the increase in investment has a multiplier effect. The initial increase in investment increases real GDP and consumers’ disposable income. In turn the increase in disposable income induces additional consumption expenditure, which serves to further increase aggregate demand and real GDP.

11.

What actions might the Fed take to stimulate business investment further? The Fed might commit to keeping the inflation rate low by stating that it will raise the interest rate at some specified point in the future if inflation starts to pick up. This commitment would help dispel fears of inflation. It would also make clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the interest rate rises. This belief would lead firms to increase their investment at the present time.

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Use the following news clip to work Problems 12 to 14. IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe The IMF said the global economic slowdown is worsening and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump. Source: Reuters, October 9, 2012 12. If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2013? The “global economic slowdown” means that the output gap will probably increase and the unemployment rate will either rise or not change.

13. a. What actions taken by the Fed in 2011 and 2012 would you expect to have influenced real GDP growth in 2013? Explain how those policy actions would transmit to real GDP. The Fed has undertaken monetary stimulus of almost historic proportions. The Fed has driven the federal funds rate to its lowest level ever, virtually 0 percent. The Fed has engaged in bouts of quantitative easing. These expansionary policies are designed to increase consumption expenditure, net exports, and particularly investment and thereby increase aggregate demand. The Fed’s goal is to increase aggregate demand and by so doing increase real GDP and employment, which would lower the stubbornly high unemployment rate.

b. Draw a graph of aggregate demand and aggregate supply to illustrate your answer to part (a). Figurer 14.4 shows the outcome described in part (b). In the absence of the Fed’s policy, the aggregate demand curve would be AD0 and the aggregate supply curve would be SAS. The Fed’s expansionary policies increased aggregate demand so the aggregate demand curve shifts to AD1. In the absence of the Fed’s policies, real GDP would be $12.7 trillion and the price level would be 119. The Fed’s expansionary policies have raised the price level to 121 and increased real GDP to $12.9 trillion.

14.

What further actions might the Fed take in 2013 to influence the real GDP growth rate in 2014? (Remember the time lags in the operation of monetary policy.) The time lags in the operation of monetary policy suggest that any further expansionary policy the Fed takes in 2013 likely will have a small effect in 2014. If, early in 2013 the Fed conducts a further quantitative easing, by buying a significant quantity of assets, there might be a positive impact on real GDP and employment in late 2014.

15.

Prospects Rise for Fed Easing Policy William Dudley, president of the New York Fed, raised the prospect of the Fed becoming more explicit about its inflation goal to “help anchor inflation expectations at the desired rate.” Source: ft.com, October 1, 2010 What monetary policy strategy is Mr. Dudley raising? How does inflation targeting work and why might it “help anchor inflation expectations at the desired rate”? Mr. Dudley is suggesting that the Fed move toward inflation rate targeting. If the Fed followed a policy of inflation rate targeting, it would make a public commitment about its inflation rate target and would explain how its policy actions will achieve its goal. Inflation rate targeting gives the public guidance about what the central bank expects the inflation rate will be. This will help “anchor inflation expectations” and, as long as the announced inflation rate target is the desired rate, it will help anchor the expectations “at the desired rate.”

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Answers to Additional Problems and Applications

Use the following information to work Problems 16 to 18. The Bank of Korea’s monetary policy is to reduce the vulnerability of South Korean won and achieve price stabilization through increasing money supply and lowering interest rates. 16. How does the Bank of Korea attempt to minimize the output gap through money supply and interest rates? To minimize the output gap (recessionary gap), as the Bank of Korea increases money supply by buying securities in an open-market operation, the Bank of Korea base rate falls. A lower interest rate boosts investment expenditure. As the interest rates fall in comparison to other countries, say, the U.S., keeping other factors unchanging, the South Korean won depreciates against the U.S. dollar, which increases net exports. The combined effect is that aggregate demand increases, implying a rightward shift in the aggregate demand curve. A multiplier process begins too. The increase in aggregate demand increases income, which in turn induces an increase in consumption expenditure. Aggregate demand further shifts to the right and the new equilibrium GDP will be higher. Money supply keeps increasing until the equilibrium GDP reaches the potential GDP.

17.

How does the policy affect the price level in the short run and the long run? Given the short-run aggregate supply, when aggregate demand keeps increasing due to continuous increase in money supply, the price level continues to increase until the potential GDP is reached. At full-employment equilibrium, the price level remains stable.

18.

Can the Bank of Korea achieve price stability and economic growth simultaneously? The Bank of Korea cannot have both price stability and economic growth simultaneously in the short term. Lowering inflation rate to achieve price stability might entail increasing interest rate which would lower employment and real GDP, thereby discouraging economic growth. The central bank has to prioritize. In the years of 2014 and 2015, the Bank of Korea has been found inclined to have economic growth as its first priority while accepting a small increase in price in the short run.

19.

What is the core inflation rate and why does the Fed regard it as a better measure on which to focus than the CPI? The core inflation rate is the rate of increase in the core personal consumption expenditure (PCE) deflator. The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel. The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy. Accordingly, the core inflation rate is the inflation rate over which the Fed believes it has the greatest control.

20.

Suppose Congress decided to strip the Fed of its monetary policy independence and legislate interest rate changes. How would you expect the policy choices to change? Which arrangement would most likely provide price stability? If interest rates are determined by Congress, there would be a bias toward persistently increasing monetary growth to keep the interest rate low and help the re-election prospects of legislators. While this policy is successful in the short run, in the long run the higher monetary growth leads to higher inflation. In turn, the higher inflation rate leads to a higher nominal interest rate. Keeping the Fed independent of Congress is most likely to provide price stability.

Use the following CBO report to work Problems 21 to 23. Fiscal 2012 Deficit: Smaller, But Still Big The budget deficit was about $1.1 trillion in fiscal year 2012, CBO estimates. That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II. Source: Congressional Budget Office 21. How does the federal government get funds to cover its budget deficit? How does financing the budget deficit affect the Fed’s monetary policy? The federal government borrows the funds. Borrowing, by selling government securities, is how the

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federal government funds its budget deficit. When the government borrows to fund its deficit, the increased demand for loanable funds raises the real interest rate. The budget deficit has no direct impact on the Federal Reserve’s monetary policy. But the budget deficit might exert an indirect effect. For its monetary policy, the Federal Reserve targets the federal funds rate and uses open market operations to meet the target. When government borrowing raises the real interest rate, the federal funds rate rises. The rise in the federal funds rate might affect the Fed’s assessment of the level at which to target the federal funds rate.

22.

How was the budget deficit of 2012 influenced by the Fed’s low interest rate policy? The Fed’s low interest rate policy lowered the interest payments the federal government had to make on its debt. Therefore the low interest rate policy decreased the amount of government spending and hence decreased the size of the government budget deficit.

23. a. How would the budget deficit change in 2013 and 2014 if the Fed moved interest rates up? If the Fed boosts interest rates, the government payments on its debt will increase. The higher payments increase the amount of government spending and therefore increase the size of the budget deficit.

b. How would the budget deficit change in 2013 and 2014 if the Fed’s monetary policy led to a rapid depreciation of the dollar? A rapid depreciation of the dollar can have two effects on the budget deficit. First it can increase the U.S. inflation rate. With the increase in the inflation rate, inflation expectations would increase, thereby increasing interest rates. The increase in the interest rate increases the budget deficit because the government must increase the interest payments it makes on its debt. Second, a rapid depreciation of the dollar can also increase U.S. net exports which decreases the U.S. unemployment rate. A decrease in unemployment decreases the needs-based expenditure the government must make and thereby lowers the budget deficit.

24.

The Federal Reserve Act of 2000 instructs the Fed to pursue its goals by “maintain[ing] long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production.” a. Has the Fed followed this instruction? The Fed would argue that it has tried to follow this instruction. The Fed would point to the relatively low inflation rate as evidence that it did not let the growth rate of the quantity of money get out of hand. And the Fed would argue that the financial crisis and ensuing recession is not the fault of its monetary policy.

b. Why might the Fed increase money by more than the potential to increase production? During a recession the Fed increases the quantity of money by more than the “long-run potential” in an effort to conduct a monetary policy that moves real GDP back to its “long-run potential.”

25.

Looking at the federal funds rate since 2000, identify periods during which, with the benefit of hindsight, the rate might have been kept too low. Identify periods during which it might have been too high. Some analysts assert that the federal funds rate was too low during the period from 2001 to 2005. During this period house prices skyrocketed. It was the following rapid fall in house prices, starting in 2006, that helped lead to the financial crisis. These analysts say that if the Fed had raised interest rates earlier, then demand for housing would have not been as strong, thereby limiting the rise in house prices. Some observers believe that the Fed kept interest rates too high at the start of in 2000 and in 20062007. In both periods the economy was poised to enter a recession. These observers say that if the Fed had lowered the interest rate before the economy entered the recession, the following recession would have been milder and might have been avoided all together.

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26.

Now that the Fed has created $3 trillion of bank reserves, how would you expect a further open market purchase of securities to influence the federal funds rate? Why? Illustrate your answer with an appropriate graph. The Fed’s immense creation of $3 trillion of bank reserves might mean that further open market operations would have no effect on the federal funds rate. The $3 trillion of reserves has sent the federal funds to virtually 0 percent, so there is little room for it to fall further. At this exceedingly low federal funds rate, banks might be willing to hold any quantity of additional reserves. In this situation, as Figure 14.5 illustrates, the demand curve for reserves is horizontal. If the demand curve for reserves is flat, then increasing the quantity of reserves has no effect on the federal funds rate because banks merely hold the additional reserves. Banks hold the reserves because the opportunity cost of holding them rather than loaning them in the federal funds market is so low.

27.

What is the Beige Book and what role does it play in the Fed’s monetary policy decision-making process? The Beige Book is a key element in the Fed’s monetary policy decision-making process. The Beige Book summarizes economic conditions within each of the Federal Reserve districts. It provides the FOMC important information about the current state of the economy that, together with forecasts of the future evolution of the economy, determines the nation’s monetary policy.

To work Problems 28 to 30, use the information that during 2012 the inflation rate increased but remained in the “comfort zone” and the unemployment rate remained high. 28.

Explain the dilemma that rising inflation and high unemployment poses for the Fed. Raising inflation and high unemployment pose a dilemma for the Fed because the policy necessary to decrease one of these factors increases the other. On one hand, to control inflation, the Fed must raise the interest rate and decrease growth in the quantity of money. But this policy raises the unemployment rate. However, on the other hand to control high unemployment the Fed needs to lower the interest rate and increase the growth rate of the quantity of money. But this expansionary policy raises the inflation rate.

29.

Why might the Fed decide to try to lower interest rates (or stimulate in other ways) in this situation? The Fed might lower the interest rate because it perceives high unemployment as a larger problem than inflation because inflation, while increasing, was in the “comfort zone.”

30.

Why might the Fed decide to raise interest rates in this situation? The Fed might raise the interest rate if it perceives that inflation will rise outside of its comfort zone and if it perceives the rising inflation as a larger problem than the high unemployment.

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Use the following information to work Problems 31 to 33. From 2009 through 2012, the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent to 2 percent. During that same period, the federal funds rate was roughly constant at 0.25 percent a year. 31. What role does the long-term real interest rate play in the monetary policy transmission process? The long-term real interest rate plays an important part in the monetary transmission process. Both consumption expenditure and investment respond to the long-term real interest rate. When the longterm real interest rate falls, consumption expenditure and investment both increase. The increase in consumption expenditure and investment increase aggregate demand and thereby increase real GDP and the price level.

32.

How does the federal funds rate influence the long-term real interest rate? The long-term interest rate is an expected average of short-term interest rates. People can either borrow or save by making a long-term commitment or by making successive short-term commitments. Adjusted for risk, the average of the interest rates on the short-term commitments must equal the long-term interest rate. If they were not equal one method of borrowing would be more or less expensive than the other. People would stream to borrow using the less expensive method, pushing that interest rate higher, back toward equality. Simultaneously other people would stream to save using the method with the higher return, pushing that interest rate lower, back toward equality. When the Fed lowers the federal funds rate, other short-term interest rates also fall. This fall makes borrowing by using a series of short-term loans less expensive and saving using a series of short-term commitments less profitable. The demand for long-term loans falls, which lowers the long-term interest rate and the supply of long-term saving commitments rises, which also lowers the long-term interest rate. So a fall in the federal funds rate lowers the long-term real interest rate.

33.

What do you think happened to inflation expectations between 2009 and 2012 and why? Inflation expectations probably increased. The expected inflation rate equals the nominal interest rate minus the real interest rate. Over this time period, the federal funds rate did not change, so the nominal interest rate did not change. But the real interest rate fell. Therefore inflation expectations increased.

34.

Dollar Reaches New Low vs. Yen Traders continued to make bets in favor of the yen, sending the dollar to a record low against the Japanese currency. Source: The Wall Street Journal, August 20, 2011 a. How do “bets in favor of the yen” influence the exchange rate? “Bets in favor of the yen” are “bets” that the yen will rise in the future. To place this “bet,” traders need to buy yen. The demand for yen increases, which raises the value of the yen and lowers the dollar exchange rate.

b. How does the Fed’s monetary policy influence the exchange rate?

The Fed’s monetary policy affects U.S. interest rates, which affect the exchange rate. For example, if people expect the Fed to either lower U.S. interest rates or else keep U.S. interest rates lower for a longer period of time, the fall in expected interest rates lowers the exchange rate. U.S. savers become more likely to sell dollars to acquire foreign exchange to save abroad, so the supply of dollars increases. Foreign savers become less likely to buy dollars to save in the United States, so the demand for dollars decreases. On both counts the U.S. exchange rate falls.

MONETARY POLICY

Use the following news clip to work Problems 35 and 36. As US Growth Lags, Some Press the Fed to Do Still More The Fed’s campaign to increase growth is not working. Economists blame the prudent, slow-acting monetary policy of the Fed, especially with regard to the pace of inflation, for the growth lags. Source: The New York Times, Feb 1, 2013 35. The short-term interest rates have been held near zero since December 2008. The Fed is being urged to push inflation to accelerate growth. How does the monetary policy of managing inflation expectations help? Long-term real interest rate equals long-term nominal interest rate minus expected inflation rate. Given the nominal interest rate is near zero, if the Fed pushes inflation, inflation expectations will rise, the real interest rate will fall. Other things remaining the same, the lower the real interest rate, the greater the investment and consumption expenditure. Aggregate demand increases, which increases real GDP.

36.

Describe how the slow response of the real economy to the monetary policy of the Fed can explain the growth lag. The lags between the Fed’s actions and their effect on the real economy are substantial It takes time before the policy affects output. Even if the interest rate drops, firms are unlikely to change their investment plans immediately. Consumers may not increase their consumption, if they are not sure that their incomes are going to increase in the long run. In addition, lower interest rates lead to a depreciation of home currency, but exports may not increase and imports may not decrease immediately as the amount of exports and import are bound by contracts, schedules and production plans for a period of time.

37.

Philly Fed’s Plosser Opposes QE3 Federal Reserve Bank of Philadelphia president Charles Plosser does not think that monetary policy can “do much to speed up the slow progress” in the labor market and opposes the Fed’s latest round of stimulus, known as QE3, saying he does not think it prudent to risk the Fed’s hard-won credibility. Source: Philadelphia Inquirer, September 25, 2012 a. Describe the QE3 asset purchases that are causing Charles Plosser concern. Mr. Plosser is concerned about the Fed’s large purchases of mortgage-backed securities.

b. How might asset purchases damage the Fed’s credibility?

The asset purchases might cause people to doubt the Fed’s commitment to price level stability. The asset purchases increase banks’ reserves and if banks loan these reserves, the money supply could expand significantly and with it the price level and inflation rate might jump higher.

38.

Suppose that the Reserve Bank of New Zealand is following the Taylor rule. In 2012, it sets the official cash rate (its equivalent of the federal funds rate) at 4 percent a year. If the inflation rate in New Zealand is 2 percent a year, what is its output gap? The Taylor rule sets the official cash rate according to CASH = 2 + INF + 0.5(INF − 2) + 0.5GAP. So the with a cash rate of 4 percent and an inflation rate of 2 percent, the Taylor rule is that 4 = 2+ 2 + 0.5(2 – 2) + 0.5GAP, or 4 = 4 + 0.5GAP. The last equation shows that the output gap is 0 percent.

Use the following news clip to work Problems 39 and 40. Bernanke on Inflation Targeting Inflation targeting promotes well-anchored inflation expectations, which facilitate more effective stabilization of output and employment. Thus inflation targeting can deliver good results with respect to output and employment as well as inflation. Source: Federal Reserve Board, remarks by Ben Bernanke to the National Association of Business Economists, March 25, 2003 39.

What is inflation targeting and how do “well anchored inflation expectations” help to achieve

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more stable output as well as low inflation? Inflation targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve a specific inflation rate goal. Inflation rate targeting helps “anchor expectations” because the public has a good idea of hat the inflation rate will be. There are fewer gyrations in inflation expectations which lead to fewer changes in the real interest rate and, accordingly fewer changes in investment and consumption expenditure. Because aggregate demand is more stable, so, too, is output.

40.

Explain how inflation targeting as described by Ben Bernanke is consistent with the Fed’s dual mandate. The Fed’s dual mandate is to maintain stable prices and maximum employment. By setting a low inflation rate target, the Fed directly helps achieve its goal of stable prices , which is the best environment for households and firms to make the saving and investment decisions. By limiting fluctuations in aggregate demand, the Fed can keep real GDP growing at a rate that more closely approximates its long-term trend.

Economics in the News 41.

After you have studied Economics in the News on pp. 406–407 (814–815 in Economics) answer the following questions. a. What was the state of the U.S. economy in the fall of 2014 when the Fed made the decision to commit to keeping interest rates low for a “considerable time”? The economy was mired in a very slow recovery from a very deep recession. The unemployment rate was high by historical standards and a recessionary gap existed. The Fed was concerned by the slow recovery from the recession.

b. What was the FOMC majority expectation about future employment, real GDP, and inflation in September 2014? The majority view was that the economy still had a large recessionary gap. The majority expected that fed policy would lead to further increases in employment and real GDP while the inflation rate would remain low.

c. How would an earlier and faster rise in interest rates influence aggregate demand?

An earlier and faster rise in interest rates would lead to an earlier and stronger restraint on the growth of consumption expenditure and investment and, thereby, an earlier and stronger restraint on the growth of aggregate demand.

d. If the San Francisco Fed view of the output gap is correct, where will interest rates be in 2016 and 2017? Why?

If the San Francisco Fed view of the output gap is correct, the Fed’s policy will lead to an inflationary gap. Real GDP will exceed potential GDP and the inflation rate will start to rise. The rise in the inflation rate will raise interest rates. And the Fed’s policy of raising the interest rate to lower the inflation rate will lead to a further rise in interest rates.

MONETARY POLICY

42.

Fed’s Evans: Offers Full Support for New Stimulus Federal Reserve Bank of Chicago President Charles Evans expressed strong support for the new stimulus provided by the central bank saying, “This was the time to act” and adding, “I am optimistic that we can achieve better outcomes through more monetary policy accommodation.” Source: The Wall Street Journal, September 18, 2012 a. Why, in the economic conditions of September 2012, was Charles Evans happy to see the Fed stimulating the economy? Mr. Evans was concerned that the economy still had a large recessionary gap and that the economy might even move into another recession.

b. What would be the effects of the Fed’s QE3 and other stimulative actions? Explain the immediate effects and the ripple effects.

If the Fed buys securities, banks’ reserves increase. The federal funds rate falls and along with it other short-term interest rates fall. The exchange rate also falls. The supply of money and the supply of loanable funds increase. The increase in the supply of loanable funds lowers the real interest rate. Consumption expenditure, investment, and net exports increase, which increases aggregate demand. Real GDP increases and the price level rises.

c. What are the risks arising from greater monetary stimulus?

The risk from greater monetary stimulus is significantly higher inflation. If the monetary stimulus is too great, it could propel the United States into a situation in which inflation and inflation expectations soar.

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Part 2: Lecture Notes

C h a p t e r

WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative—an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits. Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

N e w i n t h e Tw e l f t h E d i t i o n In all the chapters, the “Reading Between the Lines” sections are now called “Economics in the News.” A new exciting feature is a full-page end-of-chapter worked problem. The Worked Problem gives students an opportunity to work a multi-part problem that covers the core content of the chapter and consists of questions, solutions, and key figures. The answers help the students realize whether their grasp of the material is complete or needs additional study to reinforce it. This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. Students relate well to the section on self and social interest which calls out issues of both efficiency and fairness and is great for class discussion. Economics in the News covers some current issues with Facebook and Mark Zuckerberg’s vision to have the Internet available to the whole world.

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Lecture Notes

What Is Economics? I.

Definition of Economics • •

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants. Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time.

Economics • • •

Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices. Economists work to understand when the pursuit of self-interest advances the social interest Economics is divided into microeconomics and macroeconomics: • Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments. • Macroeconomics is the study of the performance of the national economy and the global economy.

On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?” Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money. Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!). The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.” Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.” Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.” A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight.

WHAT IS ECONOMICS?

II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced? What, How and For Whom? • •

• •

Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more MP3s and CDs than 5 years ago. Goods and services are produced using the productive resources called factors of production. These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital). The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training. Owners of the factors of production earn income by selling the services of their factors. Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit.

Do Choices Made in the Pursuit of Self-Interest also promote the social interest? • • •

You make a choice in your self-interest if you think that choice is the best one available for you. An outcome is in the social interest if it is best for society as a whole. A major question economists explore is “Could it be possible that when each of us makes choices in our self-interest, these choices are in the social interest?’

The Two Big Economic Questions Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economic in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions but hold off on the answers letting them know that “we can have a much more fruitful discussion when our toolbox is full.” Remind them that this course is about learning simple economic models that provide tools to seek answers to complex issues. Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer listening to a Garth Brooks CD and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average major-league baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics. Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit). •

We can examine whether the self-interested choices serve the social interest for a variety topics: • Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family • Information-Age Monopolies: A firm producing popular software leads to format standards • Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change • Financial Instability: Bank bailouts with the intent of social interest may cause more risky loans to be made in the future by banks serving their own self-interests.

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III. Economic Way of Thinking Scarcity requires choices and choices create tradeoffs. What is the difference between scarcity and poverty? Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty.

A Choice is a Tradeoff • •

A tradeoff is an exchange—giving up one thing to get another. Whatever choice you make, you could have chosen something else.

Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point: • Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption. • Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production. • Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production.

Making a Rational Choice • •

A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice. But how do people choose rationally? Why do more people choose an iPhone rather than a Windows phone? Why has the U.S. government chosen to build an interstate highway system and not an interstate high-speed railroad system? The answers turn on comparing benefits and costs.

Benefit: What you Gain • • •

The benefit of something is the gain or pleasure that it brings and is determined by preferences—by what a person likes and dislikes and the intensity of those feelings. Some benefits are large and easy to identify, such as the benefit that you get from being in school. Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate. Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza.

Cost: What You Must Give Up Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy. Students like the “Dr. Suess Version”: Opportunity cost is the thing you would have done if you did not do what you did. What is the Opportunity Cost of Getting a College Degree? When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more. Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over.

WHAT IS ECONOMICS?

To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

How Much? Choosing at the Margin •

• •

Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost). Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change. For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework.

Choices Respond to Incentives • •

Economists take human nature as given and view people acting in their self-interest. Self-interest actions are not necessarily selfish actions.

Self interest can be said to be in the eye of the beholder. Thus, covering the next portion on positive versus normative analysis can be crucial to the student’s understanding how economic agents act in their own selfinterests, but perhaps not (and often not) in other’s self-interest.

IV. Economics as Social Science and Policy Tool Economist as Social Scientist •

• •

•

Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.” Economists tend to agree on positive statements, though they might disagree on normative statements. An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world. Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem: • Natural experiment: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal or similar. • Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer). • Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond.

Economic Model vs. the General Lee Car Model When I was a kid, I had a plastic model car that I put together that was from Dukes of Hazard television show (you can insert your own “model” as you’d like). Tell the students, “Even though we all know the model car is not a “real” car, it does give us insights into what the real car is like. You have number on the door, the confederate

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flag on top, the proportions are correct and if you lift the little hood you can see what a V8 engine looks like”. An economic model is similar in that it gives us a glimpse of reality under some certain assumptions and although it is not reality it gives us insights about reality.

Economist as Policy Adviser • •

Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions. For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources.

The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable. Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.)

WHAT IS ECONOMICS?

Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel accomodations on the trip will be $3,000, gasoline will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space. Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highestvalued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel accommodations ($3,000), gasoline ($200), and food ($1,400).

The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1.

Why are economists so concerned about the material aspects of life? Explain that this is a myth! Economists are often criticized for focusing on material well-being because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index (www.freetheworld.com) and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for life-enhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters. (Be careful not to seem to be either condoning or condemning these activities.) Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

Mini Case Study Illustrating How Economists Use Modeling: Women are unfairly underpaid when compared to men. Ask your students whether this statement is positive or normative. Mention that the media frequently reports that the average woman gets paid only 3/4 the wages of the average man. Is this “fact” a sufficient test of the positive statement? If women were paid more than men in one or two professions (like professional modeling or elementary teaching) is that sufficient evidence to conclude that women in general are not underpaid when compared to men? Ask the students to think about how to properly test the model. Are these counter examples enough to discard the idea that women are underpaid? What would you take into account when you collected data to compare women’s salaries versus men’s salaries? Remind the students that any model directly comparing men’s and women’s wages should control for any differences in wage-relevant characteristics between

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working men and women. You can discuss many different reasons why a gender wage gap can occur, including: • Women are underrepresented in higher paid occupations and are overrepresented in lower paid occupations (the problem may not be unequal pay but instead it may be unequal access to high paying jobs (glass ceiling?); • Women are underrepresented among those earning advanced degrees, though mostly among older age cohorts (U.S. Bureau of Labor Statistics, Employment and Earnings, Vol. 45, January, 1998). Here the problem here might not be unequal pay but unequal access to higher education; • Women have relatively less occupational-specific work experience and have relatively less unbroken work experience, as many women struggle between pursuing a career and raising a family. For example, one study found that women who were not mothers earned 90 percent of men’s salaries, whereas those who were mothers earned only 77 percent (Waldfogel, “Understanding the ‘Family Gap’ in Pay for Women with Children,” Journal of Economic Perspectives, Vol. 12, No. 1, 1998). Does it further the public interest (and the interests of women workers specifically) to propagate normative statements about wage inequality based on statistics without taking account of all relevant factors? Summarize the discussion by noting that economic studies have indeed found evidence that a gender gap in wages exists in the United States, even after controlling for all known relevant factors. However, the gender wage gap is much less than the 1/3 number often quoted by the media, and has been decreasing significantly over the last few decades (Blau, “Trends in the Well Being of American Women, 1970-1995,” Journal of Economic Literature, Vol. 36, No.1, March 1998). Get the students to see how properly applying the science of economics to social issues helps us strip away inflammatory rhetoric and examine the problem carefully and objectively.

WHAT IS ECONOMICS?

Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways. 1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means. 2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept. Indicate that this may be a Demand or Supply curve for instance. 3. Schedule Goggles: Draw a simple “T” schedule with X and Y choosing your own numbers to “plug and chug” with the equation you first used. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.”

Graphing Data • • •

Graphs are valuable tools that clarify what otherwise might be obscure relationships. Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin. Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables.

II. Graphs Used in Economic Models •

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables: • A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship. • A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases. • A maximum or a minimum—when the variable has a highest or lowest value.

III. The Slope of a Relationship •

• • •

The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point. • In terms of symbols, the slope equals y/x, with  standing for “change in.” The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related. The slope of a curved line at a point equals the slope of the straight line that is tangent to the curved line at the point. The slope of a curved line across an arc equals the slope of the straight line between the two points on the curved line.

IV. Graphing Relationships Among More Than Two Variables •

A. When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

C h a p t e r

THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them—we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. It then concludes with an explanation of the source of the gains from specialization and exchange and the roles of firms and markets in achieving those gains. Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

N e w i n t h e Tw e l f t h E d i t i o n Chapter 2 has been slightly rewritten. Parts of Joe and Liz’s Smoothie Bar example are written more concisely without a loss or change in content. The “Economics in the News” has a new article on fracking. For all the chapters except Chapter 1, the end of chapter material now includes a new section called Worked Problem. This problem includes questions, solutions, and a key figure. The Worked Problem is available in the Study Plan and the key figure is available as an interactive animation. The Study Plan Problems and Applications have been reduced to one page, but all the deleted questions are available in the Study Plan. Additional problems and Applications remain at two pages. In this chapter the Worked Problem gives data for a production possibilities frontier and then asks a variety of questions. The first question asks the students if a combination of products is attainable and the second question asks if another combination is efficient. The answers point out how the available resources limit production. The next question asks if a combination of products has a tradeoff and the last question asks the opportunity of increasing the production of a product. The answers point out the relationship among production efficiency, tradeoff, and opportunity cost.

THE ECONOMIC PROBLEM

Lecture Notes

The Economic Problem • • •

Scarcity creates the need to make choices. Economic choices can be evaluated in terms of their efficiency. We can expand possible choices through capital accumulation and specialization and trade.

Production Possibilities and Opportunity Cost • •

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology. Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right. Books A B C D

• • •

0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other. The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change. Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods!

Production Efficiency Production is efficient only on the frontier. • We achieve production efficiency if we cannot produce more of one good without producing less of some other good. • Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF •

Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else.

CHAPTER 2

The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production.

Opportunity Cost • •

The opportunity cost of an action is the highest valued alternative forgone. Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier.

Increasing Opportunity Costs • •

•

The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost. Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger. Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies. As more and more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good.

You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve as the slope of a tangent line to the curve, that is, the slope of the line that is “just kissing” the curve at a single point. The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the Ngood model.

THE ECONOMIC PROBLEM

II. Using Resources Efficiently Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points.

The PPF and Marginal Cost • •

Marginal cost is the opportunity cost of producing one more unit of a good. As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

Books 0

200

400

600

Marginal cost of a book (movies per book) 0.5 1.0 1.5

Preferences and Marginal Benefit • • •

Preferences are a description of a person’s likes and dislikes. The marginal benefit of a good or services is the benefit received from consuming one more unit of it. The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward.

You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve. Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively). While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin.

Allocative Efficiency Allocative efficiency occurs only when marginal benefit equals marginal cost. • In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up. • When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month. • When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

CHAPTER 2

III. Economic Growth Economic growth expands production possibilities and shifts the PPF outward. • Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth. You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2008, income per person in the United States was about $100 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes.

The Cost of Economic Growth •

Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth.

A Nation’s Economic Growth • •

Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster. Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth.

Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs.

IV. Gains from Trade Specialization and trade expand consumption possibilities

Comparative Advantage and Absolute Advantage • •

•

A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers. A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities.

An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages.

THE ECONOMIC PROBLEM

Achieving the Gains from Trade •

When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat.

•

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF.

•

The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

You may want to motivate the gains from trade using an example loosely based on Tom Hanks in the movie Castaway. Ask the students, “Was Tom by himself on the island an economy?” Use a couple goods like fish and coconuts and show Tom’s production possibilities. Discuss what are the essential elements needed to have an economy. Tom produces food and then he consumes it but is this sufficient for us to call him an economy? It is an open-ended question that I end with Tom needing somebody to trade with. Once a new person washes up on shore, the two can specialize in the good for which he or she has a comparative advantage and trade for the other. Give one of them an absolute advantage and then show how consumption possibilities lie outside each person’s production possibilities. This shows the power of specialization and trade in a way that personalizes it for the student.

V. Economic Coordination Firms and Markets • •

A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

Property Rights and Money • •

The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology). Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade.

Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves.

Circular Flows Through Markets •

Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it.

CHAPTER 2

Coordinating Decisions •

Prices within markets coordinate firms’ and households’ decisions.

Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth. •

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

THE ECONOMIC PROBLEM

Additional Problems 1.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

Corn (pounds per month) 3.0 2.0 1.0 0

Corn (pounds per month) 6 4 2 0

and and and and

Cloth (yards per month) 0 2 4 6

Cloth (yards per month) 0 1.0 2.0 3.0

In problems 1 and 2, Jane’s Island produces and consumes 2 and pounds of corn and 2 yards of cloth. Joe’s Island produces and and consumes 2 pounds of corn and 2 yard of cloth. Now and the islands begin to trade. and a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Solutions to Additional Problems 1.

Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the yaxis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards. The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth. The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn.

CHAPTER 2

The marginal benefit curve slopes downward. To draw the marginal benefit curve from cloth, plot the quantity of cloth on the x-axis and the willingness to pay for cloth (that is, the number of pounds of corn that Jane is willing to give up to get a yard of cloth) on the y-axis, as illustrated in Figure 2.2. The efficient quantity is 4 yards a month. The efficient quantity to produce is such that the marginal benefit from the last yard equals the opportunity cost of producing it. The opportunity cost of a yard of cloth is 0.5 pound of corn. The marginal benefit of the fourth yard of cloth is 0.5 pound of corn. And the marginal cost of the fourth yard of cloth is 0.5 pound of corn.

Joe’s Island’s opportunity cost of a pound of corn is 1/2 yard of cloth, and its opportunity cost of a yard of cloth is 2 pounds of corn. When Joe’s Island increases the corn it produces by 2 pounds a month, it produces 1 yard of cloth less. The opportunity cost of 1 pound of corn is 1/2 yard of cloth. Similarly, when Joe’s Island increases the cloth it produces by 1 yard a month, it produces 2 pounds of corn less. The opportunity cost of 1 yard of cloth is 2 pound of corn. a.

Jane’s Island sells cloth and buys corn. Jane’s Island sells the good in which it has a comparative advantage and buys the other good from Joe’s Island. Jane’s Island’s opportunity cost of 1 yard of cloth is 1/2 pound of corn, while Joe’s Island’s opportunity cost of 1 yard of cloth is 2 pounds of corn. Jane’s Island’s opportunity cost of cloth is less than Joe’s Island’s, so Jane’s Island has a comparative advantage in producing cloth. Jane’s Island’s opportunity cost of 1 pound of corn is 2 yards of cloth, while Joe’s Island’s opportunity cost of 1 pound of corn is 1/2 yard of cloth. Joe’s Island’s opportunity cost of corn is less than Jane’s Island’s, so Joe’s Island has a comparative advantage in producing corn. With specialization and trade, together they can produce 6 pounds of corn and 6 yards of cloth and each will get 3 pounds of corn and 3 yards of cloth—an additional 1 pound of corn each and an additional 1 yard of cloth each. Hence the total gains from trade are 2 yards of cloth and 2 pounds of corn.

Additional Discussion Questions 1.

Use the PPF model to analyze an “Arms Race” between nations. You might like to get the students to realize how useful even a simple economic model (such as the PPF model) is for helping us understand and interpret important political events in history. Draw a PPF for military goods and civilian goods production (or, simply, the traditional example of “guns versus butter”). Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly “arms race.” Each country picks a point on the PPF that produces an equal level of military output (in absolute terms). What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country.

THE ECONOMIC PROBLEM

What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post–Viet Nam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. What are the implications for the next 50 years? China is currently the world’s second largest economy. It could become the biggest by mid-century. How does this development influence the strategic balance and the position of the United States? 12. Using the PPF model to analyze global environmental agreements between nations. This application of the PPF is a more “green” perspective that uses the same logic as the “Arms Race” on a timely international policy issue. Compare a rich economy PPF to a poor economy PPF, each with the same degree of concavity. (Production levels are now measured as output per person.) The goods are now “cleaner air” and “other goods and services.” What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curves. Show how the opportunity cost of requiring additional pollution reduction (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and African nations). 3.

Why do some of the brightest students not get a Recreation Marginal cost 4.0 GPA? The answer—because it doesn’t achieve (hours per day) (GPA points per hour) allocative efficiency—can now be approached. The 0.5 0.1 first conceptual step is to derive the marginal cost 1.5 0.2 curve from the PPF. The table provides eight points on 2.5 0.3 the MC curve. Tell the students that this table is from 3.5 0.4 a PPF between hours spent at recreation and GPA. 4.5 0.5 Use this opportunity to explain why we plot marginal 5.5 0.6 values at the midpoints of changes because the 6.5 0.7 marginal cost at the midpoint approximately equals the 7.5 0.8 average of the opportunity costs across the interval. The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser. Willingness Each additional hour of recreation likely yields a Recreation to pay smaller marginal benefit to the student. Translate this to the proposition that the student’s willingness to give up GPA points for additional hours of recreation decreases and provide a table similar to that in Figure 2.3 that captures this observation. The table has a preference schedule. Stress once again that this table did not come from the PPF. To determine the efficient amount of recreation and hence study time, the student must ask “Do I study a little bit longer?” That is the question. Walk the student through the thought experiment:

(hours per day)

(GPA points per hour)

0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

CHAPTER 2

If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if a take a bit of time off studying and have some fun. So I will be better off if study less and take more recreation time.

If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time.

The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs—where marginal cost equals marginal benefit.

In this example, the student studies for 4.5 hours and takes 3.5 hours a week of recreation time. Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He or she is just willing to pay what it costs him or her. 4.

Gains from Trade The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do. Here are some questions to drive home the idea of comparative advantage: Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage. Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread. Why doesn’t Vinnie Jones play soccer? Vinnie Jones was one of the world’s best soccer players. But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.

C h a p t e r

DEMAND AND SUPPLY

The Big Picture Where we have been: In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market. Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources. If you have time, it is worth forging links between Chapters 2 and 3. Chapter 2 explains why we trade in markets. Chapter 3 shows how trade in markets determines where on the PPF the economy operates. Where we are going: Demand and supply lie at the heart of the principles course. Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make. And in the macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model.

N e w i n t h e Tw e l f t h E d i t i o n The content of this chapter is largely the same except for the Economics in the News sections, which are now replaced with new current topics of coffee and bananas. The banana article is at the end of the chapter along with the extended Economic Analysis of the end-of-chapter articles. There is a reduction in the section covering all possible shifts of demand and supply. The content now focuses on situations where both curves shift, which allows for two simpler figures to be used to illustrate shifts. The single shifts of curves are already covered earlier so there is no loss of content. There is a new Worked Problem at the end of the chapter. The Worked Problem gives demand and supply schedules for roses and then asks the students how the market adjusts if the price is lower and higher than the equilibrium price. It follows up by asking the students to determine the equilibrium price and quantity. Then the Worked Problem asks the students to calculate new equilibrium prices and quantities when the supply changes and when the demand and supply both change. The Worked Problem shows the students how to make these calculations. In particular, it demonstrates how to calculate the new equilibrium when the demand and supply change using the new demand and supply schedules and using a supply and demand diagram. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Demand and Supply • • • •

In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and consumed. Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed. Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price. The money price of a good or service is the number of dollars that must be given up for it. The ratio of one (money) price to another is called a relative price. A relative price is an opportunity cost. The theory of demand and supply determines relative prices and so when we use the word “price” we mean “relative price.”

To point out the importance of relative prices, ask your students if turkey at 40¢ a pound is a good buy. Tell them that is all they know—turkey is 40¢ a pound. Generally most students respond that turkey at this price is cheap and a good buy. Then tell them that steak is 8¢ a pound. Now is turkey such a good buy? Students realize that the relative price of turkey is 5 pounds of steak per pound of turkey and so turkey is actually expensive. Point out to them that these money prices are actual prices from circa 1800. At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Also point out to them the unimportance of the money price and the crucial importance of the relative price.

Demand • •

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons: • Substitution Effect: When the relative price of good changes, the opportunity cost of the good changes. An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes. • Income Effect: A change the price of a good changes the amount that a person can afford to buy. When the price of a good rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease. Normally the good whose price rises is one of the goods for which less is purchased.

Demand Curve and Demand Schedule • The demand for a good Price Quantity refers to the entire (dollars demanded relationship between the per unit) (units) price of the good and the 1 50 quantity demanded of the 2 40 good. The table gives a 3 30 demand schedule. 4 20 • A demand curve shows 5 10 the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The figure illustrates the demand curve resulting from the demand schedule. • The demand curve is a willingness-to-pay curve—for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve.

DEMAND AND SUPPLY

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones. Bring to class two bottles of ice-cold, ready-to-drink Mt. Dew, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up. Tell the class that you are going to sell them to the high bidder. Tell them that this auction is real. The winner will get the drink and will pay. Ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy. Now begin the auction. Appoint a student to count hands (more than one for a big class). Begin at a low price: say 10¢ a bottle and count the number willing to buy. Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price. When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt. Dew (or other drink) in your classroom today. You can easily emphasize the law of demand. And, now that you have a demand curve, you can do some thought experiments that will shift it. Ask: How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom?

A Change in Demand (Demand Shifters) •

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Six factors change demand: • Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in conjunction with another good. (sugar and coffee). A rise in the price of a substitute or a fall in the price of a complement increases the demand for the good. • Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases. • Income: A normal good is one for which demand increases as income increases; an inferior good is one for which demand decreases as income increases. • Expected Future Income and Credit: When expected future income increases, demand today increases. When credit becomes easier to obtain, demand increases. • Population: The larger the (relevant) population, the greater the demand. • Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

A Change in the Quantity Demanded Versus a Change in Demand •

•

A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand. In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

II.

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Supply • •

The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price. The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce.

Supply Curve and Supply Schedule •

•

The supply of a Price Quantity good refers to (dollars supplied the entire per unit) (units) relationship 1 10 between the price 2 20 of the good and 3 30 the quantity 4 40 supplied of the 5 50 good. The table gives a supply schedule. A supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The figure illustrates the supply curve resulting from the supply schedule. The supply curve is a minimum-supply-price curve—for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of output which means that a supply curve is a marginal cost curve.

A Change in Supply (Supply Shifters) •

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Six factors change supply: • Prices of Productive Resources: If the price of a resource used to produce the good rises, the supply of the good decreases. • Prices of Related Goods Produced: A substitute in production is a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good. • Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases. • Number of Suppliers: If the number of suppliers increases, the supply increases. • Technology: Technology refers to the ways in which factors of production are used to produce a good. A technological advance increases the supply of a good. • The State of Nature: The state of nature includes all natural forces that influence supply. Bad weather or an earthquake decreases the supply of a good.

DEMAND AND SUPPLY

A Change in the Quantity Supplied Versus a Change in Supply •

•

A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply. In the top figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

III. Market Equilibrium • •

An equilibrium is a situation in which opposing forces balance. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

Price as a Regulator and Price Adjustments • •

• •

The price of a good regulates the quantities demanded and supplied. Shortage: If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price. Surplus: If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price. The price continues to adjust until the quantity supplied equals quantity demanded.

To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the intersection of the two curves. “Home Base” provides them a starting place for every story problem they face. Then as you work through examples, be sure to ask them what “shifter” is changing. This procedure will keep them using the economic tool rather than just going with a gut feeling. The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class activity. Using the experiment is straightforward. Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve. Point out that the trades you made in your little economy made both buyers and sellers better off. Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of

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scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

IV. Predicting Changes in Price and Quantity The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity.

A Change In Demand •

•

• •

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases. Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve. The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40. The supply curve does not shift; there is, however, a movement along the supply curve.

An Economic in the News feature discusses the factors that have led to higher college tuition. Because enrollment has also increased, the analysis concludes that increases in demand are the factor that has created the higher tuition. A Change In Supply • If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases. • If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases. • Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the demand curve. • The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is, however, a movement along the demand curve.

An Economic in the News explores the factors that led to a fall in the price of coffee. The analysis concludes that a bumper crop of coffee lies behind the fall in price.

DEMAND AND SUPPLY

The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five steps. Once you have already worked an example or two, walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question. 2. Think about the event(s) that you are told occur and decide whether they change demand, supply, or both demand and supply. 3. Determine if the events that change demand or supply bring an increase or a decrease. 4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve(s) in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—this view works ok for demand but is exactly wrong for supply. So emphasize the left-right shift.) 5. Find the new equilibrium and compare it with the original one. It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources.

Demand and Supply Change in the Same Direction •

•

If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous. • If the increase in demand is greater than the increase in supply, the price rises. • If the increase in demand is the same size as the increase in supply, the price does not change. • If the increase in demand is less than the increase in supply, the price falls. If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous. • If the decrease in demand is greater than the decrease in supply, the price falls. • If the decrease in demand is the same size as the decrease in supply, the price does not change. • If the decrease in demand is less than the decrease in supply, the price rises. The figure illustrates an increase in both demand and supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50.

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Demand and Supply Change in the Opposite Directions •

•

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous. • If the increase in demand is greater than the decrease in supply, the quantity increases. • If the increase in demand is the same size as the decrease in supply, the quantity does not change. • If the increase in demand is less than the decrease in supply, the quantity decreases. If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous. • If the decrease in demand is greater than the increase in supply, the quantity decreases. • If the decrease in demand is the same size as the increase in supply, the quantity does not change. • If the decrease in demand is less than the increase in supply, the quantity increases. The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5.

The Economic in the News explores the market for bananas. A disease that damages banana crops has spread from Southeast Asia to the Middle East. The disease has decreased the supply of bananas, resulting in the price rising and quantity decreasing.

DEMAND AND SUPPLY

Additional Problems 1.

What is the effect on the price of hotdogs and the quantity of hotdogs sold if a. The price of a hamburger rises? b. The price of a hotdog bun rises? c. The supply of hotdog sausages increases? d. Consumers’ incomes increase if hot dogs are a normal good? e. The wage rate of a hotdog seller increases? f. If the wage rate of the hotdog seller rises and at the same time prices of ketchup, mustard, and relish fall?

Suppose that one of the following events occurs: (i) The price of wool rises. (ii) The price of sweaters falls. (iii) A close substitute for wool is invented. (iv) A new high-speed loom is invented. a. b. c. d.

Which of the above events increases or decreases (state which) The demand for wool? The supply of wool? The quantity of wool demanded? The quantity of wool supplied?

Figure 3.1 illustrates the market for bread. a. Label the curves in the figure. b. What are the equilibrium price of bread and the equilibrium quantity of bread?

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The demand and supply schedules for potato chips are in the table. a. What are the equilibrium price and equilibrium quantity of potato chips? b. If chips were 60 cents a bag, describe the situation in the market for potato chips and explain what would happen to the price of a bag of chips.

Price (cents per bag) 40 50 60 70 80 90 100 110

Quantity Quantity demanded supplied (millions of bags a week) 170 90 160 100 150 110 140 120 130 130 120 140 110 150 100 160

In problem 4, suppose a new snack food comes onto the market and as a result the demand for potato chips decreases by 40 million bags per week. a. Has there been a shift in or a movement along the supply curve of chips? b. Has there been a shift in or a movement along the demand curve for chips? c. What is the new equilibrium price and quantity of chips?

In problem 5, suppose that a flood destroys several potato farms and as a result supply decreases by 20 million bags a week at the same time as the new snack food comes onto the market. What is the new equilibrium price and quantity of chips?

Solutions to Additional Problems 1.

d. e.

The price of a hot dog rises, and the quantity of hot dogs sold increases. Hot dogs and hamburgers are substitutes. If the price of a hamburger rises, people buy more hot dogs and fewer hamburgers. The demand for hot dogs increases. The price of a hot dog rises, and more hot dogs are sold. The price of a hot dog falls, and fewer hot dogs are sold. Hot dog buns and hot dogs are complements. If the price of a hot dog bun rises, fewer hot dog buns are bought. The demand for hot dogs decreases. The price of a hot dog falls, and people buy fewer hot dogs. The price of a hot dog falls and more hot dogs are sold. The increase in the supply of hot dog sausages lowers the price of hot dog sausages. Hot dog sausages are a factor used in the production of hot dogs. With the lower priced factor, the supply of hot dogs increases. The price of a hot dog falls and people buy more hot dogs. The price of a hot dog rises, and the quantity sold increases. An increase in consumers' income increases the demand for hot dogs. As a result, the price of a hot dog rises and the quantity bought increases. The price of a hot dog rises, and the quantity sold decreases. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. The price of a hot dog rises, but the quantity might increase, decrease, or remain the same. Ketchup, mustard, and relish are complements of hot dogs. If the price of ketchup, mustard, and relish fall, more ketchup, mustard, and relish are bought and the demand for hot dogs increases. The price of a hot dog rises, and people buy more hot dogs. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. Taking the two events together, the price of a hot dog rises, but the quantity might increase, decrease, or remain the same. (ii) and (iii) Wool is used in the production of sweaters. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. If a close substitute for wool is invented, some sweater producers will switch from wool to the substitute. When they do, the demand for wool decreases.

DEMAND AND SUPPLY

b. c.

a. b.

a. b. c.

(iv) If a new high-speed loom is invented, the cost of making wool will fall and the supply of wool will increase. (i) and (iv) If the price of wool rises there is a movement up along the demand curve. The quantity demanded of wool decreases. If a new high-speed loom is invented, the cost of producing wool will fall. So the supply of wool increases. With no change in the demand for wool, the price of wool will fall and there is a movement down along the demand curve for wool. The quantity demanded of wool increases. (i), (ii), and (iii) If the price of wool rises there is a movement up along the supply curve. The quantity supplied of wool increases. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. With no change in the supply of wool, the price of wool rises and the quantity of wool supplied increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. If some sweater producers switch to using the new close substitute for wool, the demand for wool will decrease. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right. The equilibrium price is $3 a loaf, and the equilibrium quantity is 100 loaves a day. Market equilibrium is determined at the intersection of the demand curve and supply curve. The equilibrium price is 80 cents a bag, and the equilibrium quantity is 130 million bags a week. The price of a bag adjusts until the quantity demanded equals the quantity supplied. At 80 cents a bag, the quantity demanded is 130 million bags a week and the quantity supplied is 130 million bags a week. At 60 cents a bag, there will be a shortage of potato chips and the price will rise. At 60 cents a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 110 million bags a week. There is a shortage of 40 million bags a week. The price will rise until market equilibrium is restored—80 cents a bag. There has been a movement along the supply curve. The demand for potato chips decreases, and the demand curve shifts leftward. Supply does not change, so the price falls along the supply curve. The demand curve has shifted leftward. As the new snack food comes onto the market, the demand for potato chips decreases. There is a new demand schedule, and the demand curve shifts leftward. The equilibrium price is 60 cents, and the equilibrium quantity is 110 million bags a week. Demand decreases by 40 million bags a week. That is, the quantity demanded at each price decreases by 40 million bags. The quantity demanded at 80 cents is now 90 million bags, and there is a surplus of potato chips. The price falls to 60 cents a bag, at which the quantity supplied equals the quantity demanded (110 million bags a week). The new price is 70 cents a bag, and the quantity is 100 million bags a week. The supply of potato chips decreases, and the supply curve shifts leftward. The quantity supplied at each price decreases by 20 million bags. The result of the new snack food entering the market is a price of 60 cents a bag. At this price, there is now a shortage of potato chips. The price of potato chips will rise until the shortage is eliminated.

Additional Discussion Questions 1.

John Q: Could a legal market for human organ donations have saved his dying son? An opinion piece written by Richard Epstein in The Wall Street Journal (2/21/02) discusses the donation of human organs for transplant operations. He raises the issue that if a market for human donor organs were legal, the dilemma of a lack of organs, as raised by Denzel Washington’s character in the movie “John Q,” might be closer to fiction rather than fact. You can use this movie and the motive of the main character as an intriguing basis for getting students to construct and interpret the demand and supply model.

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Can we illustrate a market for something as vital as organ donations? Begin by asking the students to graph a demand and supply model for the market for human organ donations, making sure that their model reflects the real-life characteristics of this unique market: i) the federal government does not allow individuals or businesses to engage in the buying and selling of human organs, unless the organs are donated and received for free, ii) a small number of organs are donated by living volunteers (like kidney donations) or by the families of the recently deceased (especially after an otherwise healthy individual suffers an accidental death), meaning that the positively sloped supply curve for human organ donations intercepts the quantity axis at some positive value, iii) the demand curve for organs must intercept the supply curve at a positive price. Are there unintended consequences when market forces are ignored? The government wants to assure that poor people have the same access to available organ transplants as rich people, so it imposes a zero-price restriction on the market. However, this creates a shortage of organs available for transplant, where the quantity of organs demanded at a zero price far exceeds the quantity supplied. If the market for organ donations were unregulated, then the equilibrium price for an organ would surely increase, but so would the total number of people receiving an organ transplant, and presumably, the total number of people who would survive to live another day. Should society institute a policy that maximizes the numbers of lives saved or manipulates the characteristics of those fewer lives that do get saved? Conclude this discussion with a great set-up for the efficiency versus equity issues developed later in chapter five. Our command of the demand and supply model for human organ donations allows us to discover an important insight into one aspect of health care policy: the government places a lower priority for maximizing the total number of people saved regardless of income, and a higher priority on achieving a “proper” income mix among the smaller number of people that are saved by being one of the few receiving organ transplants. 2.

What are some goods that college students might buy today but will give up when they enter the workforce after graduation? College students usually recognize that they will change their consumption patterns when they are employed after college graduation. Use this to get the students to appreciate inferior goods. When you were an undergraduate, you probably complained about having to eat mostly canned soup or beans as a cheap staple to fill your hungry stomach on a small budget. You swore that when you finally entered the workforce you wouldn’t eat soup or beans again, unless under extreme duress. Today the single food item most frequently cited by students as an inferior good is the Raman style noodles—those dry, thin, near flavorless oriental style noodles that are reconstituted with boiling water. Get the students to create a list other such inferior goods they will avoid when their incomes increase. This gets them to carefully consider how income changes can cause demand curves to shift in an unintuitive manner for an inferior good.

Because computers are cheaper and more abundantly available now than a decade ago, doesn’t this mean the supply curve for computers is downward sloping? This is a real world example for illustrating the confusion between changes in supply and changes in the quantity supplied. (It is easier to analyze this example if the students assume that consumer demand for computer software applications has not changed over the last decade.) Has anything in the world of computer manufacturing changed over the last decade? Point out that the observation about falling computer prices with rising quantities sold assumes that nothing significant has changed in the computer industry. Emphasize how such statements reflect how the ceteris paribus condition of careful economic analysis has been violated. Over the years, advances in technology have allowed computer makers to: i) offer greater computer power and versatility for contemporary software applications at the same opportunity cost of resources (market price) as before, or ii) to provide the same level of computer power and versatility for contemporary software applications at lower opportunity costs (market prices) as before. Either way, this represents a rightward shift in the supply curve for computers. The students should

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recognize that the two prices and two quantities that give the appearance of more computers offered for less are actually from two separate supply curves. 4.

Because the average price of a car has increased substantially over the last 30 years, and the number of cars owned has risen faster than the population, doesn’t this mean that the demand curve for cars is upward sloping? This is a real world example for illustrating the confusion between changes in demand and changes in the quantity demanded. (It is easier to analyze this example if the students assume that automobile production technology has not changed over these last three decades.) Has anything in the world of consumers changed over the last decade? Point out that this real world observation of car prices and rising quantities sold over time assumes that nothing significant has changed in the consumers’ environment. Emphasize how statements such as these reflect how the ceteris paribus condition of careful economic analysis has been violated. Consumer incomes have increased significantly over the last three decades, allowing them to: i) consume greater personal transportation opportunities for more family members while giving up the same amount of other goods as before, or ii) consume the same level of personal transportation opportunities while giving up less of all other goods as before. Either way, this represents a rightward shift in the demand curve for automobiles. The students should recognize that the two prices and quantities that give the appearance of more automobiles demanded at higher prices are actually from two separate demand curves. If the status of the family automobile has increased in recent decades, what affect would this have on consumer demand? There is evidence that the proportion of income that typical families spend on automobiles (versus all other goods) has increased substantially over the last 30 years. This means that the percent increase in automobile purchases has been higher than the percent increase in family incomes. This makes for a great lead into the measures of the income elasticity of demand discussed in Chapter 4.

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ELASTICITY

The Big Picture Where we have been: The student can now use the demand and supply model to generate predictions and can supplement this knowledge with the ability to provide richer predictions based on the elasticities of demand and supply. Where we are going: Demand, supply, and demand elasticity get an extensive workout in Chapter 6, where we use them to explain the division of a tax burden between buyer and seller and the impact of price controls and quotas. However, before doing that analysis, we study the efficiency and fairness of markets in Chapter 5. Students will also apply elasticity in Chapter 12 to describe demand in perfect competition. In Chapter 13, we study the relationship between total revenue and the price elasticity of demand to show that a monopoly never operates on the inelastic part of the demand curve.

N e w i n t h e Tw e l f t h E d i t i o n There are only a few minor changes to this chapter. A new introduction and application focus on the coffee market and the elasticity of demand for coffee. Two new Economics in the News applications examine demand elasticities for peanut butter in the United States market. A New Worked Problem is included. The Worked Problem presents data on changes in the price and quantity of smoothies and changes in the quantity of muffins. It asks the students to calculate the percentage changes in the price and quantity of smoothies, the price elasticity of demand for smoothies, and the cross elasticity of demand for muffins with respect to the price of a smoothie. The Worked Problem then shows the students how to make these calculations. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Elasticity • • • •

The price elasticity of demand measures how strongly buyers respond to a change in the price of a good. The price elasticity of demand can be used to make quantitative predictions of how changes affect the price and quantity demanded of a good. The income elasticity of demand measures how strongly demanders respond to a change in income, and the cross elasticity of demand measures how strongly demanders respond to the change in the price of another good. The price elasticity of supply measures how strongly producers respond to a change in the price of a good.

Price Elasticity of Demand •

In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments because it can predict the impact of a price change on total revenue or total expenditure.

Calculating Price Elasticity of Demand •

The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:

Percentage change in quantity demanded . Percentage change in price The formulas for calculating all of the elasticities in the text are based on the arc elasticity or mid-point formula, meaning the percentage changes are always calculated based on the average price (or income in the case of income elasticity) and average quantity over the range of change. If you ask students to calculate elasticities, it is important to practice calculating the percentage change using the average as the basis as it is not likely to be familiar Don’t be afraid to start with this pre-elasticity warm up to assess the sharpness of your class. Ask: “Suppose that the campus bookstore increases the price of an economics text from $75 to $100. What is the percentage increase in price?” Many will say 25 percent. But using the midpoint formula the percentage change is ($25/$87.50) × 100, which is 28.6 percent. Devise a mnemonic for elasticity calculations. Many students have a hard time remembering whether quantity or price goes in the numerator of the elasticity formulas. Have the students create their own mnemonic. Suggest McDonald’s Quarter Pounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentage changes. •

•

The demand elasticity formula yields a negative value, because price and quantity move in opposite directions. However, it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. So we use the magnitude or the absolute value of the price elasticity of demand. The table to the right has two points on the demand Price Quantity curve for pizza from a particular pizza parlor. (dollars per demanded • The absolute value of the percent change in pizza) (pizzas per week) quantity demanded is [(500 − 400)  450]  100 = 14 500 22.2 percent. 16 400 • The absolute value of the percentage change in price is [($14 − $16)  $15]  100 = 13.3 percent. • Between these two points on the demand curve, the price elasticity of demand is 22.2%  13.3% = 1.67.

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Elasticity is not the same as slope. Students sometimes wonder why we don’t just measure the slope of the demand curve to measure responsiveness. Point out to the students that the slope will change when the units change. For instance, you can compute the slope of a demand curve when the price is measured in dollars and then the slope of the exact same demand curve when the price is measured in cents. The slope with the price measured in cents is 100 times as large as the initial slope. Tell the students that it is not acceptable for the measure of responsiveness to change whenever the units of the price (or of the quantity) change.

Inelastic and Elastic Demand •

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If the price elasticity of demand is less than 1.0, the good is said to have an inelastic demand. In this case, the percentage change in the quantity demanded is less than the percentage change in price. • If the quantity demanded remains constant when the price changes, then the good is said to have perfectly inelastic demand. The price elasticity of demand is 0 and the good’s demand curve is a vertical line. If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic demand. In this case, the percentage change in the quantity demanded equals the percentage change in price. If the price elasticity of demand is greater than 1.0, the good is said to have an elastic demand. In this case, the percentage change in the quantity demanded exceeds the percentage change in price. • If the quantity demanded changes by an infinitely large Furniture 1.26 percentage in response to a tiny price change, then the Motor Vehicles 1.14 good is said to have perfectly elastic demand. The price elasticity of demand is infinite. Clothing 0.64 The table has some “real-life” elasticities from the book. Oil 0.05

Economics in Action” Elastic and Inelastic Demand This application shows real-world price elasticities of demand for a variety of goods and services as well as a table with various food elasticities. This data can be a base for discussion of the factors that might lead one item to be more elastic than the other and allow students in real-time to try to explain and apply price elasticity of demand. Economics in the News: The Elasticity of Demand for Peanut Butter The price elasticity of demand for peanut butter is the basis for this application. Further discussion of other demand elasticities for peanut butter will be explored after those elasticities are introduced.

Elasticity Along a Linear Demand Curve •

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With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price elasticity of demand changes when moving along a linear demand curve. As the figure illustrates, at points on the demand curve above the midpoint, the price elasticity of demand is elastic while at points below the midpoint, the price elasticity of demand is inelastic. At the midpoint, the price elasticity of demand is unit elastic.

Total Revenue and Elasticity •

The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. • If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. • If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change.

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• •

•

If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price, when all other influences on the quantity sold remain the same. • If a price cut increases total revenue, demand is elastic. And if a price hike decreases total revenue, demand is elastic. • If a price cut does not change total revenue, demand is unit elastic. And if a price hike does not change total revenue, demand is unit elastic. • If a price cut decreases total revenue, demand is inelastic. And if a price hike increases total revenue, demand is inelastic. Similarly, when a price changes, a consumer’s change in expenditure depends on the consumer’s elasticity of demand. • If demand is elastic, then a price cut means that expenditure on the item increases. • If demand is inelastic, then a price cut means that expenditure on the item decreases. • If demand is unit elastic, then a price cut means that expenditure on the item does not change.

How do changes in revenue relate to elasticity mathematically? When demand is elastic, the absolute value of the ratio of the percentage change in quantity demanded to percentage change in price must be greater than one. This point implies that the numerator of the formula for the price elasticity of demand must be greater than the denominator. In that case, the percentage change in quantity demanded is stronger than the percentage change in price, so revenues will change in the same direction as the quantity demanded. On the other hand, if demand is inelastic, the denominator of the formula for the price elasticity of demand must be greater than the numerator. In that case, changes in revenue will change in the same direction as the price because the percentage change in price is stronger than the percentage change in quantity. Reviewing these results also helps students understand the logic for why 1 is the significant value for the coefficient and that the elasticity being farther away from 1 means the reaction is stronger, whether elastic or inelastic.

The Factors that Influence the Elasticity of Demand The magnitude of the price elasticity of demand depends on: • The closeness of substitutes: The closer and more numerous the substitutes for a good or service, the more elastic the demand. This is critical for understanding demand in the market structure section later in the book. • The proportion of income spent on the good: The greater the proportion of income spent on a good or service, the more elastic the demand. • The amount of time elapsed since the price change: The longer the time elapsed since the price change, the more elastic the demand. Price elasticity of needs versus wants: Necessities, such as food or housing, generally have inelastic demand because there are few substitutes for food and shelter. Luxuries, such as exotic vacations, generally have elastic demand. Example: Most people’s demand for salt is inelastic, largely because most people spend a miniscule amount of their income on salt. However large Northern cities’ demand for salt is significantly more elastic. These cities use salt to treat their roads after a snow storm. Salt is a significant fraction of their budgets. Because the proportion of their income they spend on salt is large, the price elasticity of demand for these cities is much larger than that of “ordinary” consumers. How do gasoline purchases respond to changes in price over time? When gas prices rise from $2 to $4, consumers initially have few options available. At first, with a given car with a given gas mileage, higher gas prices do not reduce the quantity of gas consumers purchase by very much. As time passes and gasoline prices continue to remain high, some consumers eventually find ways to adjust their gas purchases by purchasing more fuel efficient cars, taking new jobs that are closer to their homes, or by taking fewer road trips or car pooling.

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II. More Elasticities of Demand Income Elasticity of Demand • •

The income elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the income, other things remaining the same. The income elasticity of demand is equal to:

Percentage change in quantity demanded . Percentage change in income •

•

The changes in the quantity demanded and income are percentages of the average income and quantity demanded over the range of change. The income elasticity of demand is positive for normal goods and negative for inferior goods. • If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good. As income increases, the percentage of income spent on income elastic goods increases. • If the income elasticity of demand is positive but less than 1, demand is income inelastic and the good is a normal good. As income increases, the percentage of income spent on income inelastic goods decreases. Airline Travel 5.82 • If the income elasticity of demand is negative the good is an Restaurant Meals 1.61 inferior good. Clothing 0.51 The table has some “real-life” income elasticities from the book. Food 0.14

One of the more common applications for income elasticity of demand that student’s tend to find interesting is in the stock market. Terms like cyclical, staples, and discretionary sectors are easily explained using income elasticity concepts. Students could consider questions about where in the business cycle a company’s profit might be strongest or weakest and thus more or less worthy of financial investment. Economies in Action: The Economics in Action shows actual estimates of income and cross price elasticities. Grocery stores and retail stores are a great example of how store scanned data could be used to understand the relationships between products. If a store can put a low margin product on sale and sell more of a high margin product, that is a great use of cross price elasticity data.

Cross Elasticity of Demand • •

The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. The cross elasticity of demand is equal to:

Percentage change in quantity demanded . Percentage change in price of a substitute or complement •

The changes in the quantity demanded and the price are percentages of the average price and quantity demanded over the range of change. The cross elasticity of demand is positive for substitutes and negative for complements.

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Examples: Use examples to show the students why the cross elasticity of demand is positive for substitutes and negative for complements. For instance, suppose the price of Coke rises. What effect does this price hike have on the demand for Pepsi? Students will immediately realize that the demand for Pepsi increases. So in this case the cross elasticity of demand for Pepsi with respect to the price of Coke is calculated by dividing one positive number by another, so the result will be positive. (You may need to show the result of a decrease in the price of Cock as well: If the price of Coke falls, the demand for Pepsi will fall, and the cross elasticity of demand for Pepsi with respect to Coke is calculated by dividing a negative percentage change by a negative percentage change, again resulting in a positive number.) Use specific percentage changes to calculate cross price elasticities to emphasize that the sign of the coefficient matters as well as its size. A cross elasticity of 1.5 or .3 are both substitutes but not to the same degree. A cross elasticity of −0.6 or −2.5 are both complements, but again not equally impactful. Explore how knowing cross elasticities might help store managers plan “loss leaders” or how to merchandise products each week. Some instructors will be more focused on the calculation of the elasticities while others may be more focused on interpreting the elasticity coefficients. For those focused on interpretation, tables with elasticity coefficients could be provided and questions could be framed in terms of the business cycle and how it would change sales of various products at various stores. One store that caters to higher income customers and one store that has bargain basement prices will have different amounts of shelf space devoted to different products. More data would be needed for calculating the elasticities, but students could then create the table and answer the interpretive questions as an class or take home application.

III. Elasticity of Supply • •

The elasticity of supply measures how responsive producers are to a change in the price of the good. The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain unchanged.

•

The elasticity of supply is equal to:

Percentage change in quantity supplied . Percentage change in price

Three Cases of Elasticity of Supply • • •

Supply is perfectly inelastic if the elasticity of supply equals 0. In this case, the supply curve is vertical. Supply is unit elastic if the elasticity of supply equals 1. In this case, the supply curve is linear and passes through the origin. If any supply curve is linear and passes through the origin, the supply is unit elastic; the slope of the supply curve is irrelevant. Supply is perfectly elastic if the elasticity of supply is infinite. In this case, the supply curve is horizontal.

Again, elasticity is not the same as slope. The unit-elastic supply curve is a good one to use to emphasize that elasticity and slope are not equal. Have the students calculate the elasticity of supply on two linear demand curves that pass through the origin, one with a slope of 0.5 and the other with a slope of 2. Regardless of the difference in slope, supply elasticity will be equal to 1. •

The table to the right has two points on the Price Quantity supplied supply curve for pizza from a particular pizza (dollars per (pizzas per week) parlor. pizza) • The percentage change in the quantity 14 300 supplied is [(400 − 300)  350]  100 = 28.6 16 400 percent. • The percentage change in price is [($16 − $14)  $15]  100 = 13.3 percent. • Between these two points, the elasticity of supply is 28.6%  13.3% = 2.15.

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Supply is elastic if the elasticity of supply exceeds 1.0, unit elastic if the elasticity of supply equals 1.0, and inelastic if the elasticity of supply is less than 1.0.

ELASTICITY

The Factors that Influence the Elasticity of Supply • •

Resource substitution possibilities: The more unique or rare the resources used to produce the good, the smaller the elasticity of supply. The more common the resources used to produce the good, the larger the elasticity of supply. The time frame for substitution possibilities: The longer the amount of time producers have to adjust to a change in price, the more elastic the supply will be. • Momentary supply refers to the period of time immediately following a price change. For some goods, the momentary supply can be perfectly inelastic—fresh fish the day of a price hike. For other goods, the momentary supply can be quite elastic—when the number of telephone calls increases on a holiday, the supply increases with no change in price. • Short-run supply shows how the quantity supplied responds to a price change when only some of the technological adjustments have been made. • Long-run supply shows how the quantity supplied responds to a price change when all of the technological adjustments have been made.

Economics in the News: The Elasticity of Demand for Coffee Drop in Global Coffee Prices Shrinks Farmers’ Revenue This feature connects to the chapter opening questions about the price elasticity of demand for coffee. It discusses the global decrease in coffee prices due to increased coffee production and its affect on coffee producer’s income. Additional data are added for the economic analysis.

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Additional Problems 1.

Better-than-average weather brings a bumper tomato crop. The price of tomatoes falls from $6 to $4 a basket, and the quantity demanded increases from 200 to 400 baskets a day. Over this price range, a. What is the price elasticity of demand? b. Describe the demand for tomatoes.

The figure shows the demand for pens. a. Calculate the elasticity of demand for a rise in price from $2 to $4. b. At what prices is the elasticity of demand equal to 1, greater than 1, and less than 1?

If the quantity of fish demanded decreases by 5 percent when the price of fish rises by 10 percent, is the demand for fish elastic, inelastic, or unit elastic?

The table gives the demand schedule for coffee. Price Quantity demanded (dollars per (millions of pounds a. What happens to total revenue if the price of coffee rises from $10 to $20 per pound? pound) per year) b. What happens to total revenue if the price rises to 10 30 $15 to $25 per pound? 15 25 c. What is the price when total revenue at a maximum? 20 20 25 15 d. What quantity of coffee will be sold at the price that answers part c? e. At an average price of $15 a pound, is the demand for coffee elastic or inelastic? Use the total revenue test to answer this question.

If a 10 percent fall in the price of beef increases the quantity of beef demanded by 20 percent and decreases the quantity of chicken demanded by 15 percent, calculate the cross elasticity of demand between beef and chicken.

Judy’s income has increased from $10,000 to $12,000. Judy increased her demand for concert tickets by 10 percent and decreased her demand for bus rides by 5 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

The table gives the supply schedule for shoes. Calculate the elasticity of supply when a. The price rises from $125 to $135 a pair. b. The price is $125 a pair.

Price (dollars per pair)

120 125 130 135

Quantity supplied (millions of pairs per year) 1,200 1,400 1,600 1,800

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Solutions to Additional Problems 1.

b. 2.

The price elasticity of demand is 0.33. When the price of a pen rises from $2 to $4, the quantity demanded of pens decreases from 100 to 80 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $2 to $4, an increase of $2 a pen. The average price is $3 a pen. So the percentage change in the price equals $2 divided by $3 and then multiplied by 100, which equals 66.7 percent. The quantity decreases from 100 to 80 pens, a decrease of 20 pens. The average quantity is 90 pens. So the percentage change in quantity equals 20 divided by 90 and then multiplied by 100, which equals 22 percent. The price elasticity of demand for pens equals 22 percent divided by 66.7 percent, which is 0.33. The price elasticity of demand equals 1 at $6 a pen. The price elasticity of demand is greater than 1 at prices greater than $6 a pen. The price elasticity of demand is less than 1 at prices less than $6 a pen. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve hits the y-axis. That price is $6 a pen. The demand curve is linear. Along a linear demand curve, the price elasticity of demand is greater than 1 at points above the midpoint and less than 1 at points below the midpoint. The price elasticity of demand is greater than 1 at prices above $6 a pen and less than 1 at prices below $6 a pen. The demand for fish is inelastic. The price elasticity of demand for fish equals the percentage change in the quantity of fish demanded divided by the percentage change in the price of fish. The price elasticity of demand equals 5 percent divided by 10 percent, which is 0.5. The demand is inelastic.

d. e.

The price elasticity of demand is 1.67. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price falls from $6 to $4 a basket, a fall of $2 a basket. The average price is $5 a basket. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity increases from 200 to 400 baskets, an increase of 200 baskets. The average quantity is 300 baskets. So the percentage change in quantity equals 200 divided by 300 and then multiplied by 100, which equals 66.7 percent. The price elasticity of demand for tomatoes equals 66.7 percent divided by 40 percent, which is 1.67. The price elasticity of demand exceeds 1, so the demand for tomatoes is elastic.

Total revenue increases. When the price of a pound of coffee is $10, 30 million pounds are sold and total revenue equals $300 million. When the price of a pound of coffee rises to $20, 20 million pounds are sold and total revenue is $400 million. Total revenue increases. Total revenue does not change. When the price of a pound of coffee is $15, 25 million pounds are sold and total revenue is $375 million. When the price of a pound of coffee is $25, 15 million pounds are sold and total revenue is $375 million. Total revenue does not change. Total revenue is maximized at $20 a pound. When the price of a pound of coffee is $20, 20 million pounds are sold and total revenue equals $400 million. When the price is $15 a pound, 25 million pounds are sold and total revenue equals $375 million. Total revenue increases as the price rises from $15 to $20 a pound. When the price is $25 a pound, 15 million pounds are sold and total revenue equals $375 million. Total revenue decreases as the price rises from $20 to $25 a pound. Total revenue is maximized when the price is $20 a pound. The quantity will be 20 million pounds a year. The demand schedule tells us that when the price is $20 a pound, the quantity of coffee demanded is 20 million pounds a year. The demand for coffee inelastic. The total revenue test says that if the price rises and total revenue increases, the demand is inelastic at the average price. For an average price of $15 a pound, raise the price from $10 to $20 a pound. When the price of a pound rises from $10 to $20, total revenue increases from $300 million to $400 million. So at the average price of $15 a pound, demand is inelastic. The cross elasticity of demand between beef and chicken is 2. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. The fall in the price of beef resulted in a decrease in the quantity demanded of chicken. So the cross elasticity of demand is the percentage change in the quantity demanded of chicken divided by the

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percentage change in the price of beef. The cross elasticity equals 20 percent divided by 10 percent, which is 2. 6.

Income elasticity of demand for (a) concert tickets is 0.55 and (b) bus rides is 0.275. Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $11,000, so the percentage change in income equals 18.2 percent. a. The change in the quantity demanded of concert tickets is 10 percent. The income elasticity of demand for concert tickets equals 10/18.2, which is 0.55. b. The change in the quantity demanded of bus rides is 5 percent. The income elasticity of demand for bus rides equals 5/18.2, which is 0.275. a. The elasticity of supply is 3.25. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. When the price rises from $125 to $135, the change in the price is $10 and the average price is $130. The percentage change in the price is 7.7 percent. When the price rises from $125 to $135, the quantity supplied increases from 1,400 million to 1,800 million pairs. The change in the quantity supplied is 400 million pairs, and the average quantity is 1,600 million pairs, so the percentage change in the quantity supplied is 25 percent. The elasticity of supply equals (25 percent)/(7.7 percent), which equals 3.25. b. The elasticity of supply is 3.57. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity of supply at $125, change the price such that $125 is the average price—for example, a fall in the price from $130 to $120. When the price falls from $130 to $120, the change in the price is $10 and the average price is $125. The percentage change in the price is 8 percent. When the price falls from $130 to $120, the quantity supplied decreases from 1,600 million to 1,200 million pairs. The change in the quantity supplied is 400 million pairs and the average quantity is 1,400 million pairs. The percentage change in the quantity supplied is 28.57 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 3.57.

Additional Discussion Questions 1.

How does inelastic student demand for parking hinder police efforts at preventing illegal student parking? Illegal student parking is a hassle that every university police force must deal with. Ask the students whether the campus police will have more success with doubling the current parking fine, or liberally using the “boot,” which is a heavy iron clamp locked to the wheel of a car, rendering it immobile. Students will understand that raising the parking ticket fees is simply raising the price for illegal parking, and if quantity demanded does not decrease very much, demand for those choice parking spots is inelastic. To significantly decrease the incidence of illegal parking, the price must be raised substantially. Having their personal transportation severely restricted with a boot for a period of time is a much higher “price” with a more effective result.

How inelastic is the demand for gasoline and how inelastic is the supply? How might this explain sharp price fluctuations in the market for gasoline? Students recognize that there are few good substitutes for gasoline. Ask them if they think the demand for gas is relatively elastic or inelastic. They’ll likely say that demand for gasoline is relatively inelastic. Point out that although there are some substitutes for gasoline (riding the bus, riding a bicycle, or walking), those options are not necessarily easy to substitute for driving a gas-powered vehicle. Discuss whether firms have the ability to bring more gas to the market in a short run time frame. If quantity does not adjust much when demand or supply change, price is likely to fluctuate greatly.

If the demand for gasoline is relatively inelastic, why does Joe’s Quick-Mart lose a lot of business when he raises his gas prices? Ask your students if Joe’s Quick-Mart (substitute your actual local one) convenience store would lose much business if Joe raised the price of gasoline more than a penny or two compared to the other three gas stations at the same street intersection. When the students conclude he’d lose much of his gasoline sales, point out that this

ELASTICITY

would imply that the demand for gas at Joe’s is relatively elastic, not inelastic. (If an increase in price results in a decrease in revenues, demand is elastic.) Ask them to reconcile the two results. How can demand for gasoline be inelastic when demand for gasoline at Joe’s is elastic? Their response should be that because other stations offer gasoline that is a good substitute for gasoline at Joe’s, demand for gasoline at Joe’s will be more elastic than the demand for gasoline overall. If all gas stations at the intersection raised their prices by a penny or two, the reduction in quantity demanded would be much smaller. 4.

How can knowing price elasticities of demand help student government and university officials set prices for campus events? Paying for programs in an increasingly tighter budget era makes pricing decisions even more critical. Lower prices bring in more revenue if demand is elastic. Higher prices bring in more revenue if demand is inelastic.

How can the owner of The Burger Barn determine if a one-day promotional sale on milkshakes will affect the total revenues generated by hamburger sales? This question will exercise student knowledge of cross elasticities. First, the students need to assume that the price of burgers remains unchanged. Next, the students need to determine whether the cross elasticity is positive (substitutes) or negative (complements). If burgers and milkshakes are substitutes, then burger revenues will decrease during the sale. However, if burgers and milkshakes are complements, then burger revenues will increase.

Is the demand for higher education income elastic, income inelastic or inferior? Enrollments in many institutes of higher education rose during the economic downturn, although demand for community college education may have increased the most dramatically and some institutions did see declines in enrollment. Ask students to discuss how income changes have and could affect enrollment choices and demands for financial aid programs and products.

How does price elasticity of supply explain shortages of vaccinations for H1N1 in the 20092010 school year and its wide availability as part of the standard seasonal flu vaccination in subsequent school years? The difficulty involved and changes in resources needed to launch a new vaccine meant priority lists and lack of availability in many places as the threat of H1N1 was identified. A year later, the vaccination was incorporated into the standard seasonal flu shot and everyone was encouraged to get protected.

How might knowledge of the elasticity of supply for antibiotics be important for the government’s ability to respond to potential chemical and biological attacks? In the ensuing months after the terrorist attacks, security concerns in the United States were heightened when rumors and further proclamations of pending chemical and biological attacks on the United States were reported in the media. Ask the students if it would be important for the government to know what the elasticity of supply would be for super-strength antibiotic medicines (like the popularized medicine Ciprofloxacin) available on the world market. They should consider how easy or how difficult it would be for producers to respond to an increase in demand (and increase in the equilibrium price) for Cipro.

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EFFICIENCY AND EQUITY

The Big Picture Where we have been: This chapter develops a more thorough understanding of efficiency, which was first introduced in Chapter 2. It also develops a deeper grasp of how the demand and supply model introduced in Chapter 3 influences resource allocations in an economy. Finally, it explains the situations in which a competitive market does and does not allocate resources efficiently. Where we are going: Chapter 6 applies the concepts of efficiency and deadweight loss to market regulation policies such as rent ceilings and minimum wage laws. Students should understand these concepts well to appreciate applying demand and supply to important markets in our economic world. Chapter 7 then applies the same concepts to issues surrounding international trade and government protectionist policies. The concepts of efficiency and deadweight loss recur in Chapters 12, 13, and 14, which examine perfect competition, monopoly, monopolistic competition, and regulation. The same efficiency concepts are also used in Chapters 16 and 17, which cover social issues such as public goods and externalities.

N e w i n t h e Tw e l f t h E d i t i o n The chapter opener examines traffic and driving choices, which is then more deeply analyzed in the Economics in the News section at the end of the chapter. The Economics in Action: Selling the Invisible Hand application has been update with a new real-world example on pizza delivery. A new Worked Problem section has been added. The Worked Problem presents a supply and demand diagram and then shows the students how to illustrate the consumer surplus and producer surplus. It also shows the students how to determine if a market is efficient and how to calculate the deadweight loss if an inefficient quantity is produced. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes Efficiency and Equity • • •

Using prices in markets to allocate scarce resources is one of many alternative methods of allocating scarce resources. Tools such as consumer surplus and producer surplus help evaluate efficiency. The outcomes from the various methods used to allocate scarce resources, especially markets, can be examined in terms of both their efficiency and fairness.

Resource Allocation Methods

Resources are scarce, so they somehow must be allocated. Different methods of allocating resources include: • Market price: The people who are willing and able to buy a resource get the resource. • Command: a command system allocates resources by the order (command) of someone in authority. A command system works well in organizations with clear lines of authority but does not work well at allocating resources in the entire economy. • Majority rule: resources are allocated in accordance with majority vote. Majority rule works well when the allocation decisions being made affect a large number of people and self-interest leads to bad decisions. • Contest: resources are allocated to the winner. Contests work well when the efforts of the players are hard to measure, such as top managers being in a contest to be named CEO of a company. • First-come, first-serve: resources are allocated to those who are first in line. This allocation method works well when the resource can serve just one user at a time in a sequence, as is the case with, say, a bank teller or an ATM. • Lottery: resources are allocated to the people who pick the winning number, choose the lucky card, etc. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource. • Personal characteristics: resources are allocated to people with the “right” characteristics. • Force: resources are allocated to those who can forcibly take the resources. Is allocating goods to those willing and able to pay higher prices fundamentally unfair? Students often believe that allocating resources using market prices is somehow unfair. The first section of this chapter, which discusses different ways of allocating resources, and the discussion in the last section of the chapter about the fairness of these different methods in a situation with a shortage, will help open students’ eyes to the fact that somehow resources must be allocated and using the market price has many desirable characteristics that are perhaps often overlooked. In particular, using market prices to allocate goods and services means that goods and services are sold to people who can afford them and want to buy them. Students often focus on the first part— “afford”—and ignore the second part—“want to buy.” Clearly wealthy people can better afford to buy goods and services. But this does not mean that the wealthy buy everything. For instance, it is likely the case that your cell phone is less advanced in features and service plans than cell phones owned by your students. You perhaps can better afford these phones than your students, but you simply may not want the newest, most wired smart device as much as they do. So using market prices means that people who most strongly want the newest and greatest smart phone will acquire it … at least as long as they can afford it. Other resource allocation methods generally do not take account of how strongly someone wants a good or service. As a result, other methods of allocation can allocate goods and services to people who may not value them the most.

II. Benefit, Cost, and Surplus Demand, Willingness to Pay, and Value •

•

The value of one more unit of a good or service is its marginal benefit. Marginal benefit is the maximum price that people are willing to pay for another unit of a good or service. And the willingness to pay for a good or service determines the demand for it. Consequently the demand curve for a good or service is also its marginal benefit curve. The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

EFFICIENCY AND EQUITY

How do you add “horizontally”? Students sometimes have trouble with the concept of adding individual demand curves “horizontally.” Emphasize that the quantity demanded is measured on the “horizontal” axis, so we’re simply adding together all the individual quantities demanded to get the market quantity demanded at a particular price. •

•

The demand curve in the figure shows that the maximum price a person is willing to pay for the 6 millionth gallon of milk per month is $3, so $3 is the marginal benefit of this gallon. MSB curve: In the absence of externalities, which will be discussed later, the market demand curve is also the economy’s marginal social benefit (MSB) curve. It reflects the number of dollars’ worth of other goods and services willingly given up to obtain one more unit of a good. • The figure shows that the maximum price a consumer is willing and able to pay for the 6 millionth gallon of milk is $3, so the marginal social benefit of the 6 millionth gallon of milk is $3. Consumer surplus is the value (or marginal benefit) of the good minus the price paid for it, summed over the quantity bought. The figure illustrates the consumer surplus as the shaded triangle when the price is $3 per gallon.

The negative slope of demand and declining marginal benefit. Marginal benefit is the maximum price people are willing to pay for one more unit of a good or service. Because willingness to pay determines demand, a demand curve is a marginal benefit curve. Demand curves have a negative slope because, as the price rises, the quantity demanded falls. The negative slope of the demand curve can also be explained by the concept of declining marginal benefit. The more you already have of a good, the less valuable an additional unit of that good is to you. In other words, the maximum price you are willing to pay for another unit of that good (its marginal benefit) declines as the quantity you have increases. Consumer surplus graphically is the area under the demand curve and above the price. One thing that students sometimes get hung up on is the exact shape of the consumer surplus area, in particular the steps of consumer surplus for discrete units versus the complete triangle. The point isn’t worth laboring, but if students raise the matter and are curious, you might explain that we’re assuming that the good is finely divisible so that the whole triangle is (approximately) the consumer surplus. Low prices are great for consumers. Students know that low prices are better for consumers than high prices. But consumer surplus gives them a way to demonstrate this basic idea. Take a minute to evaluate the change in consumer surplus from a given change in price. The big impact is not the marginal increase in the number of units purchased, but the increase or decrease in consumer surplus of the units that are still being purchased regardless of the change in price. The area of consumer surplus will become smaller when prices rise and larger when prices fall. This quantifies graphically something students intrinsically know: from the point of view of consumers, low prices are good and high prices are bad. The best example for most people is their strong irritation when gas prices rise and their perception of well being when gas prices fall. Even if they do not change the amount of gas they buy at all, they perceive the change in their consumer surplus.

Supply, Cost, and Minimum Supply-Price •

The cost of producing one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service. And the minimum acceptable price determines the quantity supplied. Consequently the supply curve for a good or service is also its marginal cost curve.

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The positive slope of supply and increasing marginal cost. The fact that supply curves have a positive slope implies that the marginal cost of production increases as the level of production expands. You can refer back to increasing opportunity costs to reinforce this idea for your students. As producers increase production, they will need to increase the amount of resources they use. Initially, firms use the cheapest resources possible (labor that has comparative advantage in producing the good, for example). As output expands, however, additional resources will become increasingly costly (as labor that does not have a comparative advantage in production is used in the production process). If resource costs are rising as the quantity of output supplied increases, the minimum price producers must receive to induce them to produce more will also increase. • •

•

The market supply curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price. MSC curve: In the absence of externalities, the market supply curve is the economy’s marginal social cost (MSC) curve. • The supply curve in the figure shows that the minimum price a producer must receive to be willing to produce the 6 millionth gallon of milk per month is $3, so $3 is the marginal social cost of this gallon. Producer surplus is the price of a good minus its minimum supply-price (or marginal cost), summed over the quantity sold. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.

Producer surplus graphically is the area above the supply curve and below the price line. Every unit that adds more to revenue than it does to cost adds to producer surplus. Point out how increases in price expand producer surplus and how decreases in price reduce it. From producers’ point of view, high prices are better, something that often confuses students who are used to thinking of price as cost not as revenue. This is a good moment to reinforce that difference. Is producer surplus the same as profit? At this point in the course, students don’t have all the tools necessary to understand the difference so it is perhaps best to simply say they aren’t exactly the same, and that firms will sometimes find it in their best interests to produce for a time even if they are losing money. Promise to explore profit and profit-maximization more in future chapters. If students are persistent you can explain that producer surplus equals total revenue minus total variable cost, while economic profit equals total revenue minus total cost. That means producer surplus isn’t exactly economic profit. Rather, producer surplus equals economic profit plus total fixed cost. Don’t spend much time discussing this point now, but be ready for it if you get such a question when you’re in Chapters 12, 13, or 14.

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III. Is the Competitive Market Efficient? Efficiency of Competitive Equilibrium •

•

The marginal benefit to the entire society is the marginal social benefit curve, MSB. If all the benefits from consuming a good go to its consumers, the market demand curve is the same as the MSB curve. The marginal cost to the entire society is the marginal social cost curve, MSC. If all the costs of producing a good are paid by the producers, the market supply curve is the same as the MSC curve. When the marginal social benefit of the last unit produced equals its marginal social cost, society attains efficiency. However, because the demand curve is the same as the MSB curve and the supply curve is the same as the MSC curve, the efficient quantity that sets the MSB equal to the MSC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The figure illustrates how the efficient quantity of milk, 6 million gallons per month, also is the equilibrium quantity of milk. When the efficient quantity of milk is produced, the sum of the consumer surplus and producer surplus (total surplus) is maximized.

It helps to summarize all the results of efficiency at this point, as follows: • By definition, efficiency requires that resources are being used where they are most highly valued. • When resources are used where they are most highly valued, MSB = MSC. D S • When the demand and supply curves intersect, Q = Q , and the market achieves equilibrium. • At equilibrium the total surplus in the market is maximized. (This is usually the most difficult concept to prove without use of calculus in principles courses. Be sure to emphasize to your students that the following sections and chapters will show exactly what happens to consumer and producer surplus when the market moves away from equilibrium.) • Buyers and sellers acting in their own self-interest maximize social well-being. • Adam Smith, in his 1776 book The Wealth of Nations, articulated how competition led self-interested consumers and producers to make choices that unintentionally promote the social interest as if they were led by an “invisible hand. Economics in Action: Selling the Invisible Hand This case discusses how the Invisible hand of the market allocates resources to their highest valued use first with a cartoon and then in a real-life case of pizza delivery. The Invisible Hand at work: When demand or supply shifts in a market, equilibrium changes to a new point where the MSB = MSC, as reflected in the new demand or supply curve. Show students how an increase in demand, for example, increases the MSB of every unit of output and results in a new, higher level of output that achieves efficiency. A decrease in supply raises the MSC of every unit, and with fewer units available, the MSB of those units is greater. The resulting decrease in output from the change in supply achieves efficiency. For students who want more information: Although done simply with words and a graph, this section explains the so-called “first fundamental theorem of welfare economics” that, under appropriate conditions, the competitive equilibrium is Pareto efficient (what this textbook calls an “efficient allocation”). You can extend Adam Smith’s “invisible hand” conjecture with mention of Vilfredo Pareto (1848–1923), an Italian economist who defined an efficient allocation as one in which it is not possible to rearrange the use of resources and make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s. John Hicks, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences.

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(http://www.nobel.se/economics/laureates/1972/index.html, http://www.nobel.se/economics/laureates/1983/index.html). Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the ArrowDebreu-McKenzie theorem. The A-D-M proof is deeper and more restricted than the words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.)

Market Failure • •

Inefficiency can occur because either too little of an item is produced (underproduction) or too much is produced (overproduction). In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus (decrease in total surplus) that results from producing at an inefficient level of production. The figure illustrates the deadweight loss from overproduction of milk and from underproduction

What is deadweight loss intuitively? In the figure above, production of the 4 millionth gallon of milk results in a MSB of $4 and a MSC of $2. By stopping production at 4 million gallons, society is losing that extra $2 of benefit relative to cost. In fact, the MSB will be greater than MSC for all production less than 6 million gallons. That lost value to society is deadweight loss. Similarly, production of the 8 millionth gallon of milk results in a MSB of $2 and a MSC of $4. In this case, the resources used to produce any milk beyond the 6 millionth gallon impose an additional cost that is greater than its additional benefit. In other words, resources would have a higher value elsewhere (in their best alternative use) than their use in the production of milk. That lost value to society again is deadweight loss.

Sources of Market Failure Sometimes a market overproduces or underproduces a good or service. The key obstacles to achieving an efficient allocation of resources in a market are: • Price and Quantity Regulations: A price ceiling sets the highest legal price and a price floor sets the lowest legal price. If a price ceiling or price floor makes the equilibrium price illegal, it can lead to inefficiency. Quantity regulations that limit the amount produced also lead to inefficiency. (Studied in Chapter 6) • Taxes and Subsidies: Taxes and subsidies place a wedge between the prices consumers pay and the prices producers receive. Both can lead to inefficiency. (Studied in Chapter 6) • Externalities: An externality is a cost or a benefit that affects someone other than the seller or the buyer. In that case, the demand curve is not the same as the marginal social benefit curve and/or the supply curve is not the same as the marginal social cost curve. In these cases, inefficiency results. (Studied in Chapter 16) • Public Goods and Common Resources: A public good is a good or service that is consumed simultaneously by everyone even if they don’t pay for it. Public goods lead to a free-rider problem, in which people do not pay for their share of the good. A common resource is owned by no one but available to be used by everyone. Common resources are generally over-used because no one owns the resource. In both cases, inefficiency can occur. (Studied in Chapter 17) • Monopoly: A monopoly is a firm that has sole control of a market. To maximize its profit, a monopoly produces less than the efficient quantity and so creates inefficiency. (Studied in Chapter 13)

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•

High transactions costs: The opportunity costs of making a trade are transactions costs. When these costs are high, a market might underproduce because too few transactions take place.

Alternatives to the Market If markets do not allocate resources efficiently, then one of the alternatives might do a better job. For instance, using first-come, first-serve to allocate spaces in a line at a movie theater probably works better than a market.

IV. Is the Competitive Market Fair? • •

Efficiency is a positive term, while equity is a normative term. Not everyone can agree upon what is fair. There are two general ways of defining fairness: “It’s not fair if the results aren’t fair” and “It’s not fair if the rules aren’t fair.”

It’s Not Fair If the Result Isn’t Fair •

Utilitarianism adopts this view. Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the greatest number.” This principle argues that fairness requires equality of incomes, which requires that incomes be redistributed.

Numerical example: If Lawrence makes $50,000 per year and Sylvia makes $60,000, then the marginal benefit of an additional dollar is greater for Lawrence than for Sylvia. Let’s say the marginal benefit of an additional dollar to Lawrence is equal to 8 units of “happiness,” while the marginal benefit of an additional dollar to Sylvia is only 3 units of happiness. (You may want to introduce the concept of “utility” as the economist’s proxy for “happiness.” The concept of utility will be more fully developed in Chapter 8.) If $1 of income is transferred from Sylvia to Lawrence, Sylvia will lose 3 units of happiness, but Lawrence will gain 8 units of happiness. Although Sylvia is worse off individually, the overall level of “happiness” in the economy has increased by 5 units. This process of transferring income from Sylvia to Lawrence can be repeated as long as Sylvia’s marginal benefit of an additional dollar is still less than Lawrence’s marginal benefit of an additional dollar. • •

Redistribution leads to the big tradeoff, the tradeoff between efficiency and fairness. The tradeoff occurs because taxes decrease people’s incentives to work, thereby decreasing the size of the “economic pie.” In addition, taxes lead to administration costs that also decrease the economic pie. John Rawls argued that redistribution should strive to make the poorest as well off as possible which may mean a smaller piece of a bigger pie, rather than an equal piece, to keep incentives in place.

It’s Not Fair If the Rules Aren’t Fair •

This perspective relies on the symmetry principle—the requirement that people in similar situations should be treated similarly. In economics, this means equality of economic opportunity rather than equality of economic outcomes. • Robert Nozick suggests government should promote fairness by establishing property rights for individuals and allowing only voluntary exchange of these resources. • If private property rights are enforced, if voluntary exchange takes place in a competitive market, and if none of the obstacles to efficiency listed before exist, then according to Nozick, the competitive market is fair.

What’s a “fair” grade in this class? Students generally expect to be graded based on their performance in a class. This scheme is a “fair rules” view of fairness. Discuss this observation with the class, and then ask if it would be fairer to grant everyone an A—a “fair results” view. Many students (especially ones who wouldn’t usually expect an A in a course) will find the guarantee of an A for everyone completely “fair.” Other students who know they work hard for their grades are likely to say this is “unfair.” Ask the question again, but this time consider automatically giving every student a D—or even an F. Would this be fair? Most students would agree that automatically failing everyone would not be “fair.” If automatically giving students an A is fair, why isn’t it equally fair to automatically give each student an F? Or, suppose on the final day of class, the rules of the course are changed so that regardless of a student’s previous scores, the student will be given an A—is this change fair? What if the student was automatically given an F—is this change fair? Focus again on what’s a fair “result” as opposed to a fair “rule.”

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At Issue: Price Gouging This section considers the case of Price Gouging. The legal argument and the economist’s counter argument are considered in light of a case against selling generators at twice the normal price in the aftermath of Hurricane Katrina. Economics in the News: Making Traffic Flow Efficiently Solving Traffic Congestion Recent research on how to make traffic flow more efficiently has shown the benefit of adding capacity is only temporary. Traffic expands to the natural rate of high congestion. Mass transit projects somewhat astoundingly do not reduce traffic. What does reduce traffic is congestion pricing, charging a (higher) price for driving in congested areas or at congested times..

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Additional Problems 1.

The table gives the demand and Quantity Quantity supply schedules for spring water. Price demanded supplied a. What is the maximum price that (dollars per bottle) (bottles per day) consumers are willing to pay for the 30th bottle? 0 80 0 0.50 70 10 b. What is the minimum price that 1.00 60 20 producers are willing to accept for 1.50 50 30 the 30th bottle? 2.00 40 40 c. Are 30 bottles a day less than or 2.50 30 50 greater than the efficient quantity? 3.00 20 60 d. What is the consumer surplus if the 3.50 10 70 efficient quantity of spring water is 4.00 0 80 produced? e. What is the producer surplus if the efficient quantity is of spring water is produced? f. What is the deadweight loss if 30 bottles are produced?

The table gives the demand schedules for train travel for Joe, Jean, and Joy. a. If the price of train travel is 50 cents a passenger mile, what is the consumer surplus of each consumer? b. Which consumer has the largest consumer surplus? Explain why. c. If the price of train travel falls to 30 cents a passenger mile, what is the change in consumer surplus of each consumer?

Price (cents per mile) 10 20 30 40 50 60 70 80 90 100 110

Joe 50 45 40 35 30 25 20 15 10 5 0

Quantity demanded (passenger miles) Jean 600 500 400 300 200 100 0 0 0 0 0

Joy 300 250 200 150 100 50 0 0 0 0 0

Solutions to Additional Problems 1.

d. e.

The maximum price that consumers will pay is $2.50. The demand schedule shows the maximum price that consumers will pay for each bottle of spring water. The maximum price that consumers will pay for the 30th bottle is $2.50. The minimum price that producers will accept is $1.50. The supply schedule shows the minimum price that producers will accept for each bottle of spring water. The minimum price that produces will accept for the 30th bottle is $1.50. 30 bottles is less than the efficient quantity. The efficient quantity is such that marginal benefit from the last bottle equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—40 bottles a day. Consumer surplus is $40. The equilibrium price is $2. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the triangle is ½  ($4 − $2)  40, which is $40. Producer surplus is $40. The producer surplus is the area of the triangle above the supply curve below the price. The price is $2. The area of the triangle is ½  ($2 − $0)  40, which is $40.

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b. c.

The deadweight loss is $5. Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals ½  (40 − 30)  ($2.50 − $0.50), which is $5. Joe’s consumer surplus is $9. Jean’s consumer surplus is $20, and Joy’s consumer surplus is $10. Consumer surplus is the area under the demand curve above the price. At 50 cents, Joe will travel 30 miles, Jean will travel 200 miles, and Joy will travel 100 miles. Joe’s consumer surplus equals ½  (110¢ − 50¢)  30, which equals $9. Similarly, Jean’s consumer surplus equals ½  (70¢ − 50¢)  200, which equals $20. And Joy’s consumer surplus equals ½  (70¢ − 50¢)  100, which equals $10. Jean’s consumer surplus is the largest because she places a higher value on each unit of the good than the other two do. Joe’s consumer surplus rises by $7. Jean’s consumer surplus rises by $60, and Joy’s consumer surplus rises by $30. At 30 cents a mile, Joe travels 40 miles and his consumer surplus is $16. Joe’s consumer surplus equals ½  (110¢ 30¢)  40, which equals $16. Joe’s consumer surplus increases from $9 to $16, an increase of $7. Jean travels 400 miles and her consumer surplus is $80, an increase of $60. Joy travels 200 miles and her consumer surplus is $40, an increase of $30.

Additional Discussion Questions 1.

Do price controls help following a natural disaster or emergency? The text introduces the compelling dilemma of allocating necessary goods following a natural disaster. (Though this issue is serious, if you want a few laughs—and perhaps more student engagement—use the idea of a Zombie disaster as your example.) Engage the students in a careful discussion on this theme, as it opens their eyes to the complexities involved with trying to improve upon the competitive market allocation of scarce resources, even under times of economic duress. • Should “price gouging” and “profiteering” be considered criminal acts? Price controls are often imposed for weeks after the devastating event occurs. Goods such as bottled drinking water, bags of ice, batteries, electrical generators, plywood sheets (to seal broken windows), and chain saws (to remove downed trees from roadways) are typical objects for which sellers are not allowed to raise their sale price above pre-disaster levels. Ask students to critically examine the claim that such price restrictions protect the interests of disaster victims who are trying to get their lives back to normal as quickly as possible. • What happens to the demand curve for these goods? Ask the students to use the supply and demand model to reflect changes in the market for these goods immediately after the disaster has struck. Clearly the radical change in the local environment causes a rightward shift in the demand curve, sharply raising equilibrium market price. A price ceiling results in a heart-wrenching shortage. • What happens to the supply curve for these goods? Emphasize that the devastation that creates trauma for the consumers also significantly increases the cost of replacing the goods sold in a timely fashion. Replacement of these items needs to be rather quick if the victims want to minimize any future damage to the community (continued water damage from damaged homes, illnesses from contaminated drinking water supplies, etc.). The increase in the opportunity cost of supplying these goods pushes the supply curve to the left, aggravating the shortage. Motivate the students to consider how the goods will ultimately be distributed. • Distribution under price regulation: There is much pain, but is there any gain (in efficiency or in fairness)? Often the government sets and enforces price controls for these goods after a disaster. Point out to students that in an unregulated market, only those victims who value the goods at least as much as the unregulated equilibrium price would receive the scarce goods. Under price controls, it is uncertain how the goods will be allocated. Consumers with relatively low valuation of the goods are just as likely end up with the goods as those who have a relatively high valuation, decreasing total consumer surplus. Also, point out that if private resale prices are not closely monitored, then those victims with a relatively low value for their goods would engage in arbitrage by selling the goods at a high price to victims with a

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•

relatively high valuation for the goods. This simply transfers producer surplus from sellers to low valuation consumers, the fairness of which would be difficult to justify. Can price regulation contribute to undesirable seller behavior? Since the price control erases the opportunity cost that suppliers would normally face if they fail to sell their scarce goods to the highest bidder, these sellers may consider any number of non-monetary benefits when they determine who will ultimately receive their goods: Friends and well-networked acquaintances of the suppliers will likely receive consideration over strangers who would otherwise be willing to pay a higher price. In other words, sellers can use a personal characteristics method of allocation, so they might practice racial, gender, or religious discrimination when selling their goods. Can price regulation actually prolong victims’ suffering? Point out that for suppliers to quickly replace their depleted inventory they must be willing to bid away the goods from other areas not devastated by the disaster. Also, special deliveries of these goods to the disaster area must be arranged, meaning transportation resources must also be bid away from their usual employment. Both realities increase the cost of inventory replacement. Under a price ceiling there is insufficient incentive for goods to be quickly redistributed to where they are needed the most.

The big tradeoff: How can economic analysis make us more informed citizen voters? How to properly address the big tradeoff in society is the heart of continuing debates over proposed changes to the federal income tax code. • Should tax rates be decreased in order to spur greater economic activity and increase total production of goods and services in the economy? Get the students to identify and describe the opportunity cost of this proposal. Would income inequality increase? Would the “social fabric” change? • Should tax rates be increased to reduce the federal budget deficit and outstanding, national debt, or to fund greater government services and income redistribution programs? This chapter has shown that the economic pie would decrease if income were redistributed. How much decrease in economic activity is worth the greater equality? Greater knowledge of economic analysis lets people weigh these opportunity costs more carefully and thoughtfully.

Does the concept of decreasing marginal benefits actually imply that rich people will lose fewer benefits from an income transfer than the poor will gain? Emphasize to the students that many social policies (both private and public) that favor the poor at the expense of the rich are justified on utilitarian grounds. Marginal income tax rates that rise with income provide one obvious example. A business discount for college students (who are presumed to be poorer than the general population) is another example. Yet the students should understand that the ability to make a direct comparison of benefits lost for one person against the benefits gained by another is not implied by the concept of diminishing marginal benefits. Explain to them that the assumption of decreasing marginal benefits allows us to compare the marginal benefits across different levels of consumption for the same person, but it says nothing about comparing the marginal benefits across different people at different consumption levels. To clarify, ask them the following question: Can we truly measure and compare the happiness from a rich person’s consumption level to a poor person’s consumption level for the same good? Have the students assume that the quantity of income taken away from a rich mother means that she is now able to send only one, rather than both, of her children to college. Assume also that the same quantity of income given to a poor mother enables her to send one of her two children to college when she otherwise couldn’t have afforded to send either child to college. Ask the students, “Does this imply that the happiness, or perceived value, lost by the rich mother is somehow smaller than the happiness, or perceived value gained by the poor mother?” Ask the students if anyone can honestly claim to know that one mother’s concern about providing for her second child is smaller in magnitude than another mothers’ concern about providing for her first

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child. Obviously not! Explain that if this claim is false for this example, then it is false for all examples comparing benefit gains and losses across people at different levels of in income. 4.

Do “liberals” care more about fairness than “conservatives”? Some years ago, Jim Tobin told Michael Parkin about a nice test of whether a person is a liberal or a conservative. It also generates a good classroom discussion. Here’s how it goes. Give the students the following scenario and question: You are at an oasis in a large desert and you have some ice cream in an immovable refrigerator. (Assume, for the sake of the story, that ice cream is the only food available.) The people in the next oasis some miles away have no ice cream (and no other food) and are too old and infirm to travel. You have plenty of ice cream and you can transport it to the next oasis, but on the journey, some of it will melt. Now the question: How much of the ice cream would have to survive the journey for it to be worth transporting to the next oasis? Your students will not agree (and you may not agree with your students’ conclusions). According to Tobin, the most liberal would transport if only the smallest percentage survived the journey. The most conservative would want a large proportion to survive before undertaking the redistribution. You can point out that different people choose different points on the “big tradeoff.” Be careful not to support one view over the other as the only correct viewpoint. The focus here is on understanding the tradeoff between fairness and efficiency, not the value of one over the other. You could spend the rest of the course talking about and discussing equity, fairness, or distributive justice as it is sometimes called. This material is not standard, and you’ll be hardpressed to find it in any other principles text. It is included here because governments and the news media often make judgments about what is fair and what is not fair, and students need to know what criteria are included in those judgments.

When is it price gouging and when are prices “just high”? It is common at events to have extremely high prices for items such as bottled water, beer, food, prices much higher than would be paid outside the venue. Consider soda at professional baseball games or bottled water at a theme park. Prices might be double or triple what they would be outside but it isn’t considered to be illegal. Have students discuss fairness in this context and in the context of the aftermath of a disaster. If a bottle of water is selling for $4 in both cases, why is only one case considered gouging? What do they think the outcome should have been for the man described in the case that purchased generators and transported them to the hurricane region to profit? Was he serving himself, others, or both, as Adam Smith would argue?

C h a p t e r

GOVERNMENT ACTIONS IN MARKETS

The Big Picture Where we have been: Chapter 6 uses the demand and supply concepts of Chapter 3, the elasticity concepts of Chapter 4, and the efficiency concepts of Chapter 5 to study price ceilings and floors, taxes and subsidies, production quotas, and the markets for illegal goods. The chapter helps round out the student’s exploration of the demand and supply model and its application, and should be a fulfilling exercise for putting together the “big picture.” Where we are going: Chapter 7 continues the theme of this chapter by exploring international trade and the effects on consumer surplus, producer surplus, and national welfare. It also examines the deadweight loss of government policies that limit trade, such as tariffs and import quotas. Efficiency and deadweight loss are again explored as we consider how perfectly competitive markets allocate resources in Chapter 12, and then contrast that with results for monopoly (Chapter 13), monopolistic competition (Chapter 14), and oligopoly (Chapter 15). We will return to taxes and efficiency issues when we study externalities in Chapter 16 and public goods and common resources in Chapter 17.

N e w i n t h e Tw e l f t h E d i t i o n The opener to the chapter has been updated to address minimum wages laws in New York City, which then links to a new end of chapter article about minimum wages. A new Worked Problem section has been added. The Worked Problem presents demand and supply schedules for concert tickets. Then it shows students how to determine the equilibrium price and quantity if there is no tax and if there is a tax imposed on the sellers. The Worked Problem also shows the students how to calculate the tax incidence and tax revenue. Finally the Worked Problem demonstrates to the students how to determine the efficiency of the market once the tax is imposed. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Government Actions in Markets • •

Government intervention in markets—using price controls, taxes, production quotas, and making products illegal—can affect the price and quantity in those markets. Government intervention affects the efficiency of markets and can lead to the creation of deadweight losses.

A Housing Market with a Rent Ceiling • • •

A price ceiling is a government regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to a housing market it is called a rent ceiling. A rent ceiling set above the equilibrium rent has no effect on the market. A rent ceiling set below the equilibrium rent creates a housing shortage, increased search activity, and a black market.

A Housing Shortage •

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If the government imposes a rent ceiling below the equilibrium rent, then a shortage results. In the figure the equilibrium rent is $400 per month and the equilibrium quantity of units rented is 3,000. If the government imposes a rent ceiling of $200 per month, a shortage results. The quantity demanded at that price is 5,000 and the quantity supplied is 1,000. There is a shortage of 4,000 apartments per month. Rent ceilings lead to inefficiency. In a competitive market, the equilibrium quantity is the same as the efficient quantity. In a housing market with a rent ceiling, the quantity of units available is less than the equilibrium quantity and so is less than the efficient quantity. The market underproduces, and there is a deadweight loss, as shown in the figure as the darkened triangular area.

How is the “shortage” calculated? In looking at the effects of a price ceiling, students sometimes focus only on the change in the quantity supplied relative to equilibrium instead of looking at the entire difference between the quantity demanded and quantity supplied. The shortage is measured by the difference between the quantity demanded and the quantity supplied, NOT simply by the difference between the original equilibrium quantity and the new quantity supplied. Housing Markets and Rent Ceilings: Time and the elasticity of supply. Even given the caveat above, it is worth noting the reduction in quantity supplied of rent controlled housing, especially since policy makers’ intent is usually to make housing more available to lower income tenants and less housing is available after the policy. Where might those units and firms go instead? Recall supply elasticity from Chapter 4 and ask students how the passage of time might allow property owners to fully respond to the policy. In the long run, apartment owners are more likely to change the number of apartments they offer in response to a price ceiling than in the short run. Will they switch to condominiums? Will they be able to maintain public parts of the building given lower rents? What will happen to the average age of buildings over time in a rent controlled city? Eventually, however, apartment owners may find that alternative uses for their property (as a strip mall or a storage facility, for example) become more profitable.

GOVERNMENT ACTIONS IN MARKETS

Increased Search Activity •

Search activity is the time spent looking for someone with whom to do business. Search activity is costly and increases the opportunity cost of a given product or service. A rent ceiling (or a price ceiling) that creates a shortage increases search activity.

A Black Market • •

A black market is an illegal market in which the price exceeds the legally-imposed price ceiling. In a black market, illegal arrangements are made between renters and landlords—often at effective rental rates that are higher than would be the case in an unregulated market. The level of black market rent depends on how tightly the rent ceiling is enforced. When the rent ceiling is strictly enforced, black market rent will be closer to the maximum that consumers are willing to pay, which in the figure is $600 per month.

Are Rent Ceilings Fair? • •

Using the “fair rules” criteria, blocking voluntary exchange is unfair. Using the “fair outcomes” criteria, rent ceilings are fair if they help the poor and disadvantaged. Some other allocative mechanism, such as a lottery, queuing, some form of discrimination is often used to allocate housing. These alternative allocation methods of distribution do not favor the poor and disadvantaged.

What is the goal of a rent ceiling? Point out to the students that replacing the market price as an allocative mechanism for the rental market conflicts with the stated goals of those who promote rent ceilings as a means to create affordable housing. Rent ceilings lead to a shortage, which means landlords have more ability to discriminate against renters who have a different color of skin, or practice a different religion, or who have “too many” tattoos or “too many” children. It can increase incentives for corruption as outright bribes or excessive deposits and charges for building services make up for below market rent. In addition, there is less incentive for landlords to make needed electrical or plumbing repairs, or perform maintenance on appliances. Builders have less incentive to build new housing units so that in the long run, the stock of available housing will not grow with the population, making the shortage worse.

Rent Ceilings in Practice Cities with rent ceilings tend to have significant housing shortages. Some tenants, especially those who have lived longest in the city, have lower rents but others must pay higher rents. Economics in Action: Rent Control Winners: The Rich and Famous This Economics in Action application examines the impact of rent controls in the New York City housing market.

II. A Labor Market With a Minimum Wage •

A price floor is a government-imposed regulation that makes it illegal to charge a price lower than a specified level. When a price floor is applied to labor markets, it is called a minimum wage. A minimum wage that is set above the equilibrium wage rate creates unemployment.

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Minimum Wage Brings Unemployment •

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If a minimum wage is set above the equilibrium wage rate, the quantity of labor demanded is less than the quantity of labor supplied. This surplus of labor is unemployed workers. The minimum wage creates unemployment because some workers who are willing to work at the minimum wage will not find a job. In the figure, the equilibrium wage is $8 an hour and the equilibrium quantity of employment is 30,000 hours per month. If a minimum wage rate of $12 is imposed, the initial equilibrium wage rate is made illegal. At the minimum age the quantity of labor supplied is 50,000 hours per month and the quantity demanded is 10,000 so there is a surplus of 40,000 hours. The 40,000 hour surplus means that 40,000 hours of labor is unemployed.

Labor is work that households supply and firms demand. You might be surprised to find that quite a few students think that the demand for labor is the demand by a household for a job and the supply of labor is the supply of jobs by firms. Of course, they get into a big mess with this mirror image view of the labor market. Try to avoid this all-too-common mistake by being very explicit that households supply labor and firms demand it. Sure, firms provide jobs and people want jobs to earn an income. But it is labor, not jobs, that is supplied and demanded in the labor market.

Inefficiency of a Minimum Wage • •

Fewer workers are employed with a minimum wage, so less than the efficient quantity of workers is employed. At the quantity of labor employed, the marginal social benefit of labor exceeds its marginal social cost. Because the quantity of labor employed is less than the efficiency quantity, there is deadweight loss. In addition to the deadweight loss, there is also increased job search. Higher job search costs borne by workers add to the loss from the minimum wage.

The Minimum Wage in Practice •

While some estimates say that a 10 percent rise in the minimum wage results in a decrease in employment 1 to 3 percent (particularly among teenagers), other economists argue that higher minimum wages have little impact—and potentially even a positive impact—on employment. Such studies emphasize the idea that higher wages reduce a given employee’s incentive to quit, thereby reducing recruitment and training costs for employers and increasing labor productivity and labor demand.

Is the Minimum Wage Fair? •

The minimum wage is unfair based on an evaluation of both the “result” and the “rules” of a minimum wage. The result if unfair because workers who become unemployed are worse off than they would be with no minimum wage. The minimum wage imposes an unfair rule because it blocks voluntary exchange. Even if firms are willing to hire more labor at a wage that people are willing to take, they are not permitted to do so by the minimum wage law.

At Issue: Does the Minimum Wage Cause Unemployment? This At Issue examines the issue of whether the minimum wage creates unemployment. In addition to considering the Yes and No cases presented for the minimum wage, consider pulling up data on unemployment rates by educational level and race. Minority teens in urban areas have significantly higher rates than other populations. Ask your students why they think this situation exists? Perhaps the minimum wage has become a price floor about equilibrium for this population as they have to compete with more experienced, older workers. You can also ask them if they think this outcome is “fair”? Given that many students are often paid the minimum wage, asking them if they think the differential outcome is fair can create an interesting and perhaps even heated discussion.

GOVERNMENT ACTIONS IN MARKETS

III. Taxes Tax Incidence •

Tax Incidence is the division of the burden of a tax between the buyer and the seller. The buyers’ burden arises when the price paid by the buyers rises after the tax is imposed. The sellers’ burden arises when the price they receive falls after the tax is imposed. Tax incidence does not depend on whether the tax law imposes the tax on buyers or on sellers.

A Tax on Sellers •

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Imposing a tax on sellers decreases supply because the tax is like a cost that sellers must pay. The supply curve shifts leftward. The vertical distance between the initial supply curve and the new supply curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases. The figure shows the effect of a tax imposed on sellers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week. When the tax is imposed, the supply curve shifts from S to S + tax. The length of the double headed arrow showing the vertical distance between the two supply curves equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per week.

A Tax on Buyers •

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Imposing a tax on buyers decreases demand because the tax lowers the amount they are willing to pay to the sellers. The demand curve shifts leftward. The vertical distance between the initial demand curve and the new demand curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases. The figure shows the effect of a tax imposed on buyers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week. When the tax is imposed, the demand curve shifts from D to D − tax. The length of the double headed equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per year.

Equivalence of Tax on Buyers and Sellers •

The figures above confirm the general conclusion: Regardless of whether the tax is imposed on buyers or sellers, the tax leads to the same outcome in which the new equilibrium price and quantity are identical. The tax burden is split the same way regardless of who is responsible for paying the tax to the government.

Tax Incidence and Elasticity of Demand •

With perfectly inelastic demand (a vertical demand curve), the buyer pays the entire tax. In general, the less elastic the demand, the larger the tax burden paid by the buyers (and the smaller the tax burden paid by the sellers).

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With perfectly elastic demand (a horizontal demand curve) the seller pays the entire tax. In general, the more elastic the demand, the smaller the tax burden paid by the buyers (and the larger the tax burden paid by the sellers).

Tax Incidence and Elasticity of Supply • •

With perfectly inelastic supply (a vertical supply curve) the seller pays the entire tax. In general, the less elastic the supply, the larger the tax burden paid by the sellers (and the smaller the tax burden paid by the buyers). With perfectly elastic supply (a horizontal supply curve) the buyer pays the entire tax. In general, the more elastic the supply, the smaller the tax burden paid by the sellers (and the larger the tax burden paid by the buyers).

Do consumer prices always rise when taxes rise? As long as the demand curve is not horizontal and the supply curve is not vertical, when a tax is hiked buyers will bear some of the burden of a tax and the prices they pay for good will increase. The elasticity of demand relative to the elasticity of supply is the key to determining how much burden each side of the market will bear. Consider the situation faced by smokers when the tax on cigarettes is increased. First, the demand for cigarettes is relatively inelastic. (Ask your students why they would expect cigarettes to have a relatively low elasticity of demand, relying on the determinants of elasticity presented in Chapter 4.) With relatively inelastic demand, when the government raises taxes on cigarettes, the price paid by buyers rises substantially. The incidence of the tax falls heavily on buyers. In addition, state governments have sued tobacco companies for past and future health care costs arising from the smoking-related illnesses. Tobacco companies settled these suits, paying billions of dollars in penalties, which raised their costs and decreased their supply. But smokers’ very inelastic demand for cigarettes means that the tobacco producers were able to pass on most of these costs to smokers without seeing a significant decrease in the quantity sold. On the other hand, when taxes were imposed on luxury yachts in the 1990s, because the demand for yachts was relatively elastic, yacht buyers drastically reduced their yacht purchases, and shipbuilders bore most of the burden of that tax.

Taxes and Efficiency •

Taxes drive a wedge between the price buyers pay and sellers receive. Therefore, they put a wedge between marginal benefit and marginal cost and create inefficiency. The quantity produced is less than the efficient quantity.

Economics in Action: Workers and Consumers Pay the Most Tax This Economics in Action case considers the incidence of employment and excise taxes and concludes workers and consumers are most responsible for paying them.

Taxes and Fairness The Benefits Principle •

The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government.

The Ability-to-Pay Principle •

The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden on the tax.

Examples: The federal excise tax on gasoline is an example of the “benefits principle” of taxation. Revenue collected from excise taxes on gasoline are used to finance interstate maintenance and improvements. To the extent that the purchasers of gasoline are the same people who use the interstates, then gas taxes are paid by those who receive the benefits of public interstates. On the other hand, income taxes are an example of the “ability-to-pay” principle. The progressive marginal tax rates of the U.S. tax code require those with higher incomes to pay a greater share of government expenditures.

GOVERNMENT ACTIONS IN MARKETS

IV. Production Quotas and Subsidies Production Quotas • •

A production quota is an upper limit to the quantity of a good that may be produced in a specific period of time. Production quotas will only have an impact if they are set below the equilibrium level of output in a market. A production quota results in a decrease in supply, a rise in price, a decrease in marginal cost, inefficiency from underproduction, and an incentive to cheat and overproduce.

Subsidies • •

A subsidy is a payment made by the government to a producer. A subsidy increases the supply. A subsidy results in an increase in supply, a fall in price and increase in quantity produced, an increase in marginal cost, payment to producers by the government, and inefficiency from overproduction.

Economics in Action: Rich High-Cost Farmers the Winners This Economics in Action examines farm subsidies and the tension they are creating between developed and developing countries.

V. Markets for Illegal Goods The government prohibits the trade of some goods, such as illegal drugs. Yet markets still exist, with both buyers and sellers engaging in trade.

A Free Market for a Drug •

With no penalties for selling or buying drugs, drug prices would be lower and more would be sold.

A Market for an Illegal Drug • • •

Imposing penalties on sellers decreases the supply and shifts the supply curve leftward compared to the free market case. These penalties raise the price and decrease the quantity. Imposing penalties on buyers decreases the demand and shifts the demand curve leftward compared to the free market case. These penalties lower the price and decrease the quantity. When both buyers and sellers face penalties, both the demand and supply curves shift leftward. The quantity decreases but the effect on the price is ambiguous. • If the decrease in demand exceeds the decrease in supply, the price falls. • If the decrease in demand equals the decrease in supply, the price does not change. • If the decrease in demand is less than the decrease in supply, the price rises.

Legalizing and Taxing Drugs • •

Compared to a legal and untaxed market, if drugs are legal and taxed, the price of drugs will be higher and the quantity consumed will be lower. But a high tax rate might be necessary to decrease the consumption of drugs to the level that occurs when they are illegal and so black markets might arise. An advantage of legalization and taxation is that the government can raise tax revenues for educating the population against using drugs. A disadvantage is that legalization might signal that drugs are socially acceptable, which could increase demand.

Economics in the News: Push to Raise the Minimum Wage State Minimum Wages Rising to Exceed the Federal Minimum This Economics in the News examines the push to raise state minimum wages above the federal minimum wage. This is a very timely issue for students to apply their recently learned economic analysis skills to understand. It shows how a minimum wage set above the equilibrium wage rate creates unemployment while a minimum wage set below the equilibrium wage rate has no effect.

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Additional Problems 1.

Figure 6.1 shows the demand for and supply of rental housing in Township. a. What are the equilibrium rent and equilibrium quantity of rental housing?

If a rent ceiling is set at $150 a month, what is b. The quantity of housing rented? c. The shortage of housing? d. The maximum price that someone is willing to pay for the last unit available?

The table gives the demand schedule and the Wage rate Quantity Quantity supply schedule for high school graduates. (dollars per demanded supplied a. What is the equilibrium wage and the hour) (hours per month) equilibrium quantity of employment. 6 9,000 4,000 b. What is the number of hours of labor 7 8,000 5,000 unemployed? 8 7,000 6,000 c. If a minimum wage is set at $7 an hour, 9 6,000 7,000 how many hours do high school graduates 10 5,000 8,000 work? d. If a minimum wage is set at $7 an hour, how many hours of labor are unemployed? e. If a minimum wage is set at $9 an hour, what are the number of hours of labor employed and the number of hours of labor unemployed? f. If the minimum wage is $9 an hour and demand increases by 500 hours a month, what is the wage rate paid to high school graduates and how many hours of their labor are unemployed?

The demand and supply schedules for coffee are given in the table. a. If there is no tax on coffee, what is the price of a cup of coffee and how much coffee is bought? b. If a tax of 75¢ a cup is introduced, what is the price of a cup of coffee and how much coffee is bought? Who pays the tax?

Price (dollars per cup) 1.50 1.75 2.00 2.25 2.50

Quantity Quantity demanded supplied (cups per hour) 90 30 70 40 50 50 30 60 10 70

GOVERNMENT ACTIONS IN MARKETS

Solutions to Additional Problems 1.

a. b. c. d.

a. b. c.

d. e.

a. b.

Equilibrium rent is $300 a month and the equilibrium quantity is 30,000 housing units. The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling. The shortage of housing is 40,000 housing units. At the rent ceiling, the quantity of housing demanded is 50,000, but the quantity supplied is 10,000, so there is a shortage of 40,000 housing units. The maximum price that someone is willing to pay for the 10,000th unit available is $450 a month. The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit. The equilibrium wage rate is $8.50 an hour, and employment is 6,500 hours a month. Unemployment is zero. Everyone who wants to work for $8.50 an hour is employed. They work 6,500 hours a month. A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage exceeds the minimum wage, the minimum wage is ineffective. The wage rate will be $8.50 an hour and employment is 6,500 hours. There is no unemployment. The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment. At $9 an hour, 6,000 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $9 an hour. Unemployment is equal to the quantity of labor supplied at $9 an hour minus the quantity of labor demanded at $9 an hour. The quantity supplied is 7,000 hours a month, and the quantity demanded is 6,000 hours a month. So 1,000 hours a month are unemployed. The wage rate is $9 an hour, and unemployment is 500 hours a month. At the minimum wage of $9 an hour, the quantity demanded is 6,500 hours a month and the quantity supplied is 7,000 hours a month. So 500 hours a month are unemployed. With no tax on coffee, the price is $2.00 a cup and 50 cups an hour are bought. The price is $2.25 a cup, and 30 cups an hour are bought. Consumers pay 25 cents of the tax on a cup of coffee and sellers pay 50 cents of the tax on a cup of coffee. The tax decreases the supply of coffee and raises the price of coffee. With no tax, sellers are willing to sell 30 cups an hour at $1.50 a cup. But with a 75 cent tax, they are willing to sell 30 cups an hour only if the price is 75 cents higher at $2.25 a cup.

Additional Discussion Questions 1. Do rent controls improve the quality of life for university students? The following provides a useful example to make the issue of market price regulation personally relevant for the students. Inform them that the University of California is located in the city of Berkeley, California, where the city government imposes strict rent controls. The University of Florida is located in Gainesville, Florida, where there are no rent controls. In which city would you expect incoming freshman students to have the least trouble renting an apartment? The students should understand that while apartments with low monthly rents would be very nice, they would also be very scarce due to a market shortage. Emphasize that under a rent control policy, not only are there fewer apartments for lease than if the market were unregulated, there are also many more students looking for an apartment who wouldn’t have even thought about renting at the higher rental rates of the unregulated market. Who ultimately gets the apartments? Students should see that the available units must be allocated somehow. Too many students trying to locate too few apartments means a new student will face the following difficulties: • Significant increase in search costs, such as time spent, gasoline consumed, and promising leads followed for nothing, etc. • Greater risk of being rejected by landlords simply for being the “wrong” race or ethnic background; having the “wrong” religious beliefs or personal attributes.

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Unscrupulous landlords requiring huge deposits; charging premiums for electricity or natural gas consumed; gouging the renters for minor maintenance actions; delaying important repairs to air conditioning or heating units or leaking plumbing fixtures. If rent control laws fail to promote fairness, what about efficiency? Students should see that having a rent control policy means the economy suffers from three sources of inefficiency (meaning net benefits to society are not maximized): • Those who get an apartment are not always the ones who value it the most. • Difference in the marginal benefit and marginal cost at the level of housing produced means that too few resources are used for producing the rental housing market, creating a deadweight loss. • Underused resources in the rental housing market imply that too many resources are used in other markets, resulting in the overproduction of goods and services in those markets. 2.

After the OPEC oil embargo in the 1970s, price controls were placed on gas markets that did not allow price to rise to the market clearing level. Gas shortages resulted as did black markets. Use the analysis provided in Chapter 6 on the use of price controls to discuss whether price controls likely hurt or helped consumers and the economy. Consider the following: • Who is helped and harmed by price ceilings? • Had gas prices been allowed to increase sharply, would we have made changes in our economy faster? At what cost? • How does the elasticity of demand and supply impact the degree to which price and quantity would change in the gasoline market? Price controls on gas meant people had to deal with gas shortages, informal rationing, and black markets, which reduced their ability to purchase gasoline even if the price of gasoline did not rise enough to reflect the change in market conditions. Firms paying higher costs and unable to charge higher prices would leave the market, willingly or through economic losses. Higher prices create incentives for people to reduce their purchases and find substitutes. Higher prices increase incentives for firms to develop alternate sources. Will raising the minimum wage help or hurt those who need help the most? This question makes students apply simple demand and supply analysis to discover the counter-intuitive implications from market regulation policies. Point out that minimum wage laws have at least two devastating impacts on the very people that supporters of a minimum wage say need these jobs the very most: • The higher wage attracts people with higher qualifications—like college students—to seek unskilled labor jobs that they wouldn’t otherwise seek out at a lower, unregulated wage. This means unskilled laborers who are heads of households are competing to get jobs against greater numbers of relatively more educated college students with relatively greater human capital. • Additionally, when employers determine which workers they are going to lay off after a raise in minimum wage takes effect, they are first going to release those employees with the least skills and the least experience. Those are precisely the characteristics of many uneducated, minority workers who are in the greatest need of retaining any paying job to ensure a better future. Students should understand that both of these results are the unintended consequences of trying to manipulate the market forces of supply and demand. What specifically are the “inefficiencies” of agriculture policies that prop up farm prices? Get the students to integrate concepts from many different chapters with the following example of agricultural market regulation. Inform students that the federal government regulates agriculture markets in many ways: i) it pays farmers to NOT produce output to prop up farm prices; ii) it uses output quotas to limit total farm production; and iii) it imposes price floors and

GOVERNMENT ACTIONS IN MARKETS

pays farmers for any unsold, surplus quantities. Have the students examine the impact of such market regulation and recognize that: • Too many resources are used in the agriculture markets, causing a deadweight loss from overproduction. Too few resources are used in other competitive, unregulated markets, causing deadweight loss from underproduction. Remind the students that even if the deadweight losses were not realized, society would still be moving to a lower valued point on the production possibilities frontier. • The federal government uses additional resources managing the huge surplus agricultural inventories, some of which (milk, e.g.) is very perishable and requires expensive storage facilities. Much of these perishable farm goods are spoiled before it is decided what could be done with them without depressing the market price. This implies that society is moving towards the interior of the production possibilities frontier. (If an agricultural product cannot be stored, it can sometimes be converted to other goods, like cheese. Alternatively, surplus product can be “dumped” on the world market, thereby depressing the equilibrium price of the product on the world market—to the detriment of small agrarian countries.) • The higher prices for food are used to justify increases in food stamp allotments to the poor and disadvantaged, increasing the tax revenues necessary to pay for this program. Higher tax burdens increase the deadweight loss to all markets that are taxed. This implies that society is moving even further to the interior of the production possibilities frontier. 5.

What are “sin taxes”? Ask your students to think about some of the markets mentioned in the chapter that are heavily taxed (cigarettes, for example). Alcohol purchases are also subject to federal excise taxes. Some of these taxes are often referred to as “sin” taxes. Ask students why they think that is the case. Consumption of cigarettes and alcohol is traditionally considered somewhat “taboo” (or at least unhealthy), so purchases of these products are subject to a sin tax. By taxing this consumption, the quantity consumed of these goods will decrease (although not by much if the demand for these goods is relatively inelastic). • Ask your students whether they think a tax on gasoline is a sin tax. While it may not be “sinful” or unhealthy personally to buy gasoline, some politicians actually favor increasing taxes on gasoline to further discourage use of this scarce fossil fuel. They argue that use of gasoline is unhealthy for the environment. As with other sin taxes, part of the motivation for the tax on gasoline is the resulting reduction in consumption.

How are taxes related to tax revenues? In markets with relatively inelastic demand, consumers bear most of the burden of taxes, and the quantity purchased of those goods decreases only slightly in response to higher prices. As a result, markets with relatively inelastic demand would also be expected to generate high tax revenues. On the other hand, imposing taxes in markets where demand is relatively elastic would result in large reductions in consumer purchases and, ultimately, smaller collections of tax revenue. Show this result to your students graphically, reminding them that “less elastic” demand would be steeper and “more elastic” demand would be flatter. The area of tax revenue has a smaller base when the quantity consumers purchase falls dramatically when prices rise (i.e., when a tax is imposed in a market where demand is relatively elastic). The area of tax revenue has a larger base when the quantity consumers purchase falls only a little when prices rise after the tax (i.e., when a tax is imposed in a market where demand is relatively inelastic). Example: Use Figure 6.5 in the text. With a tax of $1.50 imposed in the market, the price of cigarettes rises to $4, and the quantity purchased falls from 350 million to 325 million. The government therefore collects ($1.50 x 325 million = $487.5 million) in revenue. What if the quantity of cigarettes purchased had fallen only to 335 million instead of 325 million? In other words, what if the demand for cigarettes was less elastic? Now the government would collect (1.50 x 335 million = $502.5 million) in revenue. (Note that the “sin” taxes placed in markets with relatively inelastic demand are likely to be the very markets that generate the greatest government tax revenue as well.)

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How are elasticity and deadweight loss related? Show your students how the size of the deadweight loss triangle is related to elasticities as well. With linear supply and demand curves, the area of deadweight loss is a triangle with a height equal to the amount of the tax (the vertical distance between the two supply or demand curves) and a base equal to the decrease in the quantity purchased as a result of the tax. For any given tax, the only difference in deadweight loss across two markets will be the size of the decrease in the quantity purchased as a result of the tax. You can show this graphically by showing deadweight loss when demand is relatively steep as opposed to deadweight loss when demand is relatively flat. Just make sure you use the same tax (same vertical distance between the two supply curves) in the comparison. A Swedish economist famously noted that rent controls are possibly the best way to destroy a city, except perhaps for bombing it. Explain why this might be true. If rents are below market, it is hard for firms to cover their production costs. As time passes, building maintenance suffers, roofs aren’t replaced, new construction is eliminated, and the housing stock deteriorates. USA Today recently reported that significant increases in federal cigarette taxes (more than $1 per pack) led to a significant increase in the number of people who quit smoking, especially among teens, seniors, and low income individuals. Discuss what this means about elasticity, potential government revenue from the cigarette tax, and the goals government is trying to accomplish through “sin” tax policy. Do governments really want people to quit? If enough people quit so that the tax revenue falls, demand has hit the elastic portion of the curve. If government truly wants people to quit, taxes must be high enough to reach that portion of the curve. If government, however, wants tax revenue to help meet budget goals, they do not want to set the tax so that it moves demand into the elastic part of the demand. What do the students think is the “true” goal of the government? You can return to this discussion after discussing externalities when it will be even more meaningful.

C h a p t e r

GLOBAL MARKETS IN ACTION

The Big Picture Where we have been: Chapter 2 introduced the gains from trade in a simple model with a linear production possibilities frontier. This chapter continues the explanation of the gains from trade by looking at individual markets using demand and supply. The chapter uses the concepts of consumer surplus, producer surplus, and deadweight loss, first introduced in Chapter 5. Because of this mode of analysis, the chapter now integrates tightly with the preceding chapter, which examined changes in consumer surplus, producer surplus, and deadweight loss resulting from government policies. The chapter examines trade restrictions and protection with a focus on the deadweight loss resulting from trade restrictions. Where we are going: Chapter 7 marks the end of the basic applications of supply and demand analysis. Chapters 8 and 9 cover utility theory and indifference curves in explaining consumer demand, and Chapters 10 to 15 develop the theory of the firm and supply decisions.

N e w i n t h e Tw e l f t h E d i t i o n The case studies in the chapter have been updated to incorporate new data. The chapter ends with a new Economics in the News article about the difficulty of achieving a free trade agreement. A new Worked Problem section has been introduced. The Worked Problem covers comparative advantage and prices in the global market. It gives U.S. demand and supply schedules for honey and the world price of honey. It shows the students how to calculate the no-trade equilibrium price and quantity and, from these results, how to determine whether the United States imports or exports honey. Then it demonstrates how the quantity produced, consumed, and traded internationally changes when honey is opened to trade. Finally it shows the students how to calculate the U.S. gain from trade and the distribution of the gains and losses. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Global Markets in Action • • •

Comparative advantage means that all countries can gain from trade. Total surplus increases with international trade. There are many arguments in favor of restricting international trade, but restricting free trade results in deadweight loss and inefficiency.

The first Economics in Action application shows the major U.S. exports and imports. A great source of information about global business for undergraduates is Global Edge, which is hosted by Michigan State University (http://globaledge.msu.edu). This site compiles information from many sources and is great entry point for student research, in addition to hosting modules and other resources for global business. Students can search by state or country to compare what is traded and to get an overview of the economies of other regions.

How Global Markets Work • • • •

The goods and services that we buy from people in other countries are called imports. The goods and services that we sell to people in other countries are called exports. The United States is the world’s largest international trader and accounts for 10 percent of world exports and 13 percent of world imports. In 2013, U.S. exports were $2.3 trillion (about 14 percent of the value of U.S. production) and U.S. imports were $2.7 trillion (about 17 percent of total U.S. expenditure). The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. By specializing in producing the good in which each country has comparative advantage, both countries gain from international trade.

For more data on international trade: The data on U.S. international trade can be accessed at the Bureau of Economic Analysis web site: www.bea.gov/international/index.htm. Key facts worth emphasizing are the enormous growth in volume of trade over time and huge two-way trade in manufactures. Explain that the balance of trade along with the international borrowing and lending that finances it results from spending and saving decisions in the United States and the rest of the world, and is independent of the forces that generate the volume of trade, which this chapter covers.

U.S. Exports •

•

The United States will export goods for which it has comparative advantage. In the figure the world price of coal is $60 per ton and the price in the United States before trade is $40 per ton. The United States has a comparative advantage in producing coal because the price before trade is lower than the world price. In this case the United States will export coal. In the figure, before international trade the price of coal in the United States was $40 per ton and at that price the United States produced 3 million tons of coal per year and consumed 3 million tons per year. With international trade, the price in the United States rises to the world price, $60 per ton. At that price the United States produces 5 million tons of coal per year, consumes 1 million tons per year, and exports the difference, 4 million tons per year.

GLOBAL MARKETS IN ACTION

U.S. Imports •

•

The United States will import goods in which it does NOT have a comparative advantage. In the figure, the world price of automobiles is $20,000 per car and the price in the United States before trade is $40,000 per car, so the United States does not have a comparative advantage in producing automobiles. In this case the United States will import cars. In the figure, before international trade the price of a car in the United States was $40,000 per car and at that price the United States produced 3 million cars per year and consumed 3 million cars per year. With international trade the price in the United States falls to the world price, $20,000 per car. At that price the United States produces 1 million cars per year, consumes 5 million cars per year, and imports the difference, 4 million cars per year.

II. Winners, Losers, and the Net Gain from Trade U.S. Exports •

Exports raise the U.S. price of the good or service. With the higher price consumers lose and producers gain. The figure shows this breakdown of winners and losers. Consumer surplus decreases from area A + area B to only area A. Producer surplus increases from area D to area B + area C + area D. The increase in producer surplus more than offsets the decrease in consumer surplus, so total surplus increases. The total surplus increases by area C. Also note that the loss to consumers, area B, is picked up as a gain to producers.

U.S. Imports •

Imports lower the U.S. price of the good or service. With the lower price consumers win and producers lose. The figure shows this breakdown of winners and losers. Consumer surplus increases from area A to area A plus area B + area C. Producer surplus decreases from area B + area D to only area D. The increase in consumer surplus more than offsets the decrease in producer surplus, so total surplus increases. The total surplus increases by area C. Also note that the loss to producers, area B, is picked up as a gain to consumers.

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The Fable of Adam Blackbox: There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram (from International Economic Problems, John Wiley, 1970) is a powerful way to begin. Make up your own version with local flavor and embellishment. Adam Blackbox announces that he has discovered an amazing way to produce low-price, high-quality automobiles. He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, high-quality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love him. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and Congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering low-price, high-quality automobiles is clearly part of the process of achieving greater prosperity for all. The press becomes increasingly curious about what is going on in the giant New England auto plant. Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer. He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles. Ask your students why the president and Congress accepted Adam Blackbox initially but then changed their tune. Was Adam Blackbox hurting America or helping America?

III. International Trade Restrictions •

Governments restrict international trade to protect domestic industries from foreign competition using tariffs, import quotas, other import barriers, and subsidies

Tariffs • •

•

A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary. A tariff increases the price in the nation for the good. If the supply to the nation from the rest of the world is perfectly elastic, the price rises by the full amount of the tariff. The following occur: • Consumers buy less of the good and producers increase the quantity supplied • Government collects tariff revenue equal to the tariff times the quantity imported of the good • Less of the good is imported • A deadweight loss results. As a result of a tariff, U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss. All these results are shown in the figure. The government imposes a $10,000 per car tariff on imported automobiles so the U.S. price rises to $30,000. U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million. Imports decrease from 4 million per year to 2 million. Consumer surplus decreases from area A + area B + area C + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The government gains tariff revenue equal to area D. But both areas C are now deadweight losses, so on net society is harmed by the tariff.

GLOBAL MARKETS IN ACTION

Two notes on the impact of tariffs to point out to students: First, when a tariff is imposed imports decrease more than domestic production increases. Flipping this observation around means that when tariffs are lowered, imports increase by more than domestic production decreases. Basically, every unit we import is not a lost sale to a domestic firm. Indeed, if domestic supply is inelastic and demand elastic, domestic production may expand very little even with a huge drop in imports. Second tariffs basically force foreign firms to be more efficient than domestic firms, something that harms incentives and may limit domestic firms’ opportunities in the long run. They also can give foreign firms the incentive to move operations into the domestic economy. For instance Japanese automakers opened many manufacturing plants in the United States when their imports to the U.S. economy were limited. The upshot? U.S. automakers now face competition from Toyota, Honda, and many other automakers that have set up shop in the United States. The Economics in Action application in this section considers the decrease in U.S. tariffs over time. This feature gives you a good chance to discuss the current state of global trade negotiations.

Import Quotas • •

•

An import quota is a restriction that limits the maximum quantity of a good that may be imported in a given period. An import quota increases the price in the nation for the good. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied • The importers gain additional profit • Less of the good is imported • A deadweight loss results. As was the case with a tariff, with an import quota U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss. All these results are shown in the figure. The government imposes a 2 million per year import quota on automobiles as shown. With this quota, the supply curve becomes the U.S. supply curve below the world price of $20,000 per car and then the U.S. supply curve plus the 2 million import quota at prices above the $20,000 world price. The U.S. price rises to $30,000 per car. As a result U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million so that imports decrease from 4 million per year to 2 million. Consumer surplus decreases from area A + area B + area C + area D + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The importers’ profit is equal to the total area D. Both areas C are deadweight losses, so on net society is harmed by the import quota.

An Economics in the News case considers why the United States has switched from exporting to importing coat hangers. It examines the potential impact of a 21 percent tariff on imports of coat hangers.

Other Import Barriers • •

Although they might not have been designed to limit international trade, health, safety, and regulation barriers have that effect. Voluntary export restraints, while not common, act like a quota and exist if a country negotiates with foreign trade partners to voluntarily limit their exports.

An Economics in Action case discusses the Doha Development Agenda, the World Trade Organization and the problems with reaching agreement. Again, this is a good opportunity to have students research the current status of this negotiation and the industries that are most affected.

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Export Subsidies •

An export subsidy is a payment by the government to the producer of an exported good. These are illegal under most international trade agreements. One of the reasons that progress on international trade agreements such as the Doha Round has been difficult is that the United States and European Union pay subsidies to their farmers, which would be illegal under the past trade agreements reached for most other goods and services.

IV. The Case Against Protection Arguments for protection include the following: • The infant-industry argument: The so-called infant-industry argument for protection is that protection is necessary for a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to dynamic comparative advantage—comparative advantages change over time due to learning-by-doing. However, the infant industries argument only applies if the benefits of learningby-doing spill over to other industries and if firms have incentives to become more competitive over time, something that protection tends to limit. • The counteracts dumping argument: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly. However, it is difficult to measure the cost of production, so whether dumping is taking place is difficult to determine. Charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets. • Saves domestic jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors. • Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in wage rates generally reflect differences in productivity, and competitiveness is determined by both differences in wages and differences in productivity. • Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-thebottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries. • Prevents rich countries from exploiting developing countries: The argument for protection to prevent people of the rich industrial world from exploiting the poorer people of the developing countries is wrong. While wage rates in many developing countries are very low, they would be even lower without foreign demand for the goods that these countries produce. Through trade, countries gain access to capital and new technology that will speed development and the growth of living standards. • Reduces offshore outsourcing that sends good U.S. jobs to other countries: When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished goods from other U.S. or foreign firms, they are outsourcing. Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt. The actual number of jobs lost to offshoring is small but these people are hurt even though the overall economy gains. Does offshoring help or hurt the U.S. economy? A nifty “At Issue” application discusses this issue. It presents the conventional non-economist view that offshoring is bad and contrasts that with the conventional economist view that offshoring is similar to other (beneficial!) international trade. Does free trade exploit workers in developing countries? Students might be somewhat familiar with the terminology of “exploitation.” Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO

GLOBAL MARKETS IN ACTION

meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor.

Why is International Trade Restricted? Despite arguments against protection, trade is still restricted because key economic interests benefit from protection. • Tariff revenues provide a relatively inexpensive way for the government to collect revenues. • Rent seeking is lobbying and other political activity that seeks to capture the gains from trade. While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers. Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection. • If the gains from free trade exceed the losses, it is possible to compensate the losers so that everyone can be in favor of free trade. To some extent, unemployment compensation and job-retraining programs are designed to serve this purpose. However, providing compensation is difficult because it is hard to identify exactly who has lost a job as a result of free international trade and not because of other reasons. Another fable: There is also a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” or “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities. For further reading: If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, 3rd Edition, 2007, Prentice Hall (ISBN: 0131433547). The book tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialogue between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism. Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: --The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains. --Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade. --Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage. --International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity

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can be achieved only through free trade among nations, and that the surplus generated is more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale. --There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. The section of the chapter entitled “Cases Against Protection” contains concise and complete counter-arguments to the often heard justifications for restraining international trade. Emphasize that economists overwhelmingly agree that there is no good argument against free trade. The chapter ends with a new Economics in the News on the problems with reaching an agreement in the Transpacific Partnership trade negotiations. The talks have focused on cars and agriculture. Failing to reach agreement between the United States and Japan on these issues is a setback in terms of achieving broader agreement. The analysis shows the potential gains from reaching a trade agreement.

GLOBAL MARKETS IN ACTION

Additional Problems 1.

Suppose that the world price of bananas is 18 U.S. cents a pound and that when Australia does not trade bananas internationally, their equilibrium price in Australia is 12 U.S. cents a pound. If Australia opens up to international trade, does it export or import bananas? Explain how the price of bananas in Australia changes. How does the quantity of bananas consumed in Australia change? How does the quantity of bananas grown in Australia change?

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. a. Explain how the tariff on textiles will change the price of textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. b. Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument?

Use the information below to answer the following question U.S. Expands China Paper Anti-Dumping Tariff Responding to a case brought by the NewPage Corporation of Dayton, Ohio, the U.S. Commerce Department announced it was imposing a tariff of 99.65 percent on imported glossy paper from China. Glossy paper is the type of paper used to manufacture art books, high-end magazines, textbooks, and annual reports. In 2006 imports of glossy paper from China was estimated to be $224 million. Reuters, May 30, 2007 a. What is dumping? Who in the United States loses from China’s dumping of glossy paper? b. What argument might NewPage Corp. have used to persuade the U.S. Commerce Department to impose a 99.65 percent tariff? c. Explain who, in the United States, will gain and who will lose from the tariff on glossy paper. How do you expect the prices of magazines and textbooks that you buy to change?

Solutions to Additional Problems 1.

With no international trade, the price in Australia is less than that in the world, so Australia has a comparative advantage in producing bananas. As a result, if Australia opens up to international trade, it will export bananas. With international trade, the price of bananas in Australia rises. The higher price leads to a decrease in the quantity of bananas consumed in Australia. The higher price also leads to an increase in the quantity of bananas grown in Australia. a.

Higher tariffs increase the price U.S. consumers pay for textiles imported from China. Because the price of Chinese imported textiles rises, the quantity imported decreases. The quantity of textiles produced in the United States increases. This trade restriction means that the U.S. and Chinese gains from trade definitely decrease. Textile workers and owners of textile firms will gain from the higher price. Textile consumers will lose from the higher price. Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A

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more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods. 4.

a. b.

Dumping is when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper. Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production. The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises.

Additional Discussion Questions 1.

How can we know that the benefits to the economy from free trade are greater than the benefits accruing to the domestic industry that is protected from foreign competition? Stress to the students that if unrestrained international trade creates the efficient outcome for both countries involved, it also must mean that prosperity for each country is maximized. • Emphasize that free trade between nations encourages each country to pursue specialization in production in those industries for which the country has a comparative advantage relative to other countries. • If the total quantity of goods and services consumed in each country after international trade is greater than without international trade, then total incomes accruing to individuals must be greater, which means the prosperity of each nation’s economy as a whole is greater under free trade.

How will countries know which domestic industries have a comparative advantage in order to allocate resources towards specialization in producing those goods and services? Specialization and gains from international trade will arise naturally through relative price changes on the world market. • When domestic firms within an industry have a lower opportunity cost of production than firms in other countries, these firms discover that the price they can receive from foreign buyers (importers from other countries) is higher than the price they can receive from domestic consumers. In other words, the domestic price before international trade is lower than the world price. These domestic firms increase output, demand more labor, capital, and raw materials, and resources flow toward these industries. • When domestic firms within an industry have a higher opportunity cost of production than firms in other countries, domestic consumers discover that the price they must pay to foreign sellers for a good is lower than the price they must pay domestic producers. Domestic consumers switch their purchases to foreign imports. The domestic firms producing this good decrease their production, decrease their use of labor, capital, and raw materials, and resources flow away from these firms. • Each country’s economy naturally becomes specialized in producing output in those industries for which the country enjoys a comparative advantage. However, for each country to gain, each country must allow consumers and producers to have free access to foreign markets.

Shouldn’t we protect the workers of those industries that are hurt by foreign competition? Point out that protecting the workers in industries for which our country does not have a comparative advantage is akin to making everyone in the economy suffer a lower level of prosperity than under unrestricted trade—all to ensure that a small minority of people does not

GLOBAL MARKETS IN ACTION

suffer the economic losses associated with relocating to another community and finding employment in another industry. Use some specific examples in recent history: • If Congress imposes import quotas on Japanese vehicles being imported into the United States, tens of thousands of American autoworkers would be forced to find employment in another industry. Compare this to the tens of millions of car buyers each year that must pay hundreds or even thousands of extra dollars for their cars. • In 2002, President George W. Bush signed into law a tariff on foreign steel by some 30 percent. He effectively cost the hundreds of millions of American consumers tens of billions of dollars in higher prices for the myriad of goods containing steel, as well as those goods and services requiring transportation in trucks, trains, airplanes, and ships that are made from steel. He did this seeking political support from those states with a large presence of steel workers who work for firms that could not make a profit at the unregulated world market price of steel. The president’s defense was that other nation’s steel industries were receiving subsidies and had an “unfair “ advantage in production costs, effectively “dumping” steel in the U.S. markets at prices below production costs. Ask the students: What is “unfair” about having foreign governments effectively subsidizing the purchase of automobiles, trucks, and rail and air transportation by hundreds of millions of American citizens? Point out it is only “unfair” to the tens of thousands of steel workers who stand to face job relocation costs of finding work in another industry. • Emphasize that in each of these cases of trade restrictions, the economy as a whole would have gained from free international trade, even if autoworkers and steel workers lost some jobs. When we protect steel, or timber, or sugar, there are many more jobs in the downstream industries that use these inputs than there are jobs being protected. Higher costs limit expansion for those downstream industries. So why do they get protection? Autoworkers and steel workers are groups of people that are much more easily organized and stand to benefit much more individually from trade restrictions than the wide-spread American consumers. The result is successful lobbying efforts to restrict trade to the detriment to all consumers in the American economy. 4.

Discuss the following: Adam Smith told British politicians in the 18th century that they shouldn’t focus so much on producers. Free trade is not about importing so that others will take our exports. The argument “seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce.” But “consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer,” according to Smith. This idea will have applications as the class studies perfect competition. In the end, competition means that firms make only a normal return and society’s resources are allocated efficiently. Examine the projected increase in U.S. oil production over the next decade and contrast this with the trade data in the first Economics in Action application on U.S. trade. What effect might this change have on the composition of U.S. trade in the future? Currently, some legal barriers to exporting oil are being lifted. Hypothetically, the United States might become a major energy exporter in both refined oil and liquefied natural gas. This change could have significant impact on our balance of trade with specific countries and the composition of trade overall and could potentially impact global political priorities as well.

C h a p t e r

UTILITY AND DEMAND

The Big Picture Where we have been: Chapter 8 uses marginal utility theory to derive the downward-sloping demand curve introduced in Chapter 3 (and used throughout Chapters 4 to 7). Utility theory will also further explain the factors that change demand. Consumer surplus has been used in multiple chapters and will be reinforced in this chapter to help explain the diamond-water paradox and the difference between total utility and marginal utility. Where we are going: Chapter 9 presents a parallel analysis of the consumer problem using indifference curves. Each chapter is self-contained, so either can be omitted. Marginal analysis is used in this chapter to describe marginal utility and the utility maximizing choice for consumers. The importance of marginal analysis will be reinforced in future chapters as we move through profit maximization and choice making in factor markets. Chapter 19, which deals with risk, uses some of the concepts from this chapter, although Chapter 19 also is self-contained.

N e w i n t h e Tw e l f t h E d i t i o n The chapter introduction has been updated to focus on sugary drink consumption. The data in the case study on maximizing utility from downloading music have been updated. A new Worked Problem has been added. The Worked Problem presents Jake’s income and his marginal utility schedules for songs and cookies. It then shows the students how to calculate Jake’s utility-maximizing combination of cookies and songs and how this combination changes when the price of a song rises. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

UTILITY AND DEMAND

Lecture Notes

Utility and Demand • • •

Economists assume that people behave to make themselves as well off as possible. Consumption possibilities tell us what the consumer can afford to buy given a limited income and the prices of the goods and services they are considering. Preferences are reflected in the discussion of utility maximization

Consumption Choices •

Consumption possibilities are all the things a consumer can afford to buy.

The Budget Line • • •

•

The limits of consumption possibilities are illustrated with a budget line. The budget line marks the boundary between those combinations of goods and services that the consumer can afford to buy and those that it cannot afford. The budget line shown illustrates the possible combinations of pizza and books that a consumer with $50 income could purchase if the price of pizzas were $10 and the price of books were $10. The budget line constrains choices: Points on the budget line and inside the budget line are affordable and within the consumer’s consumption possibilities. Points beyond the budget line are not affordable.

Changes in Consumption Possibilities • • • •

Consumption possibilities change when income or prices change. An increase in income shifts the budget line rightward without changing its slope. A change in the price of one of the goods changes the intercept on its axis and changes the slope of the budget line. These changes are used again in the alternate consumer choice model in chapter 9.

Preferences •

The choice a consumer makes depends on preferences.

Total utility •

•

Total utility is the total benefit that a person gets from the consumption of goods and services. As more of a good or service is consumed, total utility increases. The table provides an example of utility from consuming movies and paperback books in a given week.

Quantity of movies 0 1 2 3 4 5 6

Total utility 0 24 44 72 80 84 86

Quantity of books 0 1 2 3 4 5 6

Total utility 0 20 30 38 44 48 50

Where do the utility numbers come from? Year after year, you will get this question from the curious student. While the numbers for utility are ordinal rather than cardinal, using those terms to explain utility to undergraduates will generally result only in many blank stares. To help with one answer to this question, try the following story: Lisa likes movies and books. We tell Lisa that we’re going to call the utility she gets from 1 movie a month 24 units of utility. Then we ask her to tell us, using the same scale, how much she would like 2, 3, or more movies, and 1, 2, 3, or more books.

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Marginal Utility •

•

Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. The table shows the marginal utility from movies. When a good generates value, it has a positive marginal utility. Total utility increases as the quantity consumed increases.

Total utility 0

Marginal utility 24 20 18

Diminishing Marginal Utility •

Quantity of movies 0

Diminishing marginal utility is the principle that as more of a good or service is consumed, its marginal utility decreases. In the table the marginal utility diminishes as more movies are consumed.

II. Utility-Maximizing Choice • •

A consumer’s choices influence the total level of his or her utility because different combinations of goods generate different amounts of utility. The key assumption of marginal utility theory is that the household consumes the combination that maximizes its utility. We have to combine the constraint imposed by the budget line with the consumer’s preferences to find the combination of products that gives the consumer the maximum available utility.

Consumer Equilibrium •

Consumer equilibrium occurs when a situation in which a consumer has allocated all available income in a way that maximizes utility given the prices of the products.

A Spreadsheet Solution •

• •

The most direct way to find the quantity of goods Quantity of Total Quantity Total and services is to make a table with the choices movies utility of books utility available. Suppose the price of a movie is $8, the 0 0 0 0 price of a book is $4, and the consumer has income 1 24 1 20 of $24. 2 44 2 30 • Calculate the combinations of products that 3 72 3 38 exhaust the available income given the prices of 4 80 4 44 the goods. In the table, the consumer can 5 84 5 48 afford (3 movies/0 books), (2 movies/2 books), 6 86 6 50 (1 movie/4 books), and (0 movies/6 books). While the consumer can also afford the combinations of products inside the budget line, the smaller quantities associated with those points would have less utility than the points on the budget line. • From the utility figures given for each product, calculate the total utility from the combination of the two products. In the same order as the affordable combinations above, these total utilities are 72, 74, 68, and 50. Emphasize that it is total utility from the combination of the two products that the consumer is trying to maximize. • Select the combination that gives the maximum total utility, (2 movies/2books for total utility of 74) in this case. While in a model we might calculate the total utility from all the possible combinations of products and then select the combination with the highest utility, this is not a likely approach for consumers in practice. A more natural way to find the consumer equilibrium is to use marginal analysis to make the decision.

Choosing at the Margin •

A consumer’s utility is maximized when the consumer spends all available income and equalizes marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

UTILITY AND DEMAND

•

If the consumer is left Marginal Marginal with money to spend, Quantity Marginal utility per Quantity Marginal utility per opportunities for of utility dollar of books utility dollar increasing utility are left movies unused, so the 1 22 2.75 1 15 4.75 consumer can only be 2 18 2.25 2 9 2.25 maximizing utility when 3 13 1.63 3 7 1.75 all available income is 4 6 0.75 4 5 1.25 spent. 5 3 0.38 5 3 0.75 The table to the right has the marginal utility schedules that are computed from the total utility schedules in the table above. (The marginal utilities are the averages of the two adjacent marginal utilities for each quantity.) Given the price of a movie of $8, the price of a paperback book of $4, the table also has the marginal utility per dollar schedules. Assume the consumer has $24 to allocate between movies and books. To maximize utility, the individual buys 2 movies and 2 books because that combination of movies and books spends all the available income and sets the marginal utility per dollar from a movie equal to that from a book. (Both equal 2.25.)

Do people really calculate and compare marginal utilities and prices? One of the challenges in teaching the marginal utility theory is getting the students to appreciate the fundamental role of a model of choice. The goal is to predict choices, not to describe the thought processes that make them. Gary Becker has made the following point, updating the reference to the pitcher (from Parkin, Economics, first edition, 1990, p. 154): Justin Verlander (or substitute a currently hot pitcher) unanimously won the 2011 Cy Young award for the American League. He effectively knows all the laws of motion, of hand-eye coordination, about the speed of the bat and ball, and so on. He’s in fact solving a complicated physics problem when he steps up to pitch, but obviously he doesn’t have to know physics to do that. Likewise, when people solve economic problems rationally they’re really not thinking, “Well, I have this budget and I read this textbook and I look at my marginal utilities and the prices and determine what maximizes my utility.” People don’t do that, but it doesn’t mean they’re not being rational. Just because a Cy Young Award winner isn’t Albert Einstein doesn’t mean he can’t make rational decisions about pitching. •

The rule to spend all income and equalize marginal utility per dollar from each good maximizes utility because anytime the marginal utility per dollar from one good exceeds that of another good, the consumer can increase his or her total utility by spending a dollar less on the good with the lower marginal utility per dollar and spending the dollar on the good with the higher marginal utility per dollar.

Counterexamples can help. To help the students see that maximizing total utility requires equalizing the marginal utility per dollar on each good, work with the case when they are not equal. Suppose the marginal utility per dollar from a movie is 20 and the marginal utility per dollar from a soda is 10. Ask “If you gained an additional dollar, what would you spend it on and by how much would your total utility increase?” The students will spend it on movies and their total utility will rise by 20. Now ask the students “If you lost a dollar, what you cut back on and how much would your total utility decrease?” The students will cut back on sodas and their total utility will fall by 10. Now tell the students that they can gain a dollar by cutting back a dollar on sodas. Ask them the net change in their total utility, which is +10. The point to make is that anytime the marginal utility per dollar from one good differs from that for another good, consumption can be rearranged by cutting back on the good with the low marginal utility per dollar and spending the dollar on the good with the high marginal utility per dollar and increasing total utility. Why don’t consumers simply choose the goods with the highest marginal utility? Students will find it relatively easy to simply memorize the rule that maximizing utility requires that the marginal utility per dollar is equal across all goods, but, intuitively, students still often expect marginal utility to be the only determinant of utility maximization. To provide some additional intuition, ask them to think about two goods they’re trying to choose between, like a new shirt and a new download of a song. Say a new shirt would have a marginal utility of 20, while the download would have a marginal utility of 1. The price of a new shirt is $30, while the price of the download is $1. Should you purchase the new shirt because it has a higher marginal utility? No! You may prefer

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the shirt, but it costs thirty times as much as the download. Even though the download has the lower marginal utility, it has a higher marginal utility per dollar (1 as opposed to 2/3).

The Power of Marginal Analysis • •

The goal of maximizing utility does not require a computer and spreadsheet, but simply comparing the marginal utility per dollar of each of the products. In the example the person’s choice between movies and books, the person maximizes his or her utility where the marginal utility per dollar from movies is equal to the marginal utility per dollar from books. Mathematically, this is represented by the equation:

MUMovie MUBook . = PMovie PBook Other applications of marginal reasoning. Help your students to appreciate that marginal reasoning is one of the most important tools for understanding the economic perspective. Remind them that we have been using marginal reasoning for many chapters now: In Chapter 2 we derived the marginal cost of production from the PPF. In Chapter 5 we discovered that competitive equilibrium is efficient because marginal social benefit (from the demand curve) equals the marginal social cost (from the supply curve). In this chapter, we discover that equating the marginal utility per dollar across all goods and services maximizes a consumer’s utility. More generally, marginal analysis shows that if the marginal gain from an action exceeds the marginal loss, take the action.

Revealing Preference • •

We don’t have to ask a consumer to state preferences because we can figure them out by observing what is purchased at various prices. The units we use to measure preference don’t matter. Any arbitrary unit will work; for instance, if utility is multiplied by 2, the marginal utility per dollar equation shows that the equilibrium consumption bundle does not change.

III. Predictions of Marginal Utility Theory Marginal utility theory predicts the law of demand. It also predicts that a decrease in the price of a substitute good increases the demand for the good; and, for a normal good, an increase in income increases demand.

A Fall in the Price of a Movie A Change in the Quantity Demanded •

If the price of a good falls and other things remain the same, the marginal utility per dollar from that good rises. As a result, the consumer increases his or her purchases of that good in order to maximize utility. (As more of the good is purchased, its marginal utility decreases; as less of other goods are purchased, their marginal utilities increase. Eventually the consumer reaches a new equilibrium at which the marginal utility per dollar for all the goods is equal.)

A Change in Demand •

When the price of a good falls, it will have an impact on the demand for related goods (substitutes and complements in consumption). In the example above, when movie prices fall, the demand for paperback books decreases, implying that movies and books are substitute goods.

A Rise in Income •

If a consumer’s income increases, the consumer will reach a new consumer equilibrium in which all the income is spent and the marginal utility per dollar from all goods is equal. Marginal utility theory predicts that as the consumer’s income increases, the demand for normal goods increases and the demand for inferior goods decreases.

Paradox of Value •

The paradox of value is that water, which is essential to life, costs little, but diamonds, which are useless in comparison to water, are expensive.

UTILITY AND DEMAND

•

The resolution to this paradox comes from distinguishing total utility from marginal utility. The total utility from water is much more than from diamonds. But we have so much water that its marginal utility is small. And we have so few diamonds that their marginal utility is high. When a household maximizes its utility, it makes the marginal utility per dollar equal for all goods. Because diamonds have a high marginal utility, they have a high price. Because water has a low marginal utility, it has a low price. Consumer surplus also can be used to resolve the paradox as well. The consumer surplus from consuming water is vast but the consumer surplus from consuming diamonds is small.

Temperature as an Analogy • • •

Temperature and utility are both abstract concepts. The concept of utility allows economists to make predictions about human choices just as temperature allows predictions of physical phenomena. Utility may not be as precise a thermometer in making some types of predictions but is still useful.

An Economics in Action case considers the utility from recorded music and concludes that the availability and convenience of downloading individual songs increases consumer surplus. The utility from playing an album is greater using a CD, so most albums are played on CDs.

IV. New Ways of Explaining Consumer Choices Behavioral Economics • •

Behavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influences economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work. There are three impediments to rational choice: bounded rationality, bounded will-power, and bounded selfinterest.

Bounded Rationality •

Bounded rationality is rationality that is bounded by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.

Bounded Willpower •

Bounded willpower is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

Bounded Self-Interest •

Bounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others.

The Endowment Effect •

The endowment effect is the tendency for people to value something more highly simply because they own it.

Endowment effect in the housing market: The housing market entered a severe slump in the late 2000s and took years to even begin to emerge. One factor might have been the endowment effect: The price that home buyers were willing to pay for a house is lower than what homeowners, with the endowment effect, believe their home is worth. Consequently homes might sit on the market for long periods of time.

Neuroeconomics •

Neuroeconomics is the study of the activity of the human brain when a person makes an economic decision. Different decisions appear to activate different areas of the brain. Some decisions are made in the pre-frontal cortex, which is where memories are stored and data are analyzed. These decisions might be deemed rational. Other decisions are made in the hippocampus, which is where memories of anxiety and fear are stored. These decisions might be deemed irrational.

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Controversy •

Whether economics should focus on explaining the decisions we observe or on what goes on inside people’s heads is the source of controversy.

The Reading Between the Lines case at the end of the chapter about efforts to outlaw large, sugary drinks should draw student reaction and interest about the role of government in helping citizens make better decisions. Although the students have not yet learned about externalities, part of the discussion can include whether government can protect itself as a payer of health care costs for the poor and elderly.

UTILITY AND DEMAND

Additional Problems 1.

Mary enjoys classical CDs and travel Quantity Total utility from Total utility from books and spends $50 a month on them. per month classical CDs travel books The table shows the utility she gets from 1 30 30 each good. 2 40 38 a. Compare the two utility schedules. 3 48 44 Can you say anything about Mary’s 4 54 46 preferences? 5 58 47 b. What do the two utility schedules tell you about Mary’s preferences? c. If a classical CD and a travel book cost $10 each, how does Mary spend the $50 a month?

Rob enjoys rock concerts and the opera. The table shows the marginal utility he gets from each activity. Rob has $100 a month to spend on concerts. A rock concert ticket is $20, and an opera ticket is $10. How many rock concerts and how many operas does he attend?

Concerts per month 1 2 3 4 5

Marginal utility from rock concerts 90 80 60 40 20

Marginal utility from operas 120 90 60 30 20

In problem 2, Rob’s uncle gives him $30 to spend on concert tickets, so he now has $130. How many rock concerts and how many operas does he attend now that he has $130 to spend?

In problem 2, if the price of a rock concert decreases to $10, how many rock concerts and operas will Rob attend?

Solutions to Additional Problems 1.

a. b.

Mary gets the same utility from 1 classical CD as from 1 travel book, but at quantities greater than 1 she gets more utility from any number of classical CDs than she does from the same number of travel books. Mary receives the same marginal utility from her first classical CD as from her first travel book. At quantities greater than 1, Mary gets more marginal utility from an additional classical CD than she gets from an additional travel book when she has the same number of each. Mary buys 3 classical CDs and 2 travel books. When Mary buys 3 classical CDs and 2 travel books she spends $50. Mary maximizes her utility when she spends all of her money and the marginal utility per dollar from classical CDs and travel books is the same. When Mary buys 3 classical CDs her marginal utility per dollar spent is 0.8 units per dollar and when Mary buys 2 travel books her marginal utility per dollar spent is 0.8 units per dollar.

To maximize his utility, Rob attends 3 rock concerts and 4 opera concerts. Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 3 rock concerts and 4 operas, he spends $60 on rock concerts and $40 on operas—a total of $100. The marginal utility from the third rock concert is 60 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 3. The marginal utility from the fourth opera is 30 and an opera ticket is $10, so the marginal utility per dollar from operas is 3. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

To maximize his utility, Rob attends 4 rock concerts and 5 operas. Rob will spend his $130 such that all of the $130 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 4 rock concerts and 5 operas, he spends $80 on rock

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concert tickets and $50 on operas—a total of $130. The marginal utility from the fourth rock concert is 40 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from opera is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas. 4.

To maximize his utility, Rob attends 5 rock concerts and 5 operas. Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 5 rock concerts and 5 operas, he spends $50 on rock concert tickets and $50 on opera tickets—a total of $100. The marginal utility from the fifth rock concert is 20 and a rock concert ticket is $10, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from operas is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

Additional Discussion Questions 1.

Have you ever eaten or drank “too much”? Use the students’ personal experience with food or drink to show them that the marginal utility for a good can be increasing, diminishing, or even negative. The example works well for many types of food and drink consumption, but college students often especially enjoy sharing their experiences (or their friends’ experiences) with alcohol. Can alcohol consumption exhibit increasing marginal utility? The first drink may not induce the euphoric feeling that many students seek, but two drinks might, with the third drink increasing the euphoria even more than the second drink. In this range of consumption, the student experiences increasing marginal utility. Point out that this increasing marginal utility isn’t likely to last forever. Can alcohol exhibit diminishing marginal utility? By the fourth or fifth drink of the evening, the additional euphoria from each drink is not as much as the prior drink, meaning the student is in the zone of diminishing marginal utility. Can alcohol exhibit negative marginal utility? After the fifth or sixth drink for the evening, most students quickly feel the discomfort of intoxication and suffer a significant decline in euphoria mixed with a significant increase in discomfort and disorientation. Continued consumption of alcohol can eventually bring the onset of alcohol poisoning, when the body starts to reject further intake of alcohol by ejecting the excess alcohol. Most students would agree that, at that point, an additional drink would generate negative marginal utility.

If the Surgeon General (and the American Medical Association) concludes that moderate wine and beer consumption can have a positive influence on cardiovascular health, how will utility and demand be affected? Ask the students to use utility theory to explain how changes in the marginal utility of beer and wine consumption will cause the demand for beer and wine to increase, despite unchanged short-run prices or consumer incomes.

Would people voluntarily pay for something seemingly undesirable? Get students to see that the utility they get from one good is oftentimes dependent on the level of other goods and services consumed. Ask the students to use utility theory to explain: 1) Why do people regularly put themselves through undesirable, rigorous exercise programs? (better health increases our marginal utility of engaging in other activities) 2) Why do students forgo lots of leisure time to take college classes? (better education increases our appreciation of the world and allows us make better choices in our lives)

UTILITY AND DEMAND

Help the students see that consumers invest in apparently undesirable goods the same way society invests in capital to increase future consumption—except it is human capital that consumers are investing in. 4.

How could utility theory help us understand the difference between a federal income tax and a federal sales tax on consumer consumption patterns? This is a real-world application of utility theory designed to boost student confidence. • Mention that federal sales tax proponents point out that sales taxes do not penalize savings whereas income taxes penalize both savings and consumption, motivating consumers to save less and consume more. • Recall how Chapter 2 used the production possibilities frontier model to show that higher present consumption and lower present investment (which is largely based on savings) decreases future consumption for society through slower economic growth. • Explain how consumers allocate their income across affordable consumption and savings combinations by equating the ratio of marginal utility per dollar for both. If the same tax revenue was collected by a federal sales tax rather than the income tax, the tax price for savings would decrease and the tax price for consumption would increase. (Make sure you explain that “savings” is an example of a “good.” In the examples used in the text, there is no savings. All income is spent on goods. When savings exists, not all of a consumer’s income is spent, but all of the income is allocated to either consumption goods or savings.) • Show how consumers adjust these ratios by increasing the marginal utility of consumption through less consumption and decreasing the marginal utility of savings by saving more. Utility is maximized at a higher level of savings when consumption is penalized through a consumption tax instead of an income tax.

How does utility theory differentiate a “need” from a “want”? If you are really in the mood for a very heated discussion on utility analysis, just ask the students what the marginal utility function for a “necessity” looks like. The students should recognize that it is perfectly vertical, where no increase in price is sufficiently large to cause the person to decrease consumption of a necessity in order to equate the marginal utility per dollar ratios across all goods and services. All income is spent on necessity until the consumer is sated, and remaining income is allocated across goods and services until the marginal utility per dollar ratios equalize. (This type of a utility function reflects lexicographic preference orderings.) Is a vertical utility function a reasonable outcome to expect for any good, even medicine or food? Point out that even the poorest of people allocate their meager incomes across more than just one good or service (the necessities). Somehow the income is allocated despite the supposed vertical marginal utility curve. How is income allocated across multiple “necessities” if all have vertical marginal utility functions? Point out that if there is more than one “necessity,” then there is more than one marginal utility function involved in allocating income. Help students to recognize that because in the real world the poor allocate their income across multiple goods, then the marginal utility per dollar ratios involved cannot be vertical, but they may be very steep. Emphasize that for these consumers to maximize their utilities, each of the marginal utility per dollar ratios will need to be equalized, making the income allocation process indistinguishable from mere “wants.” Is it even meaningful to differentiate needs from wants among multiple goods or services? There is no positive answer to this question—only a normative one. Utility analysis has just proven that there is no positive definition of a necessity. Now step back and let the sparks fly!

It is often difficult to create incentives for behavior that is very good for us in the long run but not necessarily pleasurable in the short run (studying, eating right, and exercising) and disincentives for activities that lead to future pain but present pleasure (smoking, eating whatever is convenient and tasty, sleeping through class). Have students suggest possible incentives/disincentives that they think might address this problem. Attendance and being

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prepared for class, eating right and moving more, and all kinds of other things promote our long run best interests but we live in world where diabetes is a growth industry and where many students think that access to notes in classroom technology packages means they don’t need to attend or read the book. What do they think would work, both personally and at the level of social policy? How does this relate to marginal utility theory? 7.

Type 2 Diabetes is often related to poor diets and lack of exercise. If it is avoidable, how does the material in this chapter help us understand why it is on the rise around the world? The answer to this question might well be related to bounded rationality. It definitely ties in well with a discussion of the Reading Between the Lines case.

C h a p t e r

POSSIBILITES, PREFERENCES, AND CHOICES

The Big Picture Where we have been: This chapter, along with Chapter 8, examines the consumer choices that underlie the law of demand. Budget lines were introduced in Chapter 8 and are more fully explored in this chapter. This chapter shows how the substitution effect combined with the income effect for a normal good always leads to the downward-sloping demand curve, which was assumed in Chapter 3. The concept of slope, as explained in Chapter 1 (appendix), is used to show that in equilibrium the MRS equals the relative price of the goods. Where we are going: Chapters 10 and 11 study the theory of the firm and the firm’s costs, and Chapters 12 through 15 look at firm behavior in different market structures.

N e w i n t h e Tw e l f t h E d i t i o n The material in this chapter is similar to the last edition, but the case studies have been updated. Data has been updated and a new article is used for the end-of-chapter application. A Worked Problem section has been added. The Worked Problem presents information about Wendy, who consumes 10 sugary drinks and 4 smoothies. The government taxes the sugary drinks, changing their price, and simultaneously changes the income tax, changing Wendy’s income. The Worked Problem then asks the students to calculate Wendy’s budget, Wendy’s opportunity cost of a sugary drink, Wendy’s new consumption, and the change in Wendy’s welfare. Then the Worked Problem demonstrates to the students how to use the indifference curve-budget line model to answer the questions. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Possibilities, Preferences, and Choices • •

A person’s budget in combination with his or her preferences determines what goods and services the person consumes. Using the budget line and indifference curves, economists can predict how changes in the price of a good or service affect the quantity a person demands.

Consumption Possibilities •

•

• •

A household’s consumption choices are constrained by its income and the prices of the goods and services available. A household’s budget line describes the limits to its consumption choices. The figure to the right shows a budget line for a household that buys only pizzas and books. The household can buy any combination of pizza and books that lies on or within the budget line. Combinations that lie beyond the budget line are unaffordable. Divisible goods can be bought in any quantity and we can best understand household choices if we assume all goods are divisible. The budget line illustrates a constraint on choices. Any point on or inside the line can be purchased. Any point outside the line is unaffordable and cannot be purchased.

Budget Equation • •

•

• •

We can describe the budget line by using a budget equation, which states that income equals expenditure. Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the quantity of pizza QP, and income Y, we can write a budget equation as PB  QB + PP  QP = Y, which can be rearranged into slope-intercept form as QB = Y/PB − (PP /PB )  QP. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. In the figure above, in terms of books, the household’s real income is Y/PB (5 books), which is the vertical intercept of the budget line. A relative price is the price of one good divided by the price of another good. The magnitude of the slope of the budget line, (PP /PB ), is the relative price of a pizza in terms of a book. A relative price is an opportunity cost, so the relative price of a pizza in terms of books gives the opportunity cost of a pizza in terms of books forgone. When the price of the good measured along the horizontal axis (pizzas) changes, the budget line rotates around the vertical intercept. If the price of the good falls, the budget line rotates outward and becomes flatter; if the price of the good rises, the budget line rotates inward and becomes steeper. When income changes, the budget line shifts and its slope does not change. If income increases, the budget line shifts outward; if income decreases, the budget line shifts inward.

Example: The budget line as a menu. Emphasize that the consumer’s budget line is like that part of a menu that delineates all affordable combinations of food and drinks that are available to the consumer given a budget. If you want to push this analogy, have the students assign a price to each of the two goods and then choose a level of income to be spent on the dinner. Draw the budget line and then have the students show how a rise in the price of drinks or the price of food would rotate the budget line and change relative prices. Then have the students help you illustrate how an increase in income shifts the budget line allowing more food (perhaps dessert) and the second glass of wine.

POSSIBILITIES, PREFERENCES, AND CHOICES

II. Preferences and Indifference Curves • •

A preference map shows how a person ranks various combinations of goods and services. Indifference curves are used to illustrate a person’s preference map. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. The figure to the right shows three of a person’s indifference curves between pizza and books. • By construction the consumer is indifferent among all the points on any particular indifference curve. • The consumer prefers points above any particular indifference curve to points on the curve. And the consumer prefers points on the indifference curve to points below the curve. In the figure, the consumer prefers any point on indifference curve I2 to any point on I1 and any point on I3 to any point on I2.

Marginal Rate of Substitution •

The marginal rate of substitution (MRS) is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remaining indifferent (remaining on the same indifference curve). • The magnitude of the slope of the indifference curve at any point measures the marginal rate of substitution between the goods. If the indifference curve is steep, the MRS is high; if the indifference curve is flat, the MRS is small. • The diminishing marginal rate of substitution is the general tendency for a person to be willing to give up less of good y to get one unit of good x, and at the same time remain indifferent, as the quantity of x increases. This principle implies that indifference curves generally become flatter moving along them to the right.

Degree of Substitutability • • •

The indifference curves between most goods are bowed in, with a diminishing MRS. The indifference curves for perfect substitutes are linear, with a constant MRS. The indifference curves for perfect complements are L-shaped. Utility increases (the consumer moves to a higher indifference curve) only if the quantity of both goods x and y increases.

Perfect substitutes or just substitutes? Students will remember discussions of substitutes and complements in consumption from Chapter 3, and often don’t see how “perfect” substitutes or complements are any different. Be sure to use examples to show how, even for most goods that are considered substitutes (or complements), the MRS will still be diminishing. Only when a consumer’s willingness to trade one good for the other is constant (i.e., MRS is linear) are two goods considered “perfect” substitutes. Similarly, you may drink cream in your coffee, implying coffee and cream are complements, but they’re not likely to be “perfect” complements. A cup of coffee without cream may still be better (increase your utility) than no coffee at all.

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III. Predicting Consumer Choices Best Affordable Choice •

•

The consumer will select his or her best affordable point. This point: • is on the budget line, • is on the highest attainable indifference curve, • has a marginal rate of substitution between the two goods equal to the relative price of the two goods. The figure shows the best affordable point, 2 pizzas and 3 books. This combination is on the budget, and hence is “affordable.” It also is on the highest indifference curve so that the marginal rate of substitution equals the relative price of the two goods, and hence the point is “best.”

The meaning of tangency. Emphasize to your students the meaning behind the tangency point between the indifference curve and the budget line. In particular, the marginal rate of substitution (MRS) shows the consumer’s willingness to give up one good to get more of the other good. The relative price of the two goods shows what the consumer must give up one good to get more of the other good. When a consumer equates the marginal rate of substitution (MRS) to the relative price ratio, the consumer is just willing to give up what he or she must give up, and there are no unrealized gains from substituting one good for another.

A Change In Price • •

•

The price effect shows how a change in the price of a good affects the quantity consumed of that good. When the price of the good on the x-axis falls, the budget line rotates around the y-axis intercept and becomes flatter. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: It is on the new budget line, it is on the highest attainable indifference curve, and the MRS equals the slope of the new budget line. When the price of a good changes, tracking the change in the quantity of the good consumed reveals the demand curve for that good.

The Economics in Action case study considers how the best affordable combination of movies and DVD rentals has changed over time, largely due to changes in the DVD rental market. The case study points out that a major factor leading to these changes is a fall in the price of renting a DVD (thanks to Redbox) that allowed people to rent more DVDs and see more movies. Have students illustrate this result for themselves, shifting the budget line between movies and DVDs and seeing what the new equilibrium might look like.

A Change In Income • •

• •

The income effect shows how a change in income affects the buying plans of consumers. When the price of the goods remains constant, a change in income shifts the budget line. This shift changes which indifference curve is highest attainable indifference curve. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: it is on the new budget line; it is on the highest attainable indifference curve; and the MRS equals the slope of the new budget line. A change in income shifts the demand curve, because a different quantity is consumed at the same prices. If income rises and more is consumed at each price (or if income falls and less is consumed at each price) the good is a normal good.

POSSIBILITIES, PREFERENCES, AND CHOICES

Substitution Effect and Income Effect •

For a normal good, a rise in price always decreases the quantity consumed. This result is shown by breaking the price effect into two parts, as illustrated in the figure in which the price of movies rise: • The substitution effect is the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one. The substitution effect is showing by moving the new budget line (with its new slope) so that it is tangent to the initial indifference curve. This procedure creates a (hypothetical) new best affordable point using the initial indifference curve and the hypothetical budget line. Comparing the initial best affordable point to this new one captures the substitution effect. In the figure this compares point a to point b. The substitution effect of a rise in price always leads to a decrease in the quantity consumed. • The income effect is the effect on the quantity bought of a change in income sufficient to shift the hypothetical budget line used to measure the substitution effect, so that it is the same as the actual new budget line. This process is the movement from point b to point d in the figure. For a rise in price, this change requires a decrease in income. For a normal good, the decrease in income decreases the quantity consumed. So for a normal good, the substitution effect and the income effect reinforce each other: both demonstrate that the quantity consumed decreases. For an inferior good, the decrease in income increases the quantity consumed. So for an inferior good, the substitution effect and the income effect have opposite effects on the quantity consumed. It is theoretically possible for the income effect to be large enough that the rise in the price of the good results in an increase in the quantity demanded. But such a case has not been observed in reality.

Income and substitution effects: two separate influences over demand. Income and substitution effects are typically difficult concepts for students to grasp. Be sure that the students understand how a change in a good’s price causes two separate influences on a consumer’s purchase decision: i) a higher (lower) price raises (lowers) the opportunity cost of that good, making that good less (more) attractive than all other goods; and ii) a higher (lower) price means less (more) of all goods and services is affordable, causing the quantity demanded for all normal goods to decrease (increase). A consumer may not think of each effect individually when making consumption decisions, but both effects will have an impact. Can the income effect for an inferior good ever dominate the substitution effect? Many economists have studied the infamous potato famine in Ireland in the mid-19th century in search of the elusive “upward-sloping demand curve” associated with strongly inferior goods. Indeed, when food became even scarcer than usual in that poverty-stricken country, historical records indicate that Irish families consumed a greater quantity of potatoes as the market price of potatoes increased. Many economists were misled into thinking they had found historical evidence of the world’s first recorded positively-sloped demand curve! However, they failed to remember their basic economics: it is the relative price of potatoes that is tracked on the demand curve for potatoes, not the money price. The money price of potatoes rose more slowly than the prices of other foods. This change lowered the relative price of potatoes to Irish families and so the quantity they consumed increased, in accord with the law of demand. Although some experimental evidence exists to show that demand curves with a positive slope might exist, there are no good real-world examples. An Addendum: Relationship between MRS and MU ratios: If you’ve covered both the marginal utility theory (from Chapter 8) and indifference curve theory of consumer choice in this chapter--and you’re teaching an honors section of economics majors--you might want to spend a bit of time demonstrating the equivalence of the

CHAPTER 9

two sets of results. The basic analysis that you might cover is the following: In marginal utility theory, total utility is maximized when MUM /PM = MUS/PS. (the subscript M stands for movies and the subscript S stands for sodas to be consistent with the textbook example) In indifference curve theory, the consumer is at the best affordable point when the marginal rate of substitution of movies for soda equals the relative price of movies in terms of soda. That is: MRS = PM /PS These two propositions are equivalent. To see why, there are a couple of ways to explain this. If your students are particularly good at math, begin with the fact that the change in total utility can be written as: Change in Total Utility = MUM  QM + MUS  QS where means “change in” and QM and QS are the quantities of movies and soda. Because a consumer is indifferent between any pair of points along an indifference curve, you can think of an indifference curve as a constant utility curve. So along an indifference curve, the change in total utility is zero. When the change in total utility is zero, 0 = MUM  QM + MUS  QS, And so MUM  QM = –MUS  QS. Now divide both sides of this equation by QM and also divide both sides by MUS to obtain: QS /QM = -MUM /MUS Notice that the left-hand side of the last equation is the change in soda divided by the change in movies along an indifference curve, which is the slope of the indifference curve. But the magnitude of the slope of an indifference curve is the marginal rate of substitution. So, MRS = MUM /MUS That is, the marginal rate of substitution of movies for soda is the ratio of the marginal utilities of movies and soda. Alternatively (or even in addition), many students appreciate an intuitive explanation of the relationship between the MRS and MUM /MUS. Simply start with the marginal utility of a movie equal to some number (20, for example). If the consumer would like a soda half as much as a movie, then the marginal utility of a soda would be 10 in that example. In that case, MUM /MUS = 20/10 = 2. Then ask students if they could answer the following question: “How many sodas would the consumer be willing to give up for a movie?” Most students will see that the movie is worth 2 sodas. This is simply the definition of the marginal rate of substitution, and it will always be the case that the ratio of marginal utilities will be equal to the marginal rate of substitution. Regardless of the method you use to show that MRS = MUM /MUS, the main point is that the consumer chooses the best affordable point by making the MRS equal the relative price. But that is the same as MUM /MUS = PM /PS. Multiply both sides of this equation by MUS and divide both sides by PM to obtain the marginal utility theory proposition: MUM /PM = MUS /PS. Economics in the News at the end of the chapter considers the growth of e-books and whether they will eventually replace paper books. The data show a distinct shift in growth to e-books from traditional publishing, sales of which have been flat.

POSSIBILITIES, PREFERENCES, AND CHOICES

Additional Problems 1.

Marc has an income of $20 per week. Root beer costs $5 a can and CDs cost $10 each. Figure 9.1 illustrates his preferences. a. What are the quantities of root beer and CDs that Marc buys? b. What is Marc’s marginal rate of substitution of CDs for root beer at the point at which he consumes?

Now suppose that in the situation described in problem 1, the price of a CD falls to $5 and the price of root beer and Marc’s income remain constant. a. Find the new quantities of root beer and CDs that Marc buys. b. Find two points on Marc’s demand curve for CDs. c. Find the substitution effect of the price change. d. Find the income effect of the price change. e. Are CDs a normal good or an inferior good for Marc?

Pete buys tuna and golf balls. The price of tuna is $2 a can, and the price of a golf ball is $1. Each month, Pete spends all of his income and buys 20 cans of tuna and 40 golf balls. Next month, the price of tuna will rise to $3 a can and the price of a golf ball will fall to 50¢. Assume that Pete’s preference map shows indifference curves have a bowed in shape so that they show a diminishing marginal rate of substitution. a. Will Pete be able to buy 20 cans of tuna and 40 golf balls next month? b. Will Pete want to buy 20 cans of tuna and 40 golf balls? c. Which situation does Pete prefer: tuna at $2 a can and golf balls at $1 each or tuna at $3 a can and golf balls at 50¢ each? d. If Pete changes the quantities that he buys, which good will he buy more of and which less of? e. When the prices change next month, will there be an income effect and a substitution effect at work or just one of them?

The sales tax is a tax on goods. Some people say that a consumption tax, a tax on both goods and services, would be better. Explain and illustrate with a graph what would happen if we replaced the sales tax with a consumption tax to a. The relative price of books and haircuts. b. The budget line showing the quantities of books and haircuts you can afford to buy. c. Your purchases of books and haircuts.

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Solutions to Additional Problems 1.

b. c.

e. 3.

c. d.

Marc buys 2 cans of root beer and 1 CD. Marc buys the quantities of root beer and CDs that moves him onto the highest indifference curve, given his income and the prices of root beer and CDs. The graph shows Marc’s indifference curves. So draw Marc’s budget line on the graph. The budget line is tangential to indifference curve I0 at 2 cans of root beer and 1 CD. The indifference curve I0 is the highest indifference curve that Marc can get attain. Marc’s marginal rate of substitution is 2. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Marc’s consumption point, which equals the magnitude of the slope of the budget line. The slope of Marc’s budget line is 2, so the marginal rate of substitution is 2. Marc buys 1 can of root beer and 3 CDs. Draw the new budget line on the graph with Marc’s indifference curves. The budget line now runs from 4 CDs on the x-axis to 4 cans of root beer on the y-axis. The new budget line is tangential to indifference curve I1 at 1 can of root beer and 3 CDs. The indifference curve I1 is the highest indifference curve that Marc can now get attain. Two points on Marc’s demand curve for CDs are the following: At $10 a CD, Marc buys 1 CD. At $5 a CD, Marc buys 3 CDs. The substitution effect is 1 CD. To divide the price effect into a substitution effect and an income effect, take enough income away from Marc and gradually move his new budget line back toward the origin until it just touches Marc’s indifference curve I0. The point at which this budget line just touches indifference curve I0 is 2 CDs and 0.5 can of root beer. The substitution effect is the increase in the quantity of CDs from 1 CD to 2 CDs along the indifference curve I0. The substitution effect is 1 CD. The income effect is 1 CD. The income effect is the change in the quantity of CDs from the price effect minus the change from the substitution effect. The price effect is 2 CDs (3 CDs minus the initial 1 CD). The substitution effect is an increase in the quantity of CDs from 1 CD to 2 CDs. So the income effect is 1 CD. CDs are a normal good for Marc because the income effect is positive. Pete can still buy 20 cans of tuna and 40 golf balls. When Pete buys 20 cans of tuna at $2 a can and 40 golf balls at $1 each, he spends $80 a month. Now that the price of a can of tuna is $3 and the price of a golf ball is $0.50, 20 cans of tuna and 40 golf balls will cost $80. So Pete can still buy 20 cans of tuna and 40 golf balls. Pete will not want to buy 20 cans of tuna and 40 golf balls because the marginal rate of substitution does not equal the relative price of the goods. Pete will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price. Pete prefers tuna at $3 a can and golf balls at $0.50 each because he can get onto a higher indifference curve than when tuna is $2 a can and golf balls are $1 each. Pete will buy more golf balls and fewer cans of tuna. The new budget line and the old budget line pass through the point at 20 cans of tuna and 40 golf balls. If cans of tuna are plotted on the x-axis, the marginal rate of substitution at this point on Pete’s indifference curve is equal to the relative price of a can of tuna at the original prices, which is 2. The new relative price of a can of tuna is $3/50 cents, which is 6. That is, the budget line is steeper than the indifference curve at 20 cans of tuna and 40 golf balls. Pete will buy more golf balls and fewer cans of tuna. There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant. Books are goods and so are taxed under both a sales tax and a consumption tax. Haircuts are services and so are taxed only under a consumption tax. If the sales tax is replaced with a consumption tax, the relative price of a haircut rises and the relative price of a book falls.

POSSIBILITIES, PREFERENCES, AND CHOICES

Assuming the sales tax and consumption tax are the same rate, in the figure the budget line rotates inward around a fixed book intercept. In Figure 9.2, the new budget line is BL1. The price of a book does not change but the price of a haircut rises. In general, if the relative price of a haircut rises and the relative price of a book falls, the substitution effect leads consumers to buy more books and fewer haircuts. There is, however, also an income effect. The consumer’s real income falls, which decreases the demand for normal goods. Assuming that both books and haircuts are normal goods, then the income effect offsets the substitution effect of buying more books but reinforces the substitution effect of buying fewer haircuts. In the figure, with the sales tax and budget line BL0 the consumer is initially at point A and buys 20 books per year and 4 haircuts per year. With the consumption tax and budget line BL1 the consumer moves to point B and buys 15 books per year and 3 haircuts per year.

Additional Discussion Questions 1.

How does an increase in the price of basic food staples affect real income in poor countries? Illustrate this with a budget line and hypothetical consumption bundle. Where money incomes are low, increases in food prices can devastate real incomes and the achievable consumption bundle. The budget line, already close to the origin, shifts inward even closer. Food riots returned to the global stage in 2008, and with the prices of many key grains rising in 2010, we may see continued global dialogue about the negative impact of higher food prices on the world’s poorest citizens. How would the preference map shift if a consumer had a strong preference for one of the products versus the other? How might that affect the tangency point? The map tilts to be “long” on the axis of the non-preferred product. Basically to get the person give up a unit of the preferred product, compensation in terms of units of the other product to maintain indifference would be immense. The tangency is thus likely to be near the axis of the preferred product, which means a large quantity of this good is consumed. Will a low-income person’s optimal consumption bundle change if he or she receives food stamps? Have the students apply a normal preference mapping between food and all other goods for a low-income person. With food on the vertical axis, show that a person receiving food stamps experiences a new, steeper budget line with a higher y-intercept. Show that the person can now afford a greater total amount of food for any given level of other goods, but the maximum amount of all other goods available remains unchanged. Have the students locate the consumption combination that matches the slope of the new budget line with the marginal rate of substitution of the highest indifference curve. Could the low-income person be better off with an income subsidy of equal value to the food stamp subsidy? Show that if the same level of income were given in place of food stamps, this opens up even more combinations of goods and services than with food stamps. It is impossible not find a higher indifference curve without a very unconventional indifference curve map. Could a low-income person be made equally as well off with a lower total income subsidy than the initial food stamp subsidy? Ask them to consider why the government continues to use food stamps instead of income assistance when the same quantity of extra income would bring them even more utility. Ask them why the government doesn’t minimize total welfare assistance

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expenditures by giving them just enough income to maintain a consumption bundle on the same indifference curve as with the current food stamp expenditures. Students should recognize that part of the government’s intention is to control the type of items purchased with food stamps. If low-income households were simply given cash subsidies, the costs of the welfare system would be lower, but not all low-income households would spend that cash subsidy on food only. Would the indifference curves of a preference map ever change shape when the prices of goods change? Marketing managers for Ferrari claim that they would not consider a significant price decrease in the face of falling demand. They worry that the decrease in the perceived “exclusivity” of the brand would diminish the consumer perception of their product and eventually decrease market demand. Ask the students to model this theory and show how a sharp decline in the price of a Ferrari might causes a change in the consumer’s indifference curves. (The answer is that if Ferraris were placed on the vertical axis, the indifference curves are steeper.) Would indifference curves ever move whenever the consumer’s income changes? Consumers change their buying habits as they increase their income. They buy cars with leather seats instead of cloth, designer dresses and purses, choose restaurants merely to “be seen” dining there. Does this really represent a change in the preference mapping over consumption possibilities when incomes increase? Does it change the slope of the indifference curve? Do perfect substitutes imply perfectly elastic demand? When indifference curves are straight lines, the MRS is almost never equal to the relative price ratio, meaning the consumer selects a “corner solution” (all of one good, or all of another, but not a mix of both). In the case of a relative price change, the consumer immediately switches to consuming only the other good. Ask the students if they have ever observed such peculiar consumer behavior in the real world. Do perfect complements imply perfectly inelastic demand? When the indifference curves are 90-degree angles, the consumer always purchases the product only in exact proportions. Ask the students if there is any usefulness to separating out the two goods as separate items, or whether it is more meaningful to consider them two necessary components of a single good. For example, we rarely see single shoes being offered for sale, but surely the occasional consumer loses a single shoe, or there are a small number of amputees that need only one shoe. Why is there no market for single shoes? (As a counterexample, Lands’ End actually sells single gloves or mittens to consumers who have lost one of a pair.)

C h a p t e r

ORGANIZING PRODUCTION

The Big Picture Where we have been: Chapter 10 introduces students to the firm as a decision making entity with an organizational structure and a specific goal. Key ideas in this chapter are recognizing the importance of having access to accurate cost and profitability information for making sound business decisions (learning the difference between economic versus accounting profit) and using the correct notion of efficiency as a criteria for making these decisions (understanding the difference between technological versus economic efficiency). Where we are going: The chapter provides a clear overview to the key features of the market structures to be studied in the following chapters and will help students to be able to compare and contrast the features as each is introduced. Understanding the nature of the firm allows students to gain a better appreciation of those chapters, which cover business decisions made by the firm under different market structures. Chapter 11 introduces the firm’s production function and cost functions. Chapter 12 examines firm performance in a competitive environment, and Chapter 13 explores the firm as a monopoly. Chapters 13 and 14 look at firm behavior under monopolistic competition and oligopoly. Chapter 18 covers the firm’s decisions in the resource and labor markets.

N e w i n t h e Tw e l f t h E d i t i o n The chapter opener has been streamlined and revised. The data in the application on market concentration in the U.S. economy have been updated. A new Worked Problem section has been added. The Worked Problem gives students information that can be used to calculate the opportunity costs of a bike shop. It asks the students to use the information to calculate the costs of resources purchased in the market, the opportunity cost of the resources owned by the bike shop, and the opportunity cost of all the resources used by the bike shop. The Worked Problem then demonstrates to the students how to use the information to make the required calculations. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Organizing Production • • •

Firms must organize their production so that it is as efficient as possible. Firms operate in markets that differ according to the competition within the market. Firms organize some economic activities while markets are used for other economic activity.

The Firm and Its Economic Problem •

The number and scope of business firms in the economy is vast and diverse. A firm is an institution that hires factors of production and organizes those factors to produce and sell goods and services.

The Firm’s Goal •

The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through competition or bought out by other firms seeking to maximize profit.

Do firms really maximize profit? Sometimes firms state they are willing to bear lower profits to expand market share. Other firms claim to utilize only the “greenest” technology in their production process. Ask the students if these are long term goals or short term objectives for these firms. They should see that maximizing market share or using the latest green technology is an effort to gain greater market power and consumer loyalty in the long run, so that the firm can raise market prices and increase its profits. Remember that the capital necessary to pursue green production methods can only be retained if the firms are able to match the alternative profitable uses for that capital, because the owners of that capital seek out the highest rate of return.

Accounting Profit and Economic Profit • •

A firm’s accounting profit is the firm’s revenues minus expenses and depreciation. A firm’s economic profit is equal to total revenue minus total opportunity cost.

A Firm’s Opportunity Cost of Production • •

A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production. Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner. • For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital. The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital. • The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.

Is economic profit a “better” measure of profit than accounting profit? Economic profit and accounting profit really have different purposes, so one is not universally better or worse than the other. Economic profit is a better measure of whether a firm is using its resources efficiently and is a better measure for predicting a firm’s actions, but accounting profit may be a better measure of whether the firm is earning enough revenue to pay its expenses. Emphasize the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures (GAAP). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners.

ORGANIZING PRODUCTION

Decisions •

In order to maximize economics profit, a firm must decide: • What to produce and in what quantities. • How to produce. • How to organize and compensate its managers and workers. • How to market and price its products. • What to produce itself and what to buy from others.

The Firm’s Constraints •

A firm faces three basic constraints that limit its maximum profit: • Technology Constraints: A technology is any method of producing a good or service. At the existing level of technology, a firm can produce more output only if it hires more resources, which increases its costs and limits its profits. • Information Constraints: A firm has only limited information about the quality and effort of its work force, about the current and future buying plans of its customers, and about the plans of its competitors. • Market Constraints: What a firm can sell and the prices it sets are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms.

II. Technological and Economic Efficiency •

•

There typically are many different combinations of inputs that can produce a specific level of output. Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient. The table has 4 different methods of producing a unit of Method Labor Capital output. The columns show the number of units of labor and 1 5 10 capital needed to produce 1 unit of output. • Method 2 is technologically inefficient because it uses the 2 10 10 same amount of capital but more labor than does 3 15 9 Method 1. 4 20 1 • Which method is economically efficient depends on the prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).

Does technological efficiency imply economic efficiency (or vice versa)? Point out that technological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency.

III. Information and Organization A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems. • • •

A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward. An incentive system uses a market-like mechanism inside the firm. The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways:

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• • •

Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners. Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners. Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the longterm performance of the firm.

The Economics in the News presents the case of J.P. Morgan’s losses due to the “whale” London trader. The case is analyzed through the lens of a principal/agent problem. Because the case identifies both the problems and the solution, it would be useful to reinforce this example with another drawn from recent headlines.

Types of Business Organization •

• •

•

A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income. A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners. A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment, so the personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on the firm’s profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends. Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization.

Student businesses: Students generally have no idea how to legally form and operate a business. Discussing a sole proprietorship example for a simple business is helpful and engages interest of some students. How they would legally start a business and report income so easily often reinforces the efficiency ideas we discuss elsewhere. The Economics in Action case summarizes the numbers for the various types of firms in the U.S. economy and table 10.4 nicely identifies the pros and cons of each form of organization.

IV. Markets and the Competitive Environment • • • •

Perfect competition is a market structure when there are many firms, each selling an identical product, many buyers, and with no restrictions on entry of new firms to the industry. Both firms and buyers are well informed of the prices of the products of all firms in the industry. Monopolistic competition is a market structure in which a large number of firms compete by making similar but slightly different products. Making a product slightly different from the product of a competitor is called product differentiation and it gives the firm an element of market power. Oligopoly is a market structure in which a small number of firms compete. Oligopolies might produce almost identical or differentiated goods. Monopoly arises when there is one firm, which produces a good or service that has no close substitutes and in which the firm is protected by a barrier preventing the entry of new firms.

Measures of Concentration There are two measures of market concentration: • •

The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely competitive) to 100 (not very competitive). The Herfindahl–Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly).

ORGANIZING PRODUCTION

An Economics in Action case identifies the HHI for various industries in the United States, with cigarettes and batteries being the most concentrated and quick printers and bakeries the least of those included. It also describes why other information may also be necessary to conclude how competitive a specific market is. •

•

The U.S. Justice Department uses the HHI to classify markets: • Markets with an HHI of less than 1,000 are regarded as highly competitive. • Markets with an HHI of between 1,000 and 1,800 are regarded as moderately competitive. • Markets with an HHI above 1,800 are regarded as concentrated. Concentration measures fail to take account of: • Geographic Scope of the Market: Concentration ratios define the market as the entire United States, but the relevant market might be smaller than the entire nation (newspapers, for which the market is a city) or larger than the entire nation (automobiles, for which the market is the entire world). • Barriers to Entry and Firm Turnover: For some industries, a few firms might be currently operating in the market but competition in these industries might be fierce, with firms regularly entering and exiting the industry.

An Economics in Action application considers data from 1939 to 1980 that were used to study the degree of competition in U.S. markets. These data concluded there were more firms operating in competitive markets in 1980 than in 1939. Because the data do not capture the degree of global competition that has resulted after 1980, the study may understate the degree to which markets are competitive today. •

Market and Industry Correspondence: Some firms produce a product with very specific applications for which few competitors exist, but are classified in too broad of a market (specific pharmaceutical drugs) while other firms have diversified into several distinct product lines and are subject to more effective competition than what their market share for just one product might suggest.

How do economists identify the market for a product? Examples: Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market. Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share. Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well? How about motorcycles and scooters? The World Wide Web of business. Conclude the discussion of market definition by mentioning how today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. Stress how difficult it is to discern even the relevance of the term “market” in today’s business climate. What is the relevant market for Ford Motor Company? Ford Motor Company advertises that it is the largest seller of pickup trucks in the United States. Should we be concerned that Ford might have too much market power in that area of the market? Ask the students to consider identifying what would be an appropriate definition for the “market” such that a proper market concentration measure might be calculated. Should only pickup trucks be included? Or should all cars and trucks be considered as possible substitutes? How about minivans and/or SUVs?

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V. Produce or Outsource? Firms and Markets • • • •

Factors of production can be coordinated by firms or by markets. Firms coordinate production when they can do so more efficiently than a market. Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors of production consistent. Outsourcing, buying parts or products from other firms, is an example of market coordination.

Why might firms be more efficient at coordinating production than markets? • • • • •

Firms can reduce transactions costs, which are the costs that arise from finding someone with whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled. Firms can capture economies of scale, which occurs when the cost of producing a unit of a good falls as its output rate increases. Firms can capture economies of scope, which occurs when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise. Firms can engage in team production, in which the individuals can coordinate to specialize in mutually supporting tasks. Because of these advantages, firms rather than markets coordinate most of our economic activity.

Economics in Action: Apple doesn’t produce the iPhone by itself. Global supply chains, high degrees of specialization and competition, and other innovations have made it possible for a company to design and market a product, collect most of the profit from it, and yet not produce it. Why do firms exist? Ronald Coase is the classic on this topic. You might like to tell your students about this remarkable person. Born in England in 1910, be graduated with a bachelor of commerce degree in 1932, at the depth of the Great Depression. While still an undergraduate, he was puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially important at that time because Socialists (and the young Coase was one of them) thought that central planning by government was superior to the market. Quoting from Coase’s autobiography, http://www.nobel.se/economics/laureates/1991/coase-autobio.html, “I spent the academic year 1931-32 on my Cassel Travelling Scholarship in the United States studying the structure of American industries, with the aim of discovering why industries were organized in different ways. I carried out this project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory answering the questions with which I started but the introduction of a new concept into economic analysis, transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article “The Nature of the Firm,” published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the 1991 Alfred Nobel Memorial Prize in Economic Sciences.” So, this amazing scholar had done his Nobel-prize-winning work at the age of 22! An Economics in the News article discusses how Facebook plans to use data about users’ web browsing history to target specific advertisements based on these revealed interests. It compares Facebook’s revenue to Google’s and Yahoo’s revenue.

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Additional Problems 1.

Sue can do her accounting assignment by using: a personal computer; a pocket calculator; a pocket calculator and a pencil and paper; or a pencil and paper. With a PC, Sue completes the job in half an hour; with a pocket calculator, it takes 4 hours; with a pocket calculator and with a pencil and paper, it takes 5 hours; and with a pencil and paper, it takes 14 hours. The PC and its software cost $2,000, the pocket calculator costs $15, and the pencil and paper cost $3. a. Which, if any, of the methods is technologically efficient? b. Which methods is economically efficient if Sue’s wage rate is (i) $10 an hour? (ii) $20 an hour? (iii) $50 an hour?

Alternative ways of making 100 shirts a day are in the table Method Labor to the right. (hours) a. Which methods are technologically efficient? A 10 b. Which method is economically efficient if: B 20 (i) The wage rate is $1 an hour and the rental cost of a C 50 machine is $100 an hour? D 100 (ii) The wage rate is $5 an hour and the rental cost of a machine is $50 an hour? (iii) The wage rate is $50 an hour and the rental cost of a machine is $5 an hour?

Sales of the firms in the pet food industry are in the table to the right. a. Calculate the four-firm concentration ratio. b. What is the structure of the industry?

Market shares of mat makers are in the table to the right. a. Calculate the Herfindahl-Hirschman Index. b. What is the structure of the industry?

Solutions to Additional Problems 1.

Capital (machines) 50 40 20 10

Firm Big Collar, Inc Shiny Coat, Inc Friendly Pet, Inc Naturals Way, Inc Other 8 firms

Sales (thousands of dollars) 50 75 60 65 400

Firm Made-to-last, Inc Big Wheel, Inc Magic Carpet, Inc Supreme, Inc Copra, Inc

Market share (percent) 20 17 22 17 24

All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the accounting assignment is not a technologically efficient method because it takes more hours than it would with a pocket calculator and it uses more capital. The economically efficient method is the technologically efficient method that allows the task to be done at least cost.

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(i) When the wage rate is $10 an hour: Total cost with a PC is $2,005, total cost with a pocket calculator is $55, and total cost with paper and pencil is $143. Total cost is least with a pocket calculator. (ii) When the wage rate is $20 an hour: Total cost with a PC is $2,010, total cost with a pocket calculator is $95, and the total cost with paper and pencil is $283. Total cost is least with a pocket calculator. (iii) When the wage rate is $50 an hour: Total cost with a PC is $2,025, total cost with a pocket calculator is $215, and total cost with pencil and paper is $703. Total cost is least with a pocket calculator. 2.

b. 4.

Methods A, B, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B to C to D, the amount of labor increases and the amount of capital decreases in each case. The economically efficient method in (i) is method D, in (ii) is method D, and in (iii) is method A. The economically efficient method is the technologically efficient method that allows the 100 shirts to be made at least cost. (i) Total cost with method A is $5,010, total cost with method B is $4,020, total cost with method C is $2,050, and total cost with method D is $1,100. Method D has the lowest total cost. (ii) Total cost with method A is $2,550, total cost with method B is $2,100, total cost with method C is $1,250, and total cost with method D is $1,000. Method D has the lowest total cost. (iii) Total cost with method A is $750, total cost with method B is $1,200, total cost with method C is $2,600, and total cost with method D is $5,050. Method A has the lowest total cost. The four-firm concentration ratio is 38.46. The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $50,000 + $75,000 + $60,000 + $65,000, which equals $250,000. Total industry sales equal $250,000 + $400,000, which equals $650,000. The four-firm concentration ratio equals ($250,000/$650,000) 100, which is 38.46 percent. This industry is competitive because the four-firm concentration ratio is less than 60 percent. The Herfindahl-Hirschman Index is 2,038. The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl2 2 2 2 2 Hirschman Index equals 20 + 17 + 22 + 17 + 24 , which equals 2,038. This industry is not competitive because the Herfindahl-Hirschman Index exceeds 1,800.

Additional Discussion Questions 1.

What decisions go into setting up and operating your own business? Have the students imagine starting up their own firm after graduation. Let them dream about pursuing their passion and trying to make a living at it, and get them to appreciate the complexities of organizing production and making a profit. Challenge them with the following business decision issues and open their eyes to how much risk must be endured and how much market perceptiveness is necessary to be a successful entrepreneur. Organizing your firm. Ask students if the initial capital requirements for their dream business would be extensive, such as starting up a high-performance car manufacturing firm (John DeLorean tried this, but his attempt to raise financial capital caused him to take a bit of a career detour—he was tried, and acquitted, for trafficking drugs!), or merely a modest capital outlay. Will the size and scope of their operation require a large management structure with a diversity of specialized managers, or a small, streamlined structure with only a few managers in multi-purpose roles? Will they want to spread out the risk of financial liability among stockholders in exchange for sharing a portion of their profit? Determining your firm’s financial reporting standards. What financial reporting standards will their firm practice? Ask the students how they will treat the wages paid to themselves, the owners of the firm? Mention that if their best alternative job has just experienced a significant increase in salary, the implicit cost of running their own business has just increased and their economic

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profitability has decreased. Point out that if they were to give themselves a raise to reflect the higher opportunity cost and transform that implicit cost into an explicit cost, their accounting profit then declines as well. Not only will a lower profit report for the period hurt their firm’s perceived stature in the industry, it will also make it more costly for their firm to raise financial capital in the future. Determining appropriate sources of information. Where will they receive the information needed to locate good workers and managers? Where can they find the market wages, salaries, and benefits that they must offer to their employees in order to attract quality people to work with them instead of other firms? How will they uncover all the business regulations, licensing, periodic tax filing procedures, and labor laws that must be strictly followed to remain in operation? 2.

How do corporate taxes affect efficiency? Ask the students to recall the deadweight loss of taxation analyzed in Chapter 6 and apply it to the double taxation of corporate profits. Help them to see that they can model the effects of the compounding deadweight losses by using the production possibilities frontier. Show them how the corporate tax causes movement of the economy to production combinations that are inefficient and in the interior of the production possibilities frontier.

Should you hire a contractor or a development company to build your house? Mention to the students that if a market is more efficient at allocating resources among buyers and sellers than a firm, the market will be characterized by the presence of many different contractors or consultants, rather than with traditional companies. Ask the students to identify some of these kinds of markets and get them to consider what characteristics of the products or services do not lend themselves to the organizational structure of the firm. For example, ask the students what characteristics that describe the building of new residential homes that encourages a predominance of contractors rather than firms to supply new residential housing? In this market, independent, general construction contractors who deal with many sub-contractors are the entities that tend to build individual “spec” homes. Yet, in the same market there are also a few large residential developments of “cookie cutter” homes built in a small geographic area by one firm. Perhaps the high cost of monitoring the progress in many off-site work areas, combined with a high degree of variation in the customer preferences for the product, prevents any economies of scale to be enjoyed by a firm trying to build “spec” homes. Perhaps the economies of scale can only be enjoyed in a small geographic area with a high concentration of construction sites managed by one firm.

Compare and contrast the possible result of Apple outsourcing the iPad’s production with doing it all within the firm. Competition among component makers likely leads to lower costs and a greater speed of innovation in terms of product features. Technology transfer will be more widespread as firms try to mimic what others are producing and as firms that develop new technologies are likely to be able to sell some or all of those features to other firms or markets (such as programmable chips migrating from devices to autos to green energy grids). Under the outsourcing system, Apple is more vulnerable to problems with a supplier delaying products or damaging the firm’s reputation.

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OUTPUT AND COSTS

The Big Picture Where we have been: This chapter has explained how the firm’s output decision affects its costs when the firm allocates its factors of production efficiently in the short run and in the long run. The student sees how establishing short-run productivity and cost measures and understanding how they are related reveals how a firm can predict how its costs will change with the level of output. This relationship helps firm managers make profitable output decisions in the short run and make commitments to efficient plant size in the long run. Where we are going: Chapters 12, 13, 14, and 15 use the productivity and cost relationships developed in this chapter to explain how firms make decisions in competition, monopoly, and other market structures. Chapter 18 uses these same ideas to explain how firms decide how much labor and capital to use.

N e w i n t h e Tw e l f t h E d i t i o n Some of the examples and applications have been updated. The introduction connects to a new Economics in the News case that discusses the cost implications of Starbuck’s decision to expand the number of stores it operates. A new Worked Problem section has been added. The Worked Problem gives students a table with partial data on the quantity, marginal cost, total cost, total fixed cost, total variable cost, average total cost, average fixed cost, and average variable cost. It challenges the students to complete the table and then demonstrates how to do it. The Worked Problem also shows the students how to graph the total cost curves and the average and marginal cost curves. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Output and Costs • • •

In the short run, a firm needs to increase the quantity of labor employed in order to increase its production. In the long run, a firm can increase the quantity of any or all of the factors of production it employs to increase its production. Firms must pay for the factors they use, so when a firm changes its production, its costs change.

Decision Time Frames •

A firm owner’s decisions can be categorized as short run decisions and long run decisions. • The short run is a time frame in which the quantities of some factors of production are fixed. The fixed factors include the firm’s management organization structure, level of technology, buildings and large equipment. These factors are called the firm’s plant. • The long run is a time frame in which the quantities of all factors of production can be varied. Longrun decisions are not easily reversed so usually a firm must live with the plant size that it has created for some time. The past cost of buying a plant that has no resale value is called a sunk cost.

Help the students to understand that the difference between the long run and short run is not related to calendar time. Compare the street vendor, who is a firm owner operating out of a food truck, to the giant automaker firm, Honda. Ask them how long it would take for the food vendor to double the size of his or her plant (truck, oven, etc.) versus Honda to double its plant size (factory buildings covering multiple blocks, computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long run differs among firms.

II. Short-Run Technology Constraint To increase its output in the short run, a firm must increase the quantity of labor employed. There are three relationships between the quantity of labor and the firm’s output.

Product Schedules •

Total product is the maximum output that a given quantity of labor can produce. The marginal product of labor is the increase in total product that results from a one-unit increase in the quantity of labor employed with all other inputs remaining the same. The average product of labor is equal to the total product of labor divided by the quantity of labor. The table to the right has examples of these product schedules.

Labor 0

Total product 0

Marginal product

Average product

10 10 20 2

15 6

Product Curves • •

The total product curve illustrates the total product schedule. The slope of the total product curve equals the marginal product of labor at that quantity of labor. The marginal product curve shows the additional output generated by each additional unit of labor. The marginal product of labor curve (MP) has an upside-down U shape. Increasing marginal returns occurs when the marginal product of an additional worker is greater than the marginal product of the previous worker. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and diminishing marginal returns set in. Diminishing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. The law of diminishing returns states that as a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes.

OUTPUT AND COSTS

•

113

The average product curve shows the average product that is generated by labor at each level of labor. As the figure shows, the average product of labor curve (AP) has an upside-down U shape. As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the average product of labor increases; when the marginal product of labor is less than the average product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.

The marginal pulls (but cannot not push) the average. Don’t let the students fall into the trap of thinking that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise (fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-and-true grade point average (GPA) example used in the text. Explain that if a student’s GPA is a 3.5 and the next marginal class grade is a C (2.0), followed by a B (3.0), this increasing marginal grade will not be pushing their GPA up at all. Conceptually, the students should understand that the marginal value can’t “push” the average measure higher when it is, itself, lower than the average measure. The marginal measure must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity, thereby “pulling” the average up (down). Understanding marginal returns: Ask students to picture a typical fast food restaurant. This is a “plant” and equipment with which they are familiar as customers if not also as workers. Fixed inputs include the building and the equipment. Ask them to imagine one worker trying to cook the food, take the orders and run the drive through. Add a second worker and specialization can begin to occur, so the MP initially rises. But keep adding workers and marginal product will inevitably fall. Diminishing returns is not the same as negative returns; students might need help understanding that total product is still rising, but at a decreasing rate.

III. Short-Run Cost

Labo r 0

Outpu t 0

Fixed cost (dollars ) 50

Variable cost (dollars)

Total cost (dollars)

Average fixed cost (dollars)

Average variable cost (dollars)

Average total cost (dollars)

100

150

5.00

10.00

15.00

200

250

1.66

6.67

8.33

300

350

1.39

8.33

9.72

Marginal cost (dollars) 10.00 5.00 16.67

The table above continues the previous product schedule table and shows different costs.

Total Cost •

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm’s fixed factors. Total variable cost (TVC) is the cost of the firm’s variable factors. Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

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Relation between TP and TVC. Make a graph of a TP curve on a transparency. Label the x-axis labor and the yaxis output. Put some actual numbers on the labor axis (use 1, 2, 3, 4, and 5 labor units) and tell the students that the price of a unit of labor $10. Next, change the label on the x-axis to TVC and ask the students to tell you the numbers to put on the x-axis now that it measures TVC (the numbers will now be $10, $20, $30, $40 and $50). Once the students are really clear about what you have done, pick up the transparency, turn it over, and replace it on the display base with what was previously the x-axis (TVC) running vertically. Point out that the students are now looking at a TVC curve. Emphasize that all the product curves can be derived from the TP curve and all the cost curves can be derived from the TVC curve.

Marginal Cost •

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output. The MC curve is U-shaped. Initially greater specialization makes additional units cost less than those that have come before, but eventually diminishing returns sets in and marginal costs rise.

Average Cost • • •

Average fixed cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output increases. Average variable cost (AVC) is total variable costs per unit of output. At low levels of output, AVC falls as output increases but at higher levels of output, AVC rises as output increases. Average total cost (ATC) is the total cost per unit of output. ATC = AFC + AVC. At low levels of output, ATC falls as output increases but at higher levels of output, ATC rises as output increases.

Marginal Cost and Average Cost •

The figure illustrates typical MC, AFC, AVC, and ATC curves. As the figure shows, the MC curve, the AVC curve, and the ATC curve are all U-shaped. There are other additional important points about this figure: • The vertical distance between the AVC curve and the ATC curve is the AFC. Because the AFC decreases as output increases, these curves become vertically closer to each other as output increases. • The MC curve intersects the AVC curve and ATC curve at their minimums

Why the Average Total Cost Curve is U-shaped •

The ATC curve combines the shapes of the AFC and AVC curves. The AFC curve constantly falls as output expands, pulling down ATC curve. The AVC curve first falls but then rises because of diminishing returns. Eventually AVC curve starts to rise more rapidly than the AFC falls, so at that point the ATC rises.

An Economics in the News case describes a new cost curve application insprired by Walmart’s decision to increase use of self-checkout machines in its stores. The case derives and analyzes the cost curves for both traditional clerks and for checkout assistants for shoppers using self scan technologies.

Cost Curves and Product Curves • •

The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP curve is falling, the AVC curve is rising. The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for which the MP curve is rising, the MC curve is falling and over the range of output for which the MP curve is falling, the MC curve is rising.

Making Decisions Using the Relationships Between Productivity and Cost. Explain to the students the usefulness of understanding the intuition behind the relationship between productivity measures and cost measures. For example:

OUTPUT AND COSTS

If a firm manager knows that average productivity of labor has been falling with the last additional quantity of labor hired, then the manager knows that the average variable cost (AVC) of production has necessarily been rising as the output from that additional labor has increased. If the manager knows that AVC is rising as output increases, then the manager also knows that the marginal cost (MC) of the additional output has been higher than the AVC (which has been pulling AVC up). If the manager has sold the previous units of output at a small profit, the manager might be faced with a timesensitive contractual opportunity that arises within the same short run time period. The manager might be asked to sell a little more output at the same market price as the previous sales. The manager can quickly infer that the profitability of this potential new contract will not be as high because the marginal cost of producing the extra output will be higher than the last units of output produced. The manager can infer this result through productivity-cost relationships rather than knowing marginal costs directly. Firm managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs might behave when the firm’s output must change to accommodate market changes.

Shifts in the Cost Curves •

•

The cost curves shift with changes in technology or changes in prices of factors of production. • An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a fixed input, then the average total cost curve shifts upward at low levels of output and downward at higher levels of output. A fall in the price of the fixed factor shifts the AFC and ATC curves downward but leaves the AVC and MC curves unchanged. A fall in the price of a variable factor shifts the AVC, ATC, and MC curves downward but leaves the AFC curve unchanged.

IV. Long-Run Cost In the long run, a firm can vary the level of all resources so both labor and capital are variable factors. As a result, in the long run all costs are variable costs.

The Production Function The production function determines the behavior of long run costs. • A firm’s production function typically exhibits diminishing returns to capital as well as diminishing returns to labor. The marginal product of capital is the change in total product divided by the change in capital when the quantity of labor is held constant. Holding constant the quantity of employment, after some level of output the firm will have diminishing returns to capital—the marginal product of capital decreases as more capital is used.

Short-Run Cost and Long-Run Cost •

•

In the long run, a firm can use different plant sizes. Each plant size has a different short-run ATC curve. Each short-run ATC curve is U-shaped and the larger the plant size, the greater is the output at which the average total cost is a minimum. The figure illustrates three average total cost curves for three plant sizes. ATC1 pertains to the smallest plant size and ATC3 to the largest.

The Long-Run Average Cost Curve •

The long-run average cost curve, LRAC, is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. This curve is derived from the short-run average total cost curves. It shows the lowest average total cost to produce a given level of output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

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•

The LRAC curve is a planning curve. Once the firm chooses a plant size, then it operates on the short-run costs curves associated with that plant size.

An Economics in Action case describes why a firm in the auto industry might have capital equipment that is not fully used. The firm is producing at a point on its short-run average total cost curve that is not the minimum of the short-run average cost curve, so the firm has under-utilized capital. But the production point is on the long-run average cost, so the quantity being manufactured is produced at the minimum average total cost.

Economies and Diseconomies of Scale •

•

Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output exceeds the percentage increase in all factors of production. The long-run average cost curve slopes downward in this range of output. The main source of economies of scale is greater specialization of both labor and capital. Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output equals the percentage increase in all factors of production. The long run average cost curve is horizontal in this range of output. Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output is less than the percentage increase in all factors of production. The long run average cost curve slopes upward in this range of output. The minimum efficient scale is the smallest quantity of output at which the long-run average cost curve reaches its lowest level.

Concepts are important, not just the formulas. Make good use of the glossary of productivity and cost terms provided in Table 11.2 in the text, but don’t get mired down in reciting productivity and cost measure definitions! Students must learn the definitions, but they are secondary to the concepts they define and the insights they bring. Stand back from the details of this chapter and be sure that your students learn two big ideas. • A firm’s lowest production costs depend on the manager’s flexibility to choose the level of all factors. This flexibility enables firm managers to produce at a lower cost in the long run than in the short run when some factors are fixed. • In the short run, with one or more fixed factors, production costs vary with output in a predictable way because they are directly linked to measures of factor productivity. When does the firm actually reach the “long run”? Think of the long run as a window of opportunity in which firms get to re-make decisions. If things are going well, firms may be re-making decisions regularly and extending fixed inputs on a regular basis. But if things are going poorly, the window in which a lease can be broken or a contract not renewed will be pressing. Point out to the students that the long-run average cost curve yields the lowest average cost of production possible when plant size is free to change. Once a firm commits to a specific plant size, it is locked into a specific short run cost curve configuration. Any significant departure from the range of output per period that best suits that configuration means the firm will incur higher short-run average total costs than it would have had it chosen a more appropriate plant size. If faulty market analysis or unexpected changes in market conditions cause a firm to commit to a plant that is too small (or too large) when the required range of production is actually relatively high (or relatively low), then the firm will suddenly be locked into a much less competitive production cost situation with potentially dire economic consequences. If the firm’s competitors chose their plant size more wisely, the firm might have a tough time surviving! Who is successful in the long run may depend on decisions to get bigger or smaller that wound up being correct as market conditions changed. Experiment: Learn about production by producing. This chapter is one more place where an in-class experiment has a huge payoff in student comprehension. This 30 minute experiment teaches students about product curves and production cost measures. It motivates the students to go beyond memorizing the cost and productivity definitions by getting them directly involved with generating their own data as well as productivity and cost measures. This fun exercise will illustrate the concept of diminishing returns to labor as well as how short-run productivity measures and production cost measures are related.

OUTPUT AND COSTS

• •

•

Factors: Capital: A medium-sized table (the class must have an unobstructed view of it), tear-off scratch pads with about 500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fully loaded). Labor: Provided by your students. The Task: To produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very carefully so that the corners of the paper align, and stapled. (The first fold bisects the paper along its long side and the second fold is at right angles to the first.) Once folded, it is stapled to hold the folds in place. A widget is fragile and breaks if it falls off the table. The Pre-Experiment Stage: Hire a manager from your class and appoint an auditor. Get the manager to hire a quality controller, an accountant, and some workers. Tell the manager that he must produce widgets as efficiently as possible and that he can discuss the process with his workers and with the class. The Experiment: A “work day” lasts for 1 minute. Get the class to keep time. On day 1, have one worker produce widgets. On day 2, have two workers produce widgets, and so on. You’ll probably run for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets don’t get used in a subsequent day. Each day must start clean. The Assignment (Stage 1): Have the students to calculate marginal product and average product from the total product numbers that you’re recorded. Get them to make graphs of the total product, marginal product, and average product curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweater production in the textbook. The Assignment (Stage 2). Use the data from your widget production experiment and give the students figures for the cost of the capital and the wage rate of a worker. (Make up the numbers—any will do.) Tell the students to calculate total cost, marginal cost, and average cost. Get them to make graphs of the total cost, marginal cost, and average cost curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweaters in the textbook. (This assignment and the previous one make an outstanding assignment for credit.) The Experiment Extended. If you have the time, duplicate the capital of the first experiment and repeat all its steps. You should generate a horizontal LRAC. Get the class to think about what would have to happen in the context of this experiment to get economies of scale and diseconomies of scale.

Economics in the News discusses Starbucks’ cost curves and describes how adding additional stores can move the firm downward along its long-run average cost curve and thereby lower its average total costs.

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Additional Problems 1.

Charlie’s Chocolates total product schedule is in the table. a. Draw the total product curve. b. Calculate the average product of labor and draw the average product curve. c. Calculate the marginal product of labor and draw the marginal product curve. d. What is the relationship between the average product and marginal product when Charlie’s Chocolates produces (i) less than 276 boxes a day and (ii) more than 276 boxes a day?

In problem 1, the price of labor is $50 per day, and total fixed costs are $50 per day. a. Calculate total cost, total variable cost, and total fixed costs for each level of output and draw the short-run total cost curves. b. Calculate average total cost, average fixed cost, average variable cost, and marginal cost at each level of output and draw the short-run average and marginal cost curves.

In problem 2, suppose that the price of labor increases to $70 per day. Explain what changes occur to the short-run average and marginal cost curves?

In problem 2, Charlie’s Chocolates buys a second plant and now the total product of each quantity of labor doubles. The total fixed cost of operating each plant is $50 a day. The wage rate is $50 a day. a. Set out the average total cost curve when Charlie’s operates two plants. b. Draw the long-run average cost curve. c. Over what output range is it efficient to operate one plant and two plants?

The table shows the Labor Output production function of (workers (pizzas per day) Mario’s Pizza-to-Go. Mario per day) Plant 1 Plant 2 Plant 3 Plant 4 must pay $100 a day for 1 4 8 11 13 each oven he rents and 2 8 12 15 17 $75 a day for each kitchen 3 11 15 18 20 hand he hires 4 13 17 20 22 a. Find and graph the Ovens 1 2 3 4 average total cost curve for each plant size. b. Draw Mario’s long-run average cost curve. c. Over what output range does Mario experience economies of scale? d. Explain how Mario uses his long-run average cost curve to decide how many ovens to rent.

Labor (workers per day) 1 2 3 4 5 6 7 8 9 10

Output (boxes per day) 12 24 48 84 121 192 240 276 300 312

OUTPUT AND COSTS

Solutions to Additional Problems 1.

a. b.

To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping. The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 48 boxes a day, so average product is 16 boxes per worker. The average product curve is upward sloping when the number of workers is between 1 and 8, but it becomes downward sloping when 9 and 10 workers are employed. The marginal product of labor is equal to the increase in total product when an additional worker is employed. For example, when 3 workers are employed, total product is 48 boxes a day. When a fourth worker is employed, total product increases to 84 boxes a day. The marginal product of going from 3 to 4 workers is 36 boxes. The marginal product curve is upward sloping when the number of workers is between 1 and 6, but it becomes downward sloping when 7 or more workers are employed. (i) When Charlie’s Chocolates produces fewer than 276 boxes a day, it employs fewer than 8 workers a day. With fewer than 8 workers a day, marginal product exceeds average product and average product is increasing. Up to an output of 276 boxes a day, each additional worker adds more to output than the average. Average product increases. (ii) When Charlie’s Chocolates produces more than 276 boxes a day, it employs more than 8 workers a day. With more than 8 workers a day, average product exceeds marginal product and average product is decreasing. For outputs greater than 276 boxes a day, each additional worker adds less to output than average. Average product decreases. Total cost is the sum of the costs of all the inputs that Charlie’s Chocolates uses in production. Total variable cost is the total cost of the variable inputs. Total fixed cost is the total cost of the fixed inputs. For example, the total variable cost of producing 48 boxes a day is the total cost of the workers employed, which is 3 workers at $50 a day, which equals $150. Total fixed cost is $50, so the total cost of producing 48 boxes a day is $200. To draw the short-run total cost curves, plot output on the x-axis and the total cost on the y-axis. The total fixed cost curve is a horizontal line at $50. The total variable cost curve and the total cost curve have shapes similar to those in Fig. 11.4, but the vertical distance between the total variable cost curve and the total cost curve is $50. Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output. For example, when the firm makes 48 boxes a day: Total fixed cost is $50, so average fixed cost is $1.04 per box; total variable cost is $150, so average variable cost is $3.13 per box; and total cost is $200, so average total cost is $4.17 per box. Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 24 to 48 boxes a day, total cost increases from $150 to $200, an increase of $50. That is, the increase in output of 24 boxes increases total cost by $50. Marginal cost is equal to $50 divided by 24 boxes, which is $2.08 a box. The short-run average and marginal cost curves are similar to those in Fig. 11.5. The increase in the price of labor increases total variable cost and total cost but does not change total fixed cost. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward. Average fixed cost does not change.

Total cost is the cost of all the factors of production. For example, when 3 workers are employed they now produce 96 boxes a day. With 3 workers, the total variable cost is $150 a day and the total fixed cost is $100 a day. The total cost is $250 a day. The average total cost of producing 96 boxes is $2.60. The long-run average cost curve is made up of the lowest parts of the firm’s short-run average total cost curves when the firm operates one plant and two plants. The long-run average cost curve is similar to Fig. 11.8.

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It is efficient to operate the number of plants that has the lower average total cost of a box of chocolates. It is efficient to operate one plant when output is less than 48 boxes a day, and it is efficient to operate two plants when the output is more than 48 boxes a day. Over the output range 1 to 48 boxes a week, average total cost is less with one plant than with two, but if output exceeds 48 boxes a day, average total cost is less with two plants than with one.

For example, the average total cost of producing a pizza when Mario rents 2 ovens and employs 4 workers equals the total cost ($200 rent for the ovens plus $300 for the workers) divided by the 17 pizzas produced. The average total cost equals $500÷17, which is $29.41 a pizza. The average total cost curve is U-shaped, as in Fig. 11.5. The long-run average cost curve is similar to that in Fig. 11.8. Mario experiences economies of scale at output levels of 4 to 15 pizzas a day. When economies of scale are present, the LRAC curve slopes downward. Mario’s LRAC curve slopes downward between the output levels of 4 to 15 pizzas a day. Mario will choose the plant (number of ovens to rent) that gives him minimum average total cost for the normal or average number of pizzas that people buy.

b. c.

Additional Discussion Questions 11. Is the law of diminishing returns a result of firms hiring the best workers first? Students should understand that diminishing returns to labor occur under the assumption of a homogenous work force. Emphasize that diminishing marginal returns occur due to labor’s decreasing productivity given a fixed level of capital. The law of diminishing returns is defined in the short run only. As the amount of capital increases, as technology changes, or as the size of the plant increases, labor productivity can increase. If the variable input was a herbicide or a fertilizer on a farm field, diminishing returns would still be observed. 2.

Do increasing marginal costs result from the rising wages of workers? Students should understand that rising marginal cost in the short run results from diminishing marginal productivity of labor holding the wages for labor constant. Show the students the following thought process: • Employing another labor unit increases output, but the extra output is less than the added output from the previous labor unit (diminishing marginal productivity). • Each labor unit costs the same to employ, so the firm is getting less additional output for the same additional cost (constant cost of labor). • As a result, each additional unit of output is more expensive for the firm to make than the previous units of output (rising marginal cost). This chain of reasoning is very important because it clearly shows the linkage from the firm’s production decisions and production constraints to its costs and the behavior of its cost curves.

Fixating on fixed costs. Students should be aware of how fixed costs affect pricing decisions made by firms: • Why are some consumer products cheaper to buy in bulk? The students should be aware that if packaging costs comprise a significant proportion of the total cost of an item, then an increase in the ratio of product to packaging lowers the cost per unit. The firm can be more competitive and still retain profitability if it passes some of the savings on to the customer through a lower unit price. Do firms produce where the ATC (or MC) curve is at its minimum? Students frequently ask a variation of this question. Students who ask this question should be praised because they are clearly thinking ahead and trying to use what they are learning to better understand the real world around them. However, you need to be clear to these students that costs are essentially half of the picture. Firms are in business for one reason, to maximize their profit. Profit equals revenue minus cost, so in order to maximize their profit, firms need also to be concerned with their revenue. You can intuitively tell the students that the next chapters “cover the revenue side of the

OUTPUT AND COSTS

picture” by looking at how the market structure in which a firm competes affects the firm’s revenue and hence affects its decisions. Firms want to minimize the cost of producing a given level of output, but the level of output that maximizes profit may not be at the minimum of any cost function. 5. Discuss the following in terms of fixed costs, the short run and the long run: In agricultural markets, firms hesitate to be early adopters of new technologies embodied in new capital equipment, which can be quite expensive. But once they are proven to increase productivity, firms rush to adopt them and firms that don’t (or can’t) will have difficulty surviving. Equipment is a huge fixed cost for farmers. Committing to a particular piece of equipment is a decision they will be stuck with for a while, and making the wrong choice may make them a higher cost producer. A smart farmer could buy what turns out to be the wrong piece of equipment because the new technology perhaps proved less durable than expected. This farmer might be unable to reverse that choice in time to save the farm if market conditions are overall poor. 6. Suppose you open a restaurant. Which inputs are fixed and variable in the short run? When might you hit the long run and have to make new decisions? Labor, food, and other raw materials, some portion of the utility bills, advertising all might be examples of variable inputs. The building and the equipment, whether owned or leased, are typically fixed inputs. When the lease is up, the firm gets to decide whether to renew, shut down, or go to a smaller space or a bigger space. Ask students to describe what market conditions might lead to each of the above. Why do they think so many restaurants fail? 7. Are firms that survive over long periods of time simply lucky or smarter than other firms? Sometimes the capital choice a firm makes determines its survival and it can’t change the choice easily once made. Unexpected changes in the economy or technology create winners and losers based on past capital decisions.

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PERFECT COMPETITION

The Big Picture Where we have been: Chapter 12 relies heavily on the productivity and cost analysis material of Chapter 11, the marginal analysis and efficiency issues introduced in Chapter 2 and Chapter 5, and the concept of economic profit introduced in Chapter 10. Where we are going: Chapter 12 is the first of four chapters that explore the price and output decisions of firms under various market characteristics. Chapter 12 studies perfect competition, Chapter 13 studies monopoly, Chapter 14 studies monopolistic competition, and Chapter 15 studies oligopoly. All four chapters use cost curves, marginal analysis, and the concept of efficiency.

N e w i n t h e Tw e l f t h E d i t i o n Some material is presented in a more streamlined manner that increases clarity for students. The chapter continues to explore the impact technology has on changing the market, both on the demand and supply sides. A new Worked Problem section has been added. The Worked Problem provides a market demand schedule and a firm’s average and marginal cost schedules. It then shows the students how to calculate the firm’s shutdown point and, assuming there are 1,000 identical firms, how to find the market equilibrium price and quantity. It uses these results to show the students how to determine if firms will enter or exit the market and what will be the long-run equilibrium. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Perfect Competition • • •

Firms in perfect competition face the maximum amount of competition because there are many competing firms, each of which produces an identical product. Firms in perfect competition maximize their profit by producing where MR = MC. Perfect competition leads to an efficient allocation of resources.

What is Perfect Competition? • • • •

Perfect competition is an industry in which Many firms sell identical products to many buyers There are no restrictions on entry into the industry Established firms have no advantage over existing ones Sellers and buyers are well informed about prices

How Perfect Competition Arises •

These characteristics of perfect competition arise when the minimum efficient scale for a firm is small relative to the size of the entire market. The minimum efficient scale is the smallest output at which longrun average costs are minimized.

What markets satisfy the characteristics of perfect competition? Have the students consider the markets for goods with which they are familiar to see if any meet the strict criteria for perfect competition. The markets that come closest are agricultural markets, though others such as lawn service, plumbing, gas stations, and so on, also come close. Students sometimes “worry” that these markets are not exact examples of perfect competition. Reassure them that the model of perfect competition gives us a great deal of understanding into the workings of extremely competitive real world markets and the real world firms in the markets. If there aren’t really any perfectly competitive markets, what use is studying perfect competition? The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a much fancier model! Economists use the model of perfect competition in a similar way to understand our economic world. Emphasize to students that, although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

Price Takers •

Firms in perfect competition are price takers, meaning that a firm that cannot influence the market price and so it sets its own price equal to the market price.

What is a price taker? Spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are “price takers.” On the one hand, they could offer to sell for a lower price, but they’d be giving profits away because they can sell all they want at the going market price. On the other hand, they can ask for a higher price but not even one consumer will pay because consumers know where to buy an exact substitute at a lower price.

Economic Profit and Revenue •

Firms operating in perfect competition seek to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total opportunity cost of production

PERFECT COMPETITION

• •

Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases. The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.

II. The Firm’s Output Decision Marginal Analysis and the Supply Decision • •

The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit. Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output. • When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit. • When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits • When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output. • In the figure the firm produces 4 units of output because that is the quantity that sets the firm’s marginal cost equal to its marginal revenue, that is, MR = MC. The firm then charges the going market price of $30 for its good.

What’s the point? Students find the topic of competitive market dynamics challenging. Part of their problem is that understanding the dynamics requires a strong understanding of the cost curves of the previous chapter, yet many of them still have only a shaky grasp of that important material. So emphasize the cumulative nature of economics and remind the students of the huge payoff from mastering material a bite at a time. You also can help your students by emphasizing the two primary goals of this chapter: (1) To derive the market supply curve in a competitive industry and (2) to deepen your students’ understanding of how competition among self-interested consumers and producers will move society’s resources from less valued uses to more highly valued uses, achieving an efficient allocation in the eyes of society.

Temporary Shutdown Decision •

•

The firm will temporarily shut down in the short run when price falls below the shutdown point, which is the output and price that just allows the firm to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its fixed cost.) The firm will continue operating in the short run even if it incurs an economic loss as long as the price exceeds the minimum AVC.

Why would a restaurant open on days it knows business will be bad? Monday is typically the slowest day in the restaurant industry. So why do so many restaurants stay open on Monday? The answer is that even if a restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be good business!

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Students often have a hard time understanding why operating at an economic loss can be the best action for a firm owner. The key is emphasizing: • The firm’s short-run decisions are made after some irreversible commitments have generated sunk costs. • The firm considers only avoidable future costs when making decisions. Unavoidable costs have no impact on the decision (other than to learn from them). • For the firm to continue to produce output, the firm needs only to receive revenues that exceed any avoidable costs, not necessarily all total costs. Basically, the goal of profit maximization does not guarantee that the firm will earn a positive economic profit in the short run. Sometimes the best the firm can do is to minimize its economic loss.

The Firm’s Supply Curve •

•

As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero. The figure shows the firm’s supply curve as the heavy dark line. • At prices less than the minimum average variable cost, which equals P in the figure, the firm shuts down and supplies zero. • At prices greater than the minimum average variable cost, the firm supplies along its marginal cost curve. Hence the firm’s marginal cost curve is its supply, indicated in the figure by the S = MC curve.

III. Output, Price, and Profit in the Short Run The short run is a situation in which the number of firms is fixed. In the short run, market demand and market supply interact to determine the price and quantity produced in a perfectly competitive market.

Market Supply in the Short Run •

The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and number of firms remain the same. The quantity supplied in the industry at any price is the summation of all quantities supplied by each firm at that price, so the short-run industry supply curve is the horizontal summation of all the firms’ supply curves.

Short-run Equilibrium •

Market demand and short-run market supply determine the market price and market output. Each firm takes the market price as given, and produces its profit maximizing output.

A Change in Demand • • •

Changes in market demand influence the output and the entry or exit decisions made by firms. An increase in market demand shifts the market demand curve rightward and raises the market price. Each firm responds by increasing its quantity supplied. A decrease in market demand shifts the market demand curve leftward and decreases the market price. Each firm responds by decreasing its quantity supplied.

PERFECT COMPETITION

Profits and Losses in the Short Run •

In the short run, even though firms attempt to maximize profit, they may end up breaking even or incurring an economic loss. The total economic profit (or loss) is equal to (P − ATC) × q. • If the price exceeds the ATC, the firm makes an economic profit (as illustrated in the figure). • If the price equals the ATC, the firm “breaks even” by making zero economic profit. In this case, the entrepreneur makes a normal profit. • If the price is less than the ATC, the firm incurs an economic loss.

An Economics in Action application considers the situation of Harley Davidson after a decrease in the market demand. Harley Davidson cut production and laid off workers. One plant was temporarily idled and other jobs were lost permanently.

IV. Output, Price, and Profit in the Long Run In the short run, a firm might break even, earn an economic profit or incur a loss. Because of entry and exit, in the long run a firm can only break even.

Entry • •

•

Economic profit motivates firms to enter the industry, thereby increasing the market supply. When the market supply curve shifts rightward, the market price falls. Eventually the price falls to equal the minimum ATC for each firm in the industry and firms have adjusted their plant size so they are producing at the minimum long-run average cost. At this price, firms in the industry no longer make an economic profit and so firms no longer enter the industry. The figure illustrates this long-run equilibrium. In the figure, LRAC is the long-run average cost curve and SRAC is the shortrun average cost curve. One difference between the old and new market equilibriums is that the number of firms in the industry has risen and total quantity produced in the industry has increased.

Exit • •

The effects of a decrease in market demand are the opposite of those outlined above. In the long run, competitive firms make zero economic profit (price = average total cost) so that their owners make a normal profit.

Long Run Equilibrium • •

Long run equilibrium in a competitive market occurs when there is zero economic profit and entry and exit have stopped. Because markets are constantly experiencing new changes and shocks, it is rare to see one in a state of long-run equilibrium, but each competitive markets reacts to any new changes by pushing toward it.

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Profit as a “signal”: When demand for a good increases so that the existing firms in an industry make an economic profit, the economic profit indicates that consumers are willing to pay a higher price for the good than they were willing to pay before the demand increased. The economic profit for the firms is a signal from the consumers to the owners of firms in other industries that society now values the availability of the good more highly than the availability of goods from those other industries. These self-interested firm owners choose to enter the industry in order to make an economic profit. Their self-interested decisions promote the social interest by using more resources to produce those goods that are more highly valued by society. The dynamic behavior of a perfectly competitive market characterizes the “invisible hand” coined by Adam Smith. Why would a firm stay in business if profit is zero? It is likely that you will hear this question from at least one of your students. Remind them that the profit we’re measuring is economic profit. Zero economic profit doesn’t necessarily mean that the firm isn’t making any money. Rather, zero economic profit means that the profits the accountant is reporting is exactly the same as the value of the firm’s best alternative. If the firm were to move to its best alternative, it would make the same amount of profit. If a firm is making zero economic profit, there isn’t any incentive to go anywhere else as there isn’t any place that would generate a higher return for the firm. You may need to continue reminding your students of this throughout this chapter. An Economics in Action feature examines entry and exit using the personal computer market and the farm equipment market.

V. Changes in Demand and Supply as Technology Advances Change in Demand •

Technological change can increase demand if it creates new applications for a product or new products. Technological change can also decrease demand if new ways of doing things or new products displace previous ones. • If demand increases, the price and economic profit rise. The economic profit leads to entry, which increases market supply and causes the price to fall so that eventually firms again make zero economic profit. The number of firms is greater than before the increase in demand. • If demand decreases, the price falls and economic losses are created. Firms exit the market, which raises the price and decreases the remaining firms’ economic losses. Eventually the price rises so that the surviving firms make zero economic profit. The number of firms is less than before the decrease in demand.

An Economics in the News case explores the effects of a decrease in demand for records and taped music

Change in Supply •

• •

New, cost-saving technologies typically require new plant and equipment. Consequently it takes time for new technology to spread throughout an industry. Firms that adopt the new technology lower their costs and their supply curves shift rightward. The price of the good falls but the firms with the new technology make an economic profit. Firms using the old technology incur economic losses. These firms either adopt the new technology or else exit the industry. In the long run, all the firms use the new technology and make zero economic profit. Changes in technology brings only temporary economic profit to producers, but the lower prices and better products that technological advances bring are permanent gains for consumers.

An Economics in the News case explores the implications of technological changes that have created falling costs to sequence DNA.

PERFECT COMPETITION

Do firms in perfectly competitive markets advertise? Firms in perfectly competitive markets have no incentive to advertise because their product is indistinguishable from the output of rival firms. Industry associations will sometimes advertize to increase demand for the product as a whole. Brainstorming all the ads for agricultural products such as “Pork: the other white meat,” and all the varieties of milk ads can be fun, but the point is that it isn’t a pork producer or a dairy farmer creating the ad, but all of the pork producers or dairy farmers paying dues to an industrial organization that then creates the ads. Successful advertisements might lead to an economic profit in the short run, but in the long run entry will force the firms back to zero economic profit.

VI. Competition and Efficiency Efficient Use of Resources •

Resource allocation in a market is efficient when society values no other use of the resources more highly. Resource use is efficient when production is such that the marginal social benefit of the good equals the marginal social cost of the good.

Choices, Equilibrium, and Efficiency •

•

Consumers allocate their budgets to get the most value out of them. Because consumers get the most value out of their budget, a consumer’s individual demand curve for a good is the consumer’s marginal benefit curve for the good. If no one else benefits from the good other than the consumers, then, as shown on the figure, the market demand curve for a good is the marginal social benefit curve. Firms maximize their profits in order to get the most value out of their resources. Firms make choices across all possible allocations of their resources. A firm’s supply curve for a good is its marginal cost curve. If all the costs of production of the good are paid by the producers, then, as shown in the figure, the market supply curve for a good is the marginal social cost curve. In a competitive equilibrium, the quantity demanded equals the quantity supplied. If there are no externalities, the demand curve is the same as the marginal social benefit curve and the supply curve is the same as the marginal social cost curve, so at the competitive equilibrium, the marginal social benefit equals the marginal social cost. Resource use is efficient. Because resources are used efficiently, at the competitive equilibrium there is no other allocation of resources that will generate greater net benefits to society. The figure shows this outcome, where resource use is efficient at the equilibrium quantity of 3,000 units.

Watching the work of the invisible hand: The power of the market to make firms respond to consumers’ changing demands becomes visible to the student in this chapter. When you teach the dynamics of firm entry and exit, do the analysis with a specific (and current) example with which the students can identify. Have them pick an industry that has grown and largely died in their lifetime (for me, VCRs, for them, DVDs at Blockbuster, or video cameras or film cameras). What has replaced it and how is society served by failure as well as success? Economics in the News analyzes the market for smart phone apps. It explains how the rapid expansion of smartphones increased the demand for apps, thereby bring economic profits to app producers.

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Additional Problems 1.

Bob’s is one of many burger stands along the beach. Figure 12.1 shows Bob’s cost curves. a. If the market price of a burger is $4, what is Bob’s profit-maximizing output? b. Calculate the economic profit that Bob’s makes. c. With no change in demand or technology, how will the price change in the long run?

Lucy’s Lasagna is a price taker that has the costs shown in the table. a. If lasagna sells for $7.50 a plate, what is Lucy’s profitmaximizing output? b. What is Lucy’s shutdown point? c. Over what price range will Lucy leave the lasagna industry? d. Over what price range will other firms with costs identical to Lucy’s enter the industry? e. What is the price of lasagna in the long run?

Output (plates per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 5 20 26 35 46 59

Solutions to Additional Problems 1.

Bob’s profit-maximizing quantity is 300 burgers a day. Bob’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $4 a burger. Marginal cost is $4 when 300 burgers a day are produced. Bob’s economic profit is $300 a day. Profit equals total revenue minus total cost. Total revenue equals $1,200 a day ($4 a burger multiplied by 300 burgers). The average total cost of producing 300 burgers is $3.00 a burger, so total cost equals $900 a day ($3.00 multiplied by 300 burgers). Profit equals $1,200 minus $900, which is $300 a day. The price will fall in the long run to $2.80 a burger. At a price of $4 a burger, firms make economic profit. In the long run, the economic profit will encourage new firms to enter the burger industry. As they do, the price will fall and economic profit will decrease. Firms will enter until economic profit is zero, which occurs when the price is $2.80 a burger (price equals minimum average total cost). Lucy’s profit-maximizing output is 2 plates an hour. Lucy’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $7.50 a plate. Marginal cost is the change in total cost when output is increased by 1 plate an hour. The marginal cost of increasing output from 1 to 2 plates an hour is $6 ($26 minus $20). The marginal cost of increasing output from 2 to 3 plates an hour is $9 ($35 minus $26). So the marginal cost of the second plate is half-way between $6 and $9, which is $7.50. Marginal cost equals marginal revenue when Lucy produces 2 plates an hour.

PERFECT COMPETITION

Lucy’s shutdown point is at a price of $10 a plate. The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($5, which is total cost at zero output) from total cost. Average variable cost equals total variable cost divided by the quantity produced. For example, the average variable cost of producing 3 plates is $10 a plate. Average variable cost is a minimum when marginal cost equals average variable cost. The marginal cost of producing 3 plates is $10. So the shutdown point is a price of $10 a plate. Lucy will leave the industry if in the long run the price is less than $11 a plate. Lucy’s Lasagna will leave the industry if it incurs an economic loss in the long run. To incur an economic loss, the price will have to be below minimum average total cost. Average total cost equals total cost divided by the quantity produced. For example, the average total cost of producing 2 plates is $13 a plate. Average total cost is a minimum when it equals marginal cost. The average total cost of producing 3 plates is $11.67, and the average total cost of producing 4 plates is $11.50. Marginal cost when Lucy's produces 3 plates is $10 and marginal cost when Lucy's produces 4 plates is $12. At 3 plates, marginal cost is less than average total cost; at 4 plates, marginal cost exceeds average total cost. So minimum average total cost occurs between 3 and 4 plates— $11 at 3.5 plates an hour. Firms with costs identical to Lucy’s will enter at any price above $11 a plate. Firms will enter an industry when firms currently in the industry are making economic profit. Firms with costs identical to Lucy's will make economic profit when the price exceeds minimum average total cost, which is $11 a plate. The price in the long run is $11 a plate. At $11 a plate, firms in the industry make zero economic profit.

Additional Discussion Questions 1.

Why do firms do what they do? Students should see how a clear understanding of a perfectly competitive market justifies firm behavior that otherwise might appear somewhat peculiar: Late night TV is full of zany TV commercials with firm owners who claim “I must be crazy, because I’m losing money on every sale!” Why do they advertise to increase sales if they’ll cause the owner to lose even more money? At first, it appears that these owners must be lying about “losing money on every sale.” Yet their unlikely claim is potentially true, as the various firms in their industry may currently face a market price above AVC, but below ATC in the short run. In this case they would remain in business and continue advertising, despite “losing money on every sale” because they are earning revenues above their variable costs to at least help contribute toward paying their fixed cost obligations to their creditors. Why do the same farmers always complain of losing money but never seem to exit the industry? Point out that agriculture is a collection of highly competitive markets where farming operations typically have an extremely high capital-to-labor ratio. This fact makes the typical farm’s ratio of fixed costs to variable costs very high relative to most industries. Also, much of a farmer’s capital is in the form farmland, which is difficult to sell during falling agriculture prices, lengthening the farmer’s short run time frame. In this case, the dollar difference between market price and minimum AVC will be rather large. As long as market price exceeds AVC, the farmer will minimize losses by continuing to produce output over an extended short run time frame.

What is implied about efficiency if the average cost of producing a good exceeds the price people are willing to pay for it? Remind the students that a firm’s cost curves reflect the opportunity cost to society of the firm using the resources to make the goods in its market (the resources could be making goods in some other market that could bring benefits to society). The demand curve reflects the value society places on each quantity of goods produced. If the price people are willing to pay is determined by the market supply and demand and the going market price is less than the opportunity cost of producing the last unit of the good, using more resources to increase output creates fewer net benefits for society than could be generated if the resources were used elsewhere in other markets. What happens to the resources that were used by a firm for production when that firm exits the industry? Point out that when price falls below ATC, this generates an economic loss for the firm. This is a signal from a society of consumers to the owner of the resources that he or she

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will benefit from reallocating the resources to making different goods and services from the same resources. Society also stands to benefit from this switch. How can an increase in net benefits to society be generated from the systematic destruction of firms leaving the market? A famous economist named Joseph Schumpeter coined the phrase “creative destruction” to describe the dynamics of a competitive market. While the productive capacity of a perfectly competitive industry facing declining consumer demand is ultimately destroyed, the resources themselves are not destroyed. They are simply released to firms in other markets to create goods and services that are relatively more valuable to society. This “destruction” of an industry creates goods of greater social value in another industry. That is Schumpeter’s “creative destruction.” 3.

What makes all the self-interested firms adopt the latest available technology for producing at the lowest opportunity cost possible over time? Emphasize that competitive firms cannot increase their economic profits by raising their price, so they must search for ways to increase economic profit through lowering production costs. This means that firms are constantly seeking out the latest production technologies to find a cost advantage over their competitors. If the other firms failed to adopt this low-cost production technology, they would suffer an economic loss when those that do adopt the technology lower their prices to increase market share. Firms that refuse to adopt the technology must then match a lower market price to retain their market shares, causing them to bear an economic loss and face an eventual exit from the market.

Discuss whether there are economies of scale or diseconomies of scale in class size at colleges and universities. Does it matter if the “output” is measured in tuition dollars and costs or in student success as measured by grades? Does technology impact the answer? This situation can be fun to explore. Can a great teacher supported by excellent technology be best used in a huge lecture class? Are there some types of instruction, like experimental labs, where increasing class size might lead to disaster? Why do colleges advertise their average class size and do parents and students care? How might the educational “plant” and equipment differ to support various choices in class size?

Using the global corn market, consider the impact of increasing demand for ethanol made from corn in the short and long run. The increase in demand for ethanol raises the price of corn and thereby increases corn farmers’ economic profit…at least in the short run. But in the long run, the economic profit leads existing farmers to plant more corn and more corn farmers to enter the. These long-run changes increase the supply of corn, thereby lowering the price of corn and decreasing corn farmers’ economic profit. Entry (and expansion) continues until, in the long run, corn farmers’ economic profit equals zero. At that point entry ceases and the corn market is back in long-run equilibrium.

C h a p t e r

MONOPOLY

The Big Picture Where we have been: Chapter 12 on perfect competition has shown the student how firms make output and pricing decisions under competitive market assumptions. Chapter 13 explains how a firm with monopoly power makes those same decisions. Chapter 13 evaluates the efficiency of monopoly relative to perfect competition. It also covers regulation of a natural monopoly. Where we are going: Chapter 14 describes firms and industries in monopolistic competition. Chapter 15 fills in the middle of the spectrum with a study of oligopoly. The material discussing a monopoly’s downwardsloping demand curve and resulting downward sloping marginal revenue curve is used in the next chapter in the context of a firm in monopolistic competition. The result that a monopoly can earn an economic profit is used in Chapter 15 as the explanation why oligopolistic firms want to collude to raise their prices and decrease the quantity they produce.

N e w i n t h e Tw e l f t h E d i t i o n The chapter opening and a new Economics in the News case at the end of the chapter look at Google’s success in the market. Is its dominance in search serving the market and social interests or violating anti-trust law? A new Worked Problem section has been added. The Worked Problem gives the students the demand and cost schedule for a monopoly. It then shows the students how to calculate the profit-maximizing price, quantity, economic profit, and producer surplus if the firm is a single-price monopoly. Then it demonstrates to the students the profit-maximizing quantity, economic profit, and producer surplus if the firm can perfectly price discriminate. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Monopoly • • • • •

A monopoly is a market with a single firm that is protected by barriers to entry. A monopoly maximizes its profit by producing where MR = MC and then using its demand curve to set its price. Price-discriminating monopolies charge a higher price to customers with a higher willingness to pay. Compared to a competitive market, a monopoly sets a higher price, produces a smaller quantity, and converts consumer surplus into economic profit. Natural monopolies can be regulated by the government.

Monopoly and How It Arises

A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service.

How a Monopoly Arises A monopoly has two key features: • No Close Substitutes: There are no close substitutes for the good or service. • Barriers to Entry: A constraint that protects a firm from potential competition is called a barrier to entry. There are three types of entry barriers: • Natural barriers to entry create a natural monopoly, which is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost. • An ownership barrier to entry occurs if one firm owns a significant portion of a key resource. • Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work). In the U.S., patents last twenty years, encouraging innovation and stimulating invention. Who has to have a license to produce? There are many examples of government licensing. Licensing can protect consumers from fraud and abuse, but it can also hurt consumers by preventing competition from producing an efficient allocation of resources. Have the students debate the merits of the following licensing arrangements: 1) Doctors can receive a medical license to practice medicine only by graduating from an AMAapproved medical program; 2) Lawyers can practice law only after passing an extensive Bar Exam; 3) Cab drivers in New York City can operate a taxi only if they have purchased a medallion from the city, of which there are a finite number; 4) Beauticians in many states cannot operate a beauty parlor without a state certification that requires training in sanitary practices as well as other courses completely unrelated to their profession (such as civics and history courses). What’s the advantage of patents? Granting an innovator a monopoly to the innovation increases the incentives to innovate. But the evidence whether monopoly leads to greater innovation is mixed. Consider the struggle for developing countries with populations dealing with epidemics such as AIDS. In the developed countries in which they operate, pharmaceutical companies are granted legal barriers (patents) on their drugs, granting them a legal monopoly and enabling them to earn a high economic profit once they bring a new and successful medicine to market. The anticipation of this profit provides the incentive for these firms to undertake the expensive (currently estimated at approximately $900 million per approved drug) and risky development of innovative cures for the terrible diseases afflicting mankind, such as AIDS. However, once the new medicines are made available, the absence of competition means the price is high, which decreases the use of these new medicines, especially among the population of the poorer, developing nations that have been hit the hardest by these diseases. So, once the drug is discovered, the monopoly creates a deadweight loss but without the economic profit the monopoly

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brings, the drug might not have been discovered. There is a tradeoff between current sufferers, who want a low price, and sufferers in the future, who want new and better medicines developed. The Economics in Action case considers how the information age has led to the creation of new natural monopolies. These firms have high fixed costs but almost zero marginal costs. The firms cited include Google, Microsoft, and Facebook. These same information age technological changes have hurt other monopolies such as the U.S. Postal Service, with competition from FedEx, UPS, email, and online payments systems. Local cable television providers now face competition from satellite and phone companies.

Monopoly Price-Setting Strategies • •

A single-price monopoly is a firm that sells each unit of its output for the same price to all its customers. Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

II. A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue •

• •

Quantity Total Marginal The demand curve facing a monopoly firm is Price demanded revenue revenue the market demand curve. Total revenue $4 0 $0 (TR) is the price (P) multiplied by the $3 quantity sold (Q). Marginal revenue (MR) is $3 20 $60 the change in total revenue resulting from a $1 one-unit increase in the quantity sold. $2 40 $80 The table shows the calculation of TR and −$1 MR. $1 60 $60 A key feature of a single-price monopoly is that MR < P at each quantity so the MR curve lies below the demand curve. MR < P because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

Why is MR below the price? While the formula isn’t difficult, students often have trouble understanding this concept intuitively. If a firm sells output for $2, why aren’t they getting $2 of revenue for each unit of output they sell so that marginal revenue is $2? Remind students that we are assuming that the monopoly charges the same price to all consumers. As in the table above, if on any given day, every consumer is paying $2 for output, 40 units are demanded and total revenue is $80. If the monopoly decides it wants to sell more than 40 units the next day, it must lower the price to do so. The monopoly is NOT simply lowering the price to $1 for units 41 through 60. Rather, the monopoly lowers the price on ALL units it will sell the next day. As a result, units 1 through 40 that customers used to pay $2 for will now be sold for only $1. That’s a loss of $1 on each of those 40 units for a revenue loss of $40. Part of that revenue loss is offset by the sales of units 41 through 60. Since the firm gains $1 in revenue from the sale of each of those units, there is a revenue gain of $20. A revenue loss of $40 (from lowering prices) compared with a revenue gain of $20 (from selling more output) generates a net revenue loss of $20, and (when divided by the change in output from 40 to 60) a marginal revenue of negative $1. For visual learners, showing these areas of revenue gain and revenue loss should also help (similar to Figure 13.2 in the text).

Marginal Revenue and Elasticity • • •

If demand is elastic, the MR is positive. A decrease in the price will result in a proportionately greater increase in quantity, generating an increase in revenue. If demand is unit elastic (as it is at the midpoint of a linear demand curve), the MR equals zero. A change in the price will result in a proportionate change in quantity, generating no change in revenue. If further increase in revenue is not possible from changing price, this is also the point where revenue is maximized. If demand is inelastic, MR is negative. A decrease in price will result in a proportionately smaller increase in quantity, generating a decrease in revenue.

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•

A single-price monopoly never produces in the inelastic part of its demand because if it did, the firm could increase its total profit by decreasing its output, which would raise its total revenue and decrease its total cost.

But if a monopoly is the only producer so there are no substitutes, isn’t demand always inelastic? This question is common. As the only producer of a good, a monopoly does have some control over the price it charges for output, and students understand that conceptually. For example, when you go to the movie theater, you know you’re likely to pay $5 or more for a tub of popcorn, even though you could buy the same amount of popcorn at the grocery store for $1 or less. Because you’re stuck at the movie theater with whatever options they offer, consumers end up paying a higher price. In other words, because there are fewer substitutes at the theater, demand for popcorn is less elastic. However, that fact does NOT mean that the demand for popcorn at a movie theater universally has an elasticity of demand that’s less than one. Even if demand for a monopoly’s product is fairly inelastic, the demand still has some ranges where elasticity is greater than one (anywhere above the midpoint on a linear demand curve, for example).

Price and Output Decision •

•

To maximize its profit, a monopoly produces the level of output where MR = MC. The monopoly then uses its demand curve to set the price at the highest price for which it will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 20 units of output and sets a price of $3 per unit. The firm makes an economic profit if P > ATC, which is the case for the firm in the figure. The monopoly can make an economic profit even in the long run because the barriers to entry protect the firm from competition. However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might make zero economic profit, (P = ATC) or in the short run, it might incur an economic loss (P < ATC).

Joan Robinson and Paul Samuelson: The classic monopoly diagram provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old. Women are still not attracted to economics on the scale that they’re attracted to most other disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

III. Single-Price Monopoly and Competition Compared Comparing Price and Output •

Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied. In the figure above, the competitive equilibrium quantity is 30 units and the competitive equilibrium price is $2.50 per unit.

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Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 20 units of output and sets a price of $3.00 per unit. Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Is the monopolist’s marginal cost curve its supply curve? Although most students will be satisfied with the comparison of the monopolist’s marginal cost curve to a competitive market’s supply curve, some students will mistakenly assume that the monopolist’s marginal cost curve is also the monopolist’s supply curve. A monopolist actually has no “supply curve” because there is no single curve that provides information both on the quantity supplied and the price. If the firm produces 20 units of output when it is maximizing profit, that output level is determined by the point where MC = MR. However, the price charged for that output doesn’t come from the MC curve. The price comes from the market demand curve. As a result, there is no relationship between the quantity supplied and price that is defined by the marginal cost curve.

Efficiency Comparison and Redistribution of Surpluses • •

•

A perfectly competitive industry produces the efficient quantity of output, where MSB = MSC. Because a single-price monopoly produces less output (where MSB > MR = MC = MSC), it underproduces and creates a deadweight loss. Consumer surplus is smaller with a monopoly than with perfect competition. In the figure above, the consumer surplus under perfect competition is the area under the demand curve and above the competitive equilibrium price of $2.50 per unit. Under monopoly the consumer surplus is the area under the demand curve and above the monopoly price of $3.00. Though the monopoly creates a deadweight loss, the monopoly’s owners benefit because it earns an economic profit. A monopoly’s owners benefits because the monopoly redistributes some of the consumer surplus away from the consumer and to the monopoly.

Does inefficiency imply less profit? It is important for students to recognize that the source of the inefficiency of a monopoly firm’s output and pricing decision arises from the absence of competition in the market, rather than any change in the behavioral assumptions about the firm owners. All firms maximize profit, but that goal does not imply efficiency when there is less than perfect competition in a market.

Rent Seeking •

•

Any surplus—consumer surplus, producer surplus, and economic profit—is called economic rent. Rent seeking is the pursuit of wealth by capturing economic rent. • Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit. • Rent seeking also can occur when someone uses resources lobbying the government to create a monopoly. Because of rent seeking, the social cost of monopoly exceeds the deadweight loss it creates. The resources used in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit, reducing monopoly profit.

IV. Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must: • Identify and separate different buyer types. • Sell a product that cannot be resold

Two Ways of Price Discriminating •

Price discrimination occurs because of people’s different willingness to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers.

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•

Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher willingness to pay are charged a higher price and groups with a lower willingness to pay are charged a lower price. For example, business airline travelers who have a high willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low willingness to pay and often make advance reservations. Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.

Increasing Profit and Producer Surplus • If buyers pay close to the maximum they are willing to pay, a monopoly converts consumer surplus into producer surplus. More producer surplus means more economic profit. • Economic profit is TR − TC and Producer Surplus is TR − TVC. Therefore Economic Profit = Producer Surplus − Total Fixed Costs. Consequently, for a given level of fixed costs, anything that increases producer surplus increases economic profit. • Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay for it. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the demand (= marginal revenue) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the greatest possible. But consumer surplus equals zero because the firm captures the entire consumer surplus. An Economic in Action feature considers Disney World’s ticket pricing. High prices for the first three days seem to extract most of the consumer surplus.

Efficiency and Rent Seeking With Price Discrimination • •

The more perfectly a monopoly can price discriminate, the greater the amount of its output and the more efficient the outcome. Because the producer grabs the entire surplus in perfect price discrimination, rent seeking becomes profitable, and the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

Can only monopolies price discriminate? The text uses the example of price discrimination by an airline. Another easy example of price discrimination is movie theaters: The price of watching a movie at 8:00 is higher than the price of watching the same movie at 5:00. But these examples often lead to a very pertinent question from students: “Neither airlines nor theaters are monopolies. So why can they price discriminate?” You need to explicitly tell your students that any firm which has some control over the price it sets has the potential to price discriminate. Monopolies have control over the price it sets, so we discuss price discrimination in the chapter dealing with monopoly. But in the “real world,” many firms other than monopolies, such as airlines and movie theaters, practice price discrimination. An Economics in the News application describes Microsoft’s launch of Windows 8 and includes pricing data from various sources for Windows 7 to explore price discrimination.

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V. Monopoly Regulation •

•

A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve. The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied. A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency. The social interest theory says that political and regulatory processes seek out inefficiency, reduce deadweight loss, and allocate resources efficiently. Capture theory says regulation serves the interest of producers who capture the regulators to maximize economic profits.

Efficient Regulation of a Natural Monopoly •

•

An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Qm and sets a price of Pm. There is a deadweight loss. A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Qmc and sets a price of Pmc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss. If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

Second-best Regulation of a Monopoly •

•

• •

An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Qac and sets a price of Pac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated. Government subsidies could offset those losses but would create deadweight losses from the taxes that would have to be increased to pay the subsidies. Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used. • Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities. Because rate of return regulation does not give the firm the incentive to operate efficiently, price-cap regulation is now used more frequently. A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

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Economics in the News: The Economics in the News analyzes whether Google leveraged its dominant position in search to highlight its own products and services in search results. It concludes that Google is attempting to perfectly price discriminate and does not appear to be acting against the social interest.

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Additional Problems 1.

The table has the demand schedule for industrial diamonds faced by Dolly’s Diamond Mines, a singleprice monopoly. a. Calculate Dolly’s total revenue schedule. b. Calculate its marginal revenue schedule.

Price (dollars per pound)

Dolly’s Diamond Mines in problem 1 has the total cost schedule in the table. Calculate the profit-maximizing levels of a. Output b. Price c. Economic profit d. Does Dolly’s Mines use resources efficiently? Explain your answer.

2,200 2,000 1,800 1,600 1,400 1,200

Quantity produced (pounds per day) 5 6 7 8 9 10

Quantity demanded (pounds per day) 5 6 7 8 9 10

Total cost (dollars) 8,000 9,000 10,000 11,600 13,200 15,000

Figure 13.1 illustrates the situation facing the publisher of the only newspaper containing local news in an isolated community. The publisher’s marginal cost for the new plant is constant at 20 cents per copy printed. a. What quantity of newspapers will maximize the publisher’s profit? b. What price will the publisher charge for a daily newspaper? c. What is the publisher’s daily total revenue? d. At the price charged for a newspaper, is the demand for newspapers elastic or inelastic? Why?

In the monopoly newspaper market described in problem 3, a. What is the efficient quantity of newspapers to print each day? Explain your answer. b. When the market is a monopoly, what is the consumer surplus of the readers of the newspaper? c. What is the deadweight loss created by the monopoly newspaper publisher?

What is the maximum value of resources that will be used in rent seeking to acquire Dolly’s monopoly in problem 1? Considering this loss, what is the total social cost of Dolly’s monopoly?

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Solutions to Additional Problems Price (dollars per pound)

Quantity demanded (pounds per day)

2,200

Total revenue (dollars per day) 11,000

2,000

12,000

1,800

12,600

1,600

12,800

1,400

12,600

Marginal revenue (dollars per pound) 1,000 600 200 −200 −600

1,200 1.

b. c.

12,000

The table above shows the total revenue schedule. Dolly’s total revenue schedule lists the total revenue at each quantity sold. For example, Dolly’s can sell 10 pounds for $1,200 a pound, which gives it total revenue of $12,000 at the quantity 10 pounds. The table above shows the marginal revenue schedule. Dolly’s marginal revenue schedule lists the marginal revenue that results from increasing the quantity sold by 1 pound. For example, Dolly’s can sell 5 pounds for $2,200 each, which is total revenue of $11,000 at the quantity of 5 pounds. Dolly’s can sell 6 pounds for $2,000 each, which is $12,000 of total revenue at the quantity of 6 pounds. By increasing the quantity sold from 5 pounds to 6 pounds, marginal revenue is $1,000 a pound ($12,000 minus $11,000). Dolly’s profit-maximizing output is 5.5 pounds. The marginal cost of increasing the quantity from 5 pounds to 6 pounds is $1,000 a pound ($9,000 minus $8,000). That is, the marginal cost of 5.5 pounds is $1,000 a pound. The marginal revenue of increasing the quantity sold from 5 pounds to 6 pounds is $1,000 ($12,000 minus $11,000). So the marginal revenue from 5.5 pounds is $1,000 a pound. Profit is maximized when the quantity produced is such that marginal cost equals marginal revenue. The profit-maximizing output is 5.5 pounds. Dolly’s profit-maximizing price is $2,100 a pound. The profit-maximizing price is the highest price that Dolly’s can sell the profit-maximizing output of 5.5 pounds. Dolly’s can sell 5 pounds for $2,200 and 6 pounds for $2,000, so it can sell 5.5 pounds for $2,100 a pound. Economic profit equals total revenue minus total cost. Total revenue equals price ($2,100 a pound) multiplied by quantity (5.5 pounds), which is $11,550. Total cost of producing 5 pounds is $8,000 and the total cost of producing 6 pounds is $9,000, so the total cost of producing 5.5 pounds is $8,500. So Dolly’s economic profit equals $11,550 minus $8,500, which is $3,050. Dolly’s is inefficient. Dolly’s charges a price of $2,100 a pound, so consumers receive a marginal benefit of $2,100 a pound. Dolly’s marginal cost is $1,000 a pound. That is, the marginal benefit of $2,100 a pound exceeds Dolly’s marginal cost. The profit-maximizing output is 200 newspapers a day. Profit is maximized when the firm produces the output at which marginal cost equals marginal revenue. Draw in the marginal revenue curve. It runs from 100 on the y-axis to 250 on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 200 newspapers a day. The highest price that the publisher can sell 200 newspapers a day is determined from the demand curve. The price charged is 60 cents a paper. The daily total revenue is $120 (200 papers at 60 cents each).

MONOPOLY

Demand is elastic. Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the demand curve. The price at the midpoint is 50 cents. So at 60 cents a paper, demand is elastic.

The efficient quantity is 300 newspapers—the quantity that makes marginal benefit (price) equal to marginal cost. With 300 newspapers available, people are willing to pay 40 cents for a paper. To produce 300 newspapers, the publisher incurs a marginal cost of 40 cents a paper. Consumer surplus is the area under the demand curve above the price. When the market is a monopoly, the price is 60 cents, so consumer surplus equals (100 cents minus 60 cents) multiplied by 200/2 papers a day, so the consumer surplus is $40 a day. Deadweight loss arises because the publisher does not produce the efficient quantity. Output is restricted to 200, and the price is increased to 60 cents. The deadweight loss equals (60 cents minus 40 cents) multiplied by 100/2 so the deadweight loss is $10 a day.

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The maximum that will be spent on rent seeking is $3,050 a day—an amount equal to Dolly’s economic profit. The total social cost equals the deadweight loss plus the amount spent on rent seeking. To calculate the deadweight loss, first calculate the efficient output—the intersection point of the demand curve (marginal benefit curve) and the marginal cost curve. Do this by finding the equations to the two curves and solving them. The efficient output is 8.25 pounds. The deadweight loss equals $1,512.50. The loss to society is $4,562.50 ($3,050 plus $1,512.50).

Additional Discussion Questions 1.

The double-edged sword of a natural monopoly. Emphasize how economic analysis reveals the social benefits and costs of an industry characterized by a downward sloping, long-run LRAC curve. Ask the student the following questions: What is the characteristic of the monopoly market that allows a natural monopoly to potentially produce output at the lowest possible LRAC? The student should see that a lack of competition allows the firm to potentially serve the entire market at a lower unit cost than if it had to share the market with any other number of firms. A multi-firm market would be forced to produce at a higher LRAC. What is the characteristic of a monopoly market that allows a natural monopoly to potentially charge consumers a price premium above long-run LRAC? If the natural monopoly has the freedom to set its own price, the student should identify the lack of competition that prevents the consumer from benefiting from production actually occurring at the lowest LRAC. On the one hand, the lack of competition is the only way to allow society to enjoy a (potentially) more efficient allocation of resources, yet it also allows the firm to extract consumer surplus while generating an inefficient resource allocation—a “double-edged sword.”

Troubles with price discrimination: The ethics of scalping. Get the students to address the realities of arbitrage in secondary markets that arise when the primary seller of a good refuses to price discriminate. Is it in society’s best interest (economically efficient) to allow the scalping of tickets? The students should see that ticket scalping is just a form of price discrimination, which is a business practice shown in the text to increase the level of efficiency in resource allocation within a monopoly market context. Why do the original ticket sellers refuse to price discriminate like the scalpers? There are many possible reasons: • The original seller of the tickets (usually the music group giving the concert or the ticket sellers that are under direct contract for them) may want to avoid the reputation of charging different prices to different people, or different prices at different time intervals before the concert.

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•

The original seller may not have the ability to distinguish between high and low demand customers, unlike the “scalpers” who sell the tickets standing outside the doors on the day of the concert. • The original sellers may be very risk averse and prefer to sell every ticket well in advance of the concert date, based on the expectations of sales potential made with the best available information at the time. They may reason that if a concert sells out quickly, the demand for future concerts will increase because more people come to believe that the group is “hot” and a must-see act. However, information about the actual demand for a concert becomes clearer as the concert date draws nearer and the equilibrium price for a ticket may change significantly. Scalpers must gamble that ticket prices will increase when it eventually becomes clear that demand for the event is relatively high. They bear the risk that the original ticket seller would not bear: that the ticket prices may also decrease if it is revealed that demand for the event is relatively low. Is it “fair” to allow scalping of concert tickets? Remind the students that the practice of price discrimination can increase monopoly profits for the resellers while simultaneously increasing efficiency for society. Remind them also of the principle of opportunity cost and ask them to consider how much efficiency they are willing to give up in the name of “fairness.” Point out that fairness is a normative concept—different people might have different ideas of fairness. For instance, the scalper who sells his or her tickets surely believes that the actions are fair. The purchaser of the scalped ticket might believe that paying above the asked price is unfair but the person is still willing to buy the ticket as long as the scalped price is less than the maximum price he or she is willing to pay. If it is unfair to scalp tickets because of the way price discrimination transfers consumer surplus to producer surplus, then what about other forms of price discrimination? Ask the students to consider the following scenarios. They should understand that, in each case, there is an identifiable group of consumers who have a different willingness to pay for the product or service mentioned. • If the costs of projecting a movie are the same at all times of day, why are matinee movie prices lower than evening movie prices for the exact same movie in the exact same theater? Why do movie theaters often give students discounts? • If the cost of publication is the same for all potential subscribers, then why do magazines and newspapers offer students discounts on subscription prices? • If the cost of serving beverages and supplying entertainment (live bands) is the same for both men and women, then why do bars and clubs offer “Ladies’ Night” where women get free drinks or pay no cover charge? • If the cost of serving food and beverages is the same for all diners, then why do seniors get a price break from restaurants for the exact same meals? How would you measure the inefficiency of a monopoly? The students should see that the lost potential for consumer and producer surplus could be calculated as deadweight loss, but that is only part of the total loss of benefits. Ask the students: Is there more to the inefficiency of a monopoly than meets the eye? If you are rather brave, you may want to ask the students to play the following game: Show the class a fresh, real fivedollar bill. Announce that it is a monopoly profit that anyone in class can receive simply by submitting the highest, non-zero price bid for it. Mention that even if the highest bid is only one penny, then that person will receive the five-dollar bill. However, everyone else that submits a bid must also pay you the value of that bid, regardless of whether they are successful. (This bid price reflects the cost involved with rent-seeking behavior.) In the case of a tie for highest bid, a run-off bidding contest among the tied high bidders will occur, but their first bid still stands as a debt to you, the holder of the monopoly profit. How much would YOU bid for this monopoly profit? Ask the students to write down on a small piece of paper their name and the price he or she is willing to bid for the five-dollar bill. They may write a bid of zero cents, but they will not get a chance to win. Announce that you will collect

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the money from them later (you will have their name and their bid). After collecting the bids, roughly tally them up and announce the winning bid, as well as the total sum of the bids to be collected. There are two possible scenarios to the outcome of this auction: • There is one high bidder, and this bid is usually very close to the monopoly profit offered for sale—there are usually one or two students who want to signal their “devil-may-care” attitude or signal their status as a relatively wealthy student who can afford to play extravagant games. • There is a tie between two or more students. The resulting run-off bidding is usually very high, because each of the remaining students hasn’t yet fully appreciated the economic notion of sunk costs. In this latter case, do not be surprised if the winning bid is more than five dollars, as the “winner” wants desperately not to lose the full amount of his or her initial bid. What is the total opportunity cost of the resources used to pursue monopoly profits? Point out that the bids represent the resources people use (usually through lobbying efforts) to pursue a monopoly market position by convincing government to restrict competition. Ultimately, only one person wins, but all contenders expend resources in the pursuit. That is why all losing bidders had to pay their bid price. Can we compare the value of lost output in other markets that could have been produced against the value of those goods and services produced specifically for pursuing a monopoly? Emphasize that the goods and services that were used to pursue a monopoly would not have been chosen for production if the monopoly profit hadn’t been offered up for sale in the first place. That is how we can know that rent seeking is inefficient—there was a decline in net benefits for society from forgone production of higher-valued goods. After the discussion is over, give the highest bidder the five-dollar bill in exchange for the bid he or she pledged. (You were warned about having to be brave!) If the highest bid is over five dollars, just state that you will forgive the student his or her debt and call it a wash. Then announce that the other bidders are also off the hook, as you were just trying to make the scenario as realistic as possible. Many sighs of relief will be heard. 4.

When the old AT&T had a virtual monopoly on long distance service, it created a rate structure that had high prices M-F 8 am to 5 pm, medium prices M-F 5:01 pm – 11 pm, and low prices M-F 11:01 pm -7:59 am and all day weekends and holidays. How might the differences in elasticities for business phone users and household phone users explain this rate structure? Long distance pricing under the unregulated AT&T monopoly is a great example of price discrimination. Add on to the example the “Reach Out and Touch Someone” campaign to increase residential demand, and price sensitive households across America called Grandma on Sunday evening. Businesses had little ability in that era to shift their demand to other periods and phone service, while expensive, was a small part of their total costs. Both these factors made business demand for long distance phone services relatively inelastic and lead to the high price of long-distance calling during business hours.

Gilead has changed the pricing structure on its essential AIDS medications so that prices are high in industrialized countries, medium in emerging countries, and low in the poorest countries. Discuss whether this is an example of price discrimination and whether resources are efficiently allocated given patents and high drug development costs. This issue could easily be the basis for a good debate or opinion essay. Clearly Gilead is price discriminating. Likely Gilead is increasing its economic profit. Society has a strong interest in creating more innovation and technological change. Perhaps Gilead’s pricing structure can further these goals by increasing the profit from its innovation. This three-tier pricing model could be regarded as “fair” or “unfair” depending on which nation and which part of the health care matrix an agent represents.

How does technological change lead to new competition for old monopolies and sometimes to their failure? Changes at the U.S. Postal Service are widely reported. Kodak filed bankruptcy. Streaming on computers becomes potentially a viable substitute for cable television. These examples certainly help frame an answer to the important question “Does having a monopoly guarantee success?”

C h a p t e r

MONOPOLISTIC COMPETITION

The Big Picture Where we have been: Chapter 14 continues the general analysis of the firm’s output and price decision by examining the case of monopolistic competition. This chapter also examines efficiency using the ideas introduced and explained in Chapters 2 and 5, and uses the market concentration measures explained in Chapter 10. Where we are going: Chapter 15 presents the final market structure, oligopoly. Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. The material presented in this chapter is not used explicitly in the following chapters.

N e w i n t h e Tw e l f t h E d i t i o n A new chapter introduction and concluding Economics in the News application focus on product differentiation in the market for tennis racquets. A new Worked Problem section has been added. The Worked Problem gives students a demand schedule for personal trainers, the marginal cost, and average total cost. Then it shows the students how to determine the profit-maximizing quantity and price, the markup, and excess capacity. Finally it explains to the students whether the scenario in the problem is the long-run equilibrium and what will happen to drive the market to the long-run equilibrium. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Monopolistic Competition • •

Firms in monopolistic competition face competition from many other firms that produce a similar but differentiated product from its own. Firms in monopolistic competition maximize their profit by producing where MR = MC.

What Is Monopolistic Competition?

Monopolistic competition is a market structure in which: • A large number of firms compete • Each firm produces a differentiated product • Firms compete on product quality, price, and marketing • Firms are free to enter and exit

Large Number of Firms •

The large number of firms in a monopolistically competitive industry implies that each firm has a small market share, no firm can dictate market conditions, and collusion (conspiring to fix a higher price) is impossible.

Product Differentiation •

Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Because close but not perfect substitutes exist, some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping.

Competing on Quality, Price, and Marketing • • • •

Product differentiation allows a firm to compete with other firms in product quality, price, and marketing. Quality: Physical attributes that differentiate a product, including differences in design, reliability, and service provided. Price: There is a tradeoff between quality and price. Marketing: The two main forms are advertising and packaging.

An Economics in Action application considers 10 monopolistically competitive industries. The application shows the 4-firm concentration ratios and Herfindahl-Hirschman Index.

Entry and Exit •

With no barriers to entry, firms in monopolistically competitive industries make zero economic profit in the long run.

Examples of Monopolistic Competition •

Examples of a monopolistic industry include audio and video equipment, sporting goods, and jewelry.

Ask students to bring in an empty beverage bottle of their choice. From the pile in the front of the room, have students help separate them into products in competing markets. A surprising large numbers of water bottles will appear, and differences as simple as packaging enter the conversation.

II. Price and Output in Monopolistic Competition The Firm’s Short-Run Output and Price Decision •

The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly). The downward sloping demand curve means that the firm’s marginal revenue curve also is downward sloping and lies below the demand curve.

Why do these firms face a downward-sloping demand curve if there are so many substitutes available? Remind the students about the “everything-else-constant” condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people

MONOPOLISTIC COMPETITION

prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded—a downward sloping demand. •

•

In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve, which, as noted, lies below the demand curve. The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $15 per pizza. The firm earns an economic profit if P > ATC (as is the case for the firm in the figure). If P = ATC, the firm earns zero economic profit, and if P < ATC, the firm incurs an economic loss.

Profit Maximizing Might be Loss Minimizing •

In the short run, profit maximizing quantity of output might be the loss minimizing quantity of output. The text explores the case of Excite@Home.

Long Run: Zero Economic Profit •

•

Unlike a monopoly, firms in monopolistic competition cannot earn economic profit in the long run. If the firms are earning an economic profit, other firms enter the market. Entry continues as long as firms in the industry earn an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward. Eventually the demand decreases enough so that the firms earn only a normal profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 10 pizzas per hour (where MR = MC) and sets a price of $7.50 per pizza.

Why do entry and exit shift the demand curve facing the firm? Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. You can now haul out your cell phone and return to it as your in-class example. Likely your phone will have a camera. Though the early history is fuzzy—it’s replete with small attempts that led to either small failures or small successes—the first largely successful cell phone/camera was the J-phone marketed in Japan in 1997. In the United States, Sprint had the first success: It sold over 1 million camera phones in 2002. Clearly these phones were wildly popular and inspired imitators. You can draw the figure showing a monopolistic competitive firm earning a large economic profit and tell the students that this was the case with these first phones. But then competitors entered the market. When the second phone entered the market, show how the demand for the first firm was affected by shifting it and its marginal revenue curve leftward. You can easily point out how entry decreased the first firm’s profit. Continue by discussing how further entry shifted the demand curve further leftward until, in the long run, the company was left with only a normal profit.

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Monopolistic Competition and Perfect Competition Unlike firms in perfect competition, firms in monopolistic competition have excess capacity and a markup: • Excess Capacity: A firm has excess capacity if it produces less than its efficient scale, the quantity that minimizes its average total cost. In the long run, a firm in perfect competition produces at the minimum ATC but, a firm in monopolistic competition produces less than the quantity that minimizes the ATC. • Markup: A firm’s markup is the amount by which its price exceeds its marginal cost. A firm in perfect competition has no markup but a firm in monopolistic competition charges a price that is greater than its marginal cost of production.

Is Monopolistic Competition Efficient? •

Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity, monopolistic competition might be efficient.

III. Product Development and Marketing Product Development •

•

Product development is costly, but can bring in additional revenue. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation. At a low level of product development, the marginal revenue of better products exceed the marginal cost so firms develop more new products. At high levels, the marginal cost exceeds the marginal revenue and so firms develop fewer new products. Because MR is less than P in monopolistic competition, product development is probably not at its socially efficient level.

Food lore says that buffalo wings started out at a restaurant in Buffalo, New York, and now are on the menu of virtually every bar and casual dining restaurant in the nation. Many other similar examples can be identified. Success breeds imitation in the world of competition and sometimes the original creator is not in business in the end as rivals creep in and engage in a never-ending series of one-upsmanship.

Advertising •

Advertising and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.

An Economics in Action case explores the cost of selling a pair of shoes. The vast majority of the costs are selling costs. •

Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. Advertising efforts are successful if they increase demand, which can lead to increased profit. But if all firms advertise, more firms might survive, and so the demand for any one firm is less than otherwise.

Using Advertising to Signal Quality •

Heavy marketing and advertising expenditures are a signal to consumers of a high-quality product. A signal is an action taken by an informed person (or firm) to send a message to uninformed people.

Efficiency of Advertising and Brand Names •

Advertising and brand names might be efficient if they provide consumers with information about the precise nature of product differences and about product quality. So the final verdict about the efficiency of monopolistic competition is ambiguous.

An Economics in the News feature considers product differentiation in the market for tennis racquets. It shows how a new, electronic racquet, will make an economic profit in the short run but zero economic profit in the long run.

MONOPOLISTIC COMPETITION

Additional Problems 1.

The figure shows the situation facing Well Done, Inc., a producer of steak sauce. a. What quantity does Well Done produce? b. What does it charge? c. How much profit does Well Done make? d. If all steak sauce firms have identical cost curves and face identical demand curves, what happens to the number of firms in the market in the long run? e. In the long run, will the price of steak sauce rise, fall, or not change?

Solutions to Additional Problems 1.

a. b. c.

d. e.

To maximize profit, Well Done produces the quantity at which marginal revenue equals marginal cost. Well Done produces 200 bottles a week. To maximize profit, Well Done charges the highest price that allows it to sell the 200 bottles of steak sauce it produces. This price is read from the demand curve and is $4 a bottle. Economic profit equals total revenue minus total cost. The price is $4 and the quantity sold is 200 bottles, so total revenue is $800. Average total cost is $3, so total cost equals $600. Economic profit equals $800 minus $600, so Well Done makes an economic profit of $200 a week The firms are making an economic profit so new firms will enter the market. In the long run the number of firms is greater than in the short run. In the long run the number of firms increases so that each firm’s demand is less than in the short run. With the lowered demand the price of steak sauce is lower in the long run.

Additional Discussion Questions 1.

In what sense is a firm in monopolistic competition similar to a monopoly firm? Emphasize that each firm has some ability to raise market price through marketing effort and product differentiation. This means MR < P at all levels of output. In the long run, both markets are inefficient in the strict allocative efficient sense because: i) production does not occur at the lowest possible unit cost, and ii) P (=MSB) > MC (=MSC) at equilibrium, so each firm produces less output than is socially efficient.

In what sense is a firm in monopolistic competition similar to a perfectly competitive firm? Emphasize that entry and exit affect the market price that each firm can charge in both markets. Also, low barriers to entry and exit make it impossible for any firm to enjoy economic profits in the long run.

Is advertising real information or is it just hype? Have the class discuss whether an increase in the consumer’s willingness to pay for a product is sufficient to justify advertising as socially beneficial. There are only normative answers to this question, but it is still a useful exercise in carefully thinking about how we define efficiency in economic modeling.

Imagine a four lane road in any suburban area in the country. Often there will be gas stations directly across the road from one another, rarely facing peak demand. Would it be more efficient to have just one gas station? If so, why do two survive over long periods of time? The situation of competing gas stations on opposite corners is a good example of excess

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capacity in monopolistic competition. Empty pumps and a less busy attendant mean gas costs a little more than otherwise; that is, the mark-up is positive. But consumers much prefer the convenience of pulling up to an open pump on the side of the road on which they are traveling rather than trying to cross multiple lanes of traffic to get in line for a gas pump with slightly cheaper gas which would more likely be the case if gasoline stations competed in a perfect competitive industry. Drivers find it worth paying a few cents more rather than having to maneuver across traffic and then wait available pump at a big busy station. 5.

What does it mean for a product to be differentiated? In papers and other assignments, I have had students argue that beer and soda were products that were “identical” or homogeneous rather than differentiated. It is worth having a discussion about what it means to be differentiated and the various methods firms can use to differentiate their products. Location, staffing and service, flavors, sizes, formulas, and even just packaging might differentiate products. As long as there is some difference between the goods or services, they might well be differentiated.

Ford Motor Company today is taking market share from rivals and innovating new products with features consumers find desirable. But in the past, Ford famously lost market share to rivals when founder Henry Ford refused to engage in product differentiation, preferring instead the efficiency of mass production of a single product, saying that customers could get a Model T in any color, as long as it was black. What are the advantages and disadvantages of product differentiation? Can the market itself work out the right amount of product differentiation over time? If there are economies of scale, having fewer, larger amounts of production reduces cost. Differentiation adds costs, not just in formulas, but in packaging and other resources. If the differentiation is meaningful to consumers, then having various types of products and levels of quality and service adds meaningful value. To some degree, if a differentiation persists in the market, people must find it worth paying for. Consumers though must have good access to information and firms must be free to enter and exit as what the market wants changes over time.

Are brands the same as companies? Does a crowded aisle at the store mean lots of competition? Most nationally distributed consumer products are created by firms in markets that are oligopolistic. The breakfast cereal aisle is crowded with all kinds of brands, but only 3-4 companies make most of the breakfast cereal sold nationwide. The toothpaste aisle is again crowded with varieties but the toothpaste market is dominated by just a couple of firms. Going back to the material in Chapter 10 about the differences between market structures and market concentration measures, now is a good time for an assignment or a discussion about the differences between brands and firms. Brand proliferation can be a sign of a lack of competition when students may interpret it as robust competition. This assignment or discussion can serve as a good bridge to discussing oligopoly.

C h a p t e r

OLIGOPOLY

The Big Picture Where we have been: Chapter 10 began the study of the theory of the firm by describing various market structures and defining economic profit. Chapter 11 introduced various cost and production measures. Chapters 12, 13, and 14 presented perfect competition, monopoly, and monopolistic competition, respectively. Chapter 15 now wraps up the analysis of the firm’s output and price decision by examining oligopoly. The chapter examines various approaches to studying firm behavior in oligopoly and is the last of the chapters that focus on the theory of the firm. Where we are going: Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. None of the material in this chapter is used explicitly in the following chapters.

N e w i n t h e Tw e l t h E d i t i o n The introduction and closing Economics in the News have been updated to focus on competition in the cell phone service provider market. A new Worked Problem section has been added. The Worked Problem presents a scenario dealing with two competitive firms that could illegally collude to restrict their production and boost their prices. It then shows the students how to analyze this situation using game theory and what will be the Nash equilibrium. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Oligopoly •

Firms in oligopoly have only a few competitors. Their behavior can be analyzed using game theory, which shows the prisoners’ dilemma they can face.

The Economics in Action shows the Herfindahl-Hirschman Indices for 10 markets that are oligopolies. The text points out that the dividing line between oligopolistic and monopolistic competition is usually a HHI of 2,500.

What is Oligopoly?

The distinguishing features of an oligopoly are the presence of natural or legal barriers that prevent the entry of new firms and so only a small number of firms compete.

Barriers to Entry • •

A natural oligopoly market occurs when the efficient scale of production allows only a few firms to meet the market demand. A legal oligopoly arises when a legal barrier to entry protects the small number of firms in the market.

Small Number of Firms • • •

Because of entry barriers, the number of firms is small and each has a large share of the market. Because there are a small number of firms, the firms in an oligopoly market are interdependent—each firm’s profit depends on its actions and the actions of its competitors. The firms have a temptation to form a cartel, which is a group of firms acting together—colluding—to limit output, raise price, and increase economic profit. Such collusion is illegal in the United States but it still occurs.

II. Oligopoly Games •

Economists think of oligopoly as a game between just a few players and use game theory to study oligopolistic behavior. Game theory is a tool for studying strategic behavior—behavior that takes into account the expected behavior of others and the recognition of mutual interdependence.

What is a Game? •

• Games have rules, strategies, payoffs, and outcomes. The Prisoner’s Dilemma captures many of the essential features of games and gives a good illustration of how game theory works and generates predictions.

Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decision-making process. Game theory is a big step for the student and need a significant amount of time to develop. This chapter is designed to be flexible and provide you with many options on just how far to go. 1. You might want to introduce only the prisoner’s dilemma game. 2. You might want to spend serious time applying the prisoner’s dilemma to a cartel game. 3. You might want to extend the range of examples and apply the prisoner’s dilemma to a real-world research and development game. 4. Finally, you might want to introduce repeated and sequential games and some of their applications and implications. Each of the steps laid out above is optional, but cumulative. You can stop at any point, but shouldn’t try to skip a step except that you can teach the R&D game based on the general introduction to the prisoner’s dilemma without teaching the longer and more complex cartel game.

OLIGOPOLY

The Prisoners’ Dilemma • • • • •

•

In the prisoner’s dilemma, the rules specify that each prisoner is placed in a separate room and must choose whether to confess without conferring with his accomplice. Strategies are all the possible actions of each player. The game’s payoff matrix, a table that shows the payoffs for every possible action by each player for every possible action by each other player, is to the right. In it are the payoffs from each prisoner’s strategies, which are to confess or deny involvement in the serious crime. The choices of both players determine the outcome of the game. We use the concept of a Nash equilibrium to predict the outcome of a game. Art (A) and Bob (B) have been caught A’s strategies stealing cars. Both men are sentenced to Deny Confess two years in jail for this crime. Both are suspected of committing a more serious 10 years 3 years crime for which the prosecutor has Confess insufficient evidence for a conviction. The 3 years 1 year two men are each interrogated for the B’s more serious crime in separate cells. Each strategies prisoner is told that if he confesses and his 2 years 1 year partner denies, he will serve 1 year in jail Deny and his partner will serve 10 years, while if 10 years both confess, both serve 3 years. If neither 2 years confesses, each man will spend 2 years in jail, after being convicted of a lesser crime. These “payoffs” are in the payoff matrix. In the Nash equilibrium of the prisoner’s dilemma game, player A takes the best possible action given the action of player B and player B takes the best possible action given the action of player A. The Nash equilibrium for the prisoners’ dilemma is for both players to confess. This outcome is bad for them because both would be better off if each denied. • A dominant strategy is a strategy is better than another for one player, regardless of how the other players play. In the prisoners’ dilemma, each player has a dominant strategy of “Confess.”

An Oligopoly Price-Fixing Game •

• •

Firms in an oligopoly can face a prisoners’ dilemma game. Suppose there are two firms, A and B. The firms could enter into a collusive agreement to jointly boost their price and decrease their output. Once the agreement is made, each firm must select its strategy: cheat on the agreement or comply with the agreement. The payoff matrix is to the right. Each A’s strategies firm’s profit depends on its strategy and Comply that of its competitor. Cheat The Nash equilibrium for the game is for −$1 million $0 both firms to cheat on the agreement. Cheat The outcome is bad for them because both would be better off if each complied B’s $0 $5 million with the agreement. This Nash strategies equilibrium is called a dominant strategy $3 million $5 million equilibrium, which is an equilibrium in Comply which the best strategy of each player is to cheat regardless of the strategy of the $3 million −$1 million other player.

The Economics in Action considers R&D spending in the facial tissue market, with Proctor & Gamble producing Puffs and Kimberly Clark, Kleenex. In this game both firms spend for R&D, which is less profitable for both than if they could collude and do no research. Rivalry forces them to be innovative. This case reminds students that firms do R&D to sell products rather than for higher moral purposes.

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A Game of Chicken •

• •

In an R&D game of chicken, two firms, A and B, can conduct R&D. The firm that conducts the R&D must pay for the R&D, but the R&D will lead to a new product that both firms can produce. Each firm’s strategies are to conduct the R&D or not conduct the R&D. The payoff matrix for this game is to the right This game does not have a Nash equilibrium that is a dominant strategy equilibrium. Here the equilibrium is for one firm to conduct the R&D but we cannot predict which firm will conduct it.

A’s strategies R&D No R&D $2 million

$3 million

R&D B’s strategies

$2 million $1 million

$1 million $0 million

No R&D $3 million

$0 million

Examples of oligopoly to discuss: Gillette and Schick compete aggressively to capture the market for men’s razors; AMD and Intel do likewise for the CPU market. These products are made by dominant consumer products corporations that spend significant resources on research and development and advertising to develop brand loyalty. Discuss the entry barriers a firm considering going into these markets might face and why they are likely to remain dominated by just a couple of key firms. Ask your students to apply this analysis to another oligopolistic market and to identify the entry barriers and ways firms engage in both price and non-price competition.

III. Repeated Games and Sequential Games Many more potential outcomes are possible if players repeatedly play games. Players also can often wait until a rival has made a move before choosing a response.

A Repeated Duopoly Game •

If a game is played repeatedly, it is possible for players of the game to reach the cooperative equilibrium in which the players make and share the monopoly profit. Because the game is played repeatedly, a player can use a tit-for-tat strategy, in which the player cooperates in the current period if the other player cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period.

Economics in the News Airbus versus Boeing considers the plane makers’ rivalry in producing passenger jets and their decisions whether to discount or charge list price. • A tit-for-tat strategy used with the payoff matrix at the top of the page leads to the cooperative equilibrium. Are there any real-world cooperative equilibria? The OPEC oil cartel is an excellent example of how useful game theory can be to explain real world events. Use the prisoner’s dilemma game to illustrate the incentive each nation faces: whether to cheat on their agreement or comply with it. A tit-for-tat strategy makes all the nations (as a group) better off but the demand for oil fluctuates and it is difficult for each nation to determine whether the other nations are cheating on the agreement. This combination makes a cartel agreement difficult to monitor, which is why we see the price of oil fluctuate so much, even during peaceful times. Saudi Arabia is widely believed to be the market leader for the cartel. Its oil output decisions have waxed and waned significantly over time, so oil prices fall when its government needs the extra oil revenues (cheating) or rises when the political environment requires greater economic unity among the Arab nations (cooperating).

OLIGOPOLY

A Sequential Entry Game in a Contestable Market • •

A contestable market is a market in which firms can enter and leave so easily that those firms in the market face competition from potential entrants. Firms in a contestable market play a sequential entry game. In this game, the firms in the market might set a competitive price and earn only a normal profit to keep the potential entrant out. A less costly strategy is limit pricing, which sets the price at the highest level that inflicts a loss on the entrant. The potential entrant is kept out and the existing firms earn an economic profit. However, limit pricing works only if the firm that sets the price is somehow locked into the price it will set at the second stage of the game.

How does a game tree work? The textbook uses the simplest possible example to illustrate the sequential entry game in a contestable market. It doesn’t explicitly explain the “backward induction” method of solving such a game, but it implicitly uses that method. If you choose to spend more time on sequential entry examples, you might want to be more explicit.

IV. Antitrust Law • •

Antitrust law is the law that regulates oligopolies and prevents them from becoming monopolies or behaving like monopolies. The two federal agencies that enforce antitrust laws are the Federal Trade Commission and the Antitrust Division of the U.S. Justice Department.

The Antitrust Laws • •

The Sherman Act (1890) made it a felony to create or attempt to monopolize an industry. Section I declares it illegal to conspire with others to restrict competition. Section II deems any attempt to monopolize illegal. The Clayton Act (1914) makes illegal certain business practices if they “substantially lessen competition or tends to create a monopoly.” These practices include price discrimination, typing arrangements, requirements contracts, exclusive dealing, territorial confinement, acquiring a competitor’s shares or assets, or becoming a director of a competing firm. If these actions do not substantially lessen competition and do not tend to create a monopoly, the actions are legal.

Price Fixing by Competitors Always Illegal • •

Price fixing by competitors is per se illegal, which means it is always illegal. There is no defense that can justify the practice. By restricting production, a price-fixing cartel raises the price to the monopoly level. Consumers suffer and deadweight losses are created.

Three Antitrust Policy Debates •

• •

Resale Price Maintenance: Resale price maintenance (also called vertical price fixing) occurs when a distributor agrees with a manufacturer to resell a product at or above a specified minimum price. Resale price maintenance is illegal only when it is judged to be anticompetitive. Whether resale price maintenance creates an inefficient or efficient use of resources is debated. It is efficient when it induces retailers to provide the efficient level of service to customers (e.g., be financially able to explain to potential consumers the benefits of a particular good). Tying Arrangements: A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another, different product. These bundling arrangements may enable a firm to price discriminate, resulting in an increase in efficiency. Predatory Pricing: Predatory pricing is setting a low price to drive competitors out of business with the intention of setting a monopoly price when the competition has gone. Economists are skeptical that predatory pricing occurs.

An Economics in Action case considers the U.S. versus Microsoft antitrust case, including the charges, Microsoft’s response and the outcome. Students may want to consider how Microsoft’s market power has changed in the last decade. Is it a result of government intervention? Or is it a result of competition as Apple has gained increasing market share in operating systems as its sales have grown?

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Mergers and Acquisitions • •

A merger occurs when two or more firms agree to combine to create one larger firm. Acquisitions occur when one firm buys another firm. FTC guidelines stipulate that a HHI above 1,800 indicates a concentrated market, and a merger in this market that would increase the index by 50 points is likely to be challenged.

The Economics in Action feature describes how the FTC used its HHI guidelines to block the proposed AT&T acquisition of T Mobile. The Economics in the News feature examines price wars in the cell phone service provider market between AT&T and T Mobile. It points that if the companies adopt tit-for-tat punishment strategies, then the price war could end and their profits would increase.

OLIGOPOLY

Additional Problems 1.

Two firms, Faster and Quicker, are the only two producers of sports cars on an island that has no contact with the outside world. The firms collude and agree to share the market equally. If neither firm cheats on the agreement, each firm makes $3 million economic profit. If either firm cheats, the cheater can increase its economic profit to $4.5 million, while the firm that abides by the agreement incurs an economic loss of $1 million. Neither firm has any way of policing the actions of the other. a. What is the payoff matrix of a game that is played just once? b. Describe the best strategy for each firm in a game that is played once. c. What is the equilibrium if the game is played once?

Solutions to Additional Problems 1.

The payoff matrix has the following cells: Both abide by the agreement: Faster makes $3 million profit, and Quicker makes $3 million profit; both cheat: Faster makes $0 profit, and Quicker makes $0 profit; Faster cheats and Quicker abides by the agreement: Faster makes $4.5 million profit, and Quicker incurs a $1 million loss; Quicker cheats and Faster abides by the agreement: Quicker makes $4.5 million profit, and Faster incurs $1 million loss. The best strategy for each firm is to cheat. If Quicker abides by the agreement, the best strategy for Faster is to cheat because it would make a profit of $4.5 million rather than $3 million. If Quicker cheats, the best strategy for Faster is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $1 million. So Faster’s best strategy is to cheat, no matter what Quicker does. Repeat the exercise for Quicker. Quicker’s best strategy is to cheat, no matter what Faster does. The equilibrium is that both firms cheat and each makes normal profit.

Additional Discussion Questions 1.

Could you manage a successful cartel? Emphasize the fragility of cartel arrangements by using the following numerical example. Point out that if a cartel is to operate successfully, all the firms must behave collectively as a monopoly, producing market output where MR = MC and charging the resulting profit-maximizing price. Because there are multiple firms in a cartel, and each firm is likely to have different production cost functions, then this raises two critical issues: • How should production quotas be allocated across firms to minimize total production costs and maximize potential profits? • How should the profit quotas be allocated across firms to maintain compliance? Start by assuming there are 3 firms in the cartel MC for MC for MC for with the marginal cost schedules in the table. Quantity Firm A Firm B Firm C Also assume that the profit-maximizing level of 1 2 1 2 output for a monopoly would occur at 9 units per period, where MR = $3. Finally assume that 2 1 2 3 there are no fixed costs. Now, if you were the 3 2 3 4 leader for the cartel, how would you propose 4 3 4 5 the production quotas be allocated to minimize 5 4 5 6 production costs and maximize profits to share? Based on minimizing variable costs, and knowing that MR = $3 at 9 units of output, Firm A should produce 4 units, Firm B should produce 3 units and Firm C should produce at 2 units per period. Total output is 9 units, MC = $3 for all three firms, and the total cost of industry production is: $8 for Firm A, $6 for firm B, and $5 for firm C for a total cost of $19 per period. How should the profit quotas be distributed across the firms? Ask the students to consider allocating profits according to each firm’s share of total production costs. Firm A would receive 8/19 of the profits, firm B would receive 6/19 and firm C would receive 5/19 of the profits. Most

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students will accept this as a “fair” allocation of profits for the firms. But this agreement will not work for long. Will the cartel survive using this profit quota arrangement? Point out that what keeps each firm in compliance with the agreement is not an independent assessment of “fairness” for the ultimate profit distribution. The profit quota agreement must be worthwhile to each and every firm in the cartel. Emphasize that the profit from complying must exceed the profit from cheating for each firm if the cartel agreement is to be successful in the long run. What is the opportunity cost for complying for each firm? Point out that based on Firm C’s cost function, the prospect of its competing with the other firms is rather grim. But Firm A’s cost function implies that it would not fear the threat of competition from the other firms because A’s marginal cost is lower than each of its two (potential) competitors. Because A does not fear cheating, it will have the upper hand in determining profit quotas for the cartel. Clearly Firm A will want as much profit as it can have from each of the other firms without making their profit from cheating exceed their profit from complying. That is the only profit sharing arrangement that will allow the cartel to survive over time. What, then, is the long-run profit-sharing agreement? The answer depends on the demand for the good or service as well as the strategies played by each firm. For instance if the demand is inelastic but low, so that if Firm A increased its output by 1 unit the price would fall so precipitously that Firm C suffered an economic loss, then even though the 4th unit would not be directly profitable for Firm A to produce, the threat of so doing might allow Firm A to grab some of Firm C’s “fair share” of profit. What industries are dominated by cartels? OPEC isn’t the only example of a cartel. Ask students what they think of when they hear the word “cartel,” and a common response is “drug cartel.” Like the cartels studied in this chapter, members of a drug cartel agree upon the price at which their merchandise can be sold. Cooperation can be maintained through a repeated game where a system of punishments is incorporated. Consider the punishments members of a drug cartel can impose for violating an agreed-upon price rule. It probably isn’t much of a surprise that cooperation among drug cartel members can be maintained when the consequences of cheating on any agreement include death or the slow and painful removal of one’s fingernails. Another example of a cartel that students won’t be as likely to suggest is the NCAA. The NCAA is an example of a buyer’s cartel, as opposed to a seller’s cartel, but the results are similar. Schools that are members of the NCAA have agreed not to pay their student athletes a salary, effectively “fixing” the price paid for student athletes. Cooperation is maintained through a system of punishments for violations of NCAA rules. The incentive to cheat on those agreements still exists, as the number of NCAA violations attests. Has Microsoft attempted to create a monopoly? Whether Microsoft is a monopoly depends on the market being defined. Many of your students will have their own opinions, but use the “Antitrust Showcase” in the text is a starting point for discussion. The issue of having a standard to create programs and products around continues to be debated as programming for Apple’s applications for the iPhone differ from standards used by other firms, and as Apple rejected flash technology offered by Adobe and widely used in other applications. Can firms create entry barriers? Students often have a difficult time identifying entry barriers. Some come from economies of scale, some from government activity, and some the firms create. Consider the barriers in the airline industry or cell phone services. Gates and landing slots may come from government activity. Economies of scale certainly exist. But firms also work hard to differentiate their products and try to capture market share through strategic barriers such as AT&T’s initially exclusive ability to offer the iPhone. Students have little knowledge of distribution generally so using specific examples from different types of industries can broaden their knowledge. If predatory pricing is generally not regarded as a problem by economists and antitrust enforcers, why is dumping such a big deal? Again as suggested in the lecture notes, this is a good place to reinforce the trade theory discussed in chapter 7. Prior to the Uruguay Round, voluntary export restraints were widely used (and abused) as a way around agreements to reduce

OLIGOPOLY

trade barriers. Their use was restricted by that agreement. Since then, dumping cases have exploded at the same time predatory pricing cases are largely no longer pursued. Searching the World Trade Organization web site will yield many examples of dumping cases. Alleging dumping can be as simple as saying the product is being sold at a lower price than a domestic firm can match, which is often the definition of a product likely to be imported. Do low prices hurt consumers? Consumer surplus and producer surplus can be used to reinforce the prior examples.

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The Big Picture Where we have been: A parallel is drawn between the equilibrium in markets, introduced in Chapter 3, and the concept of equilibrium in a political marketplace. The concept of efficiency, introduced in Chapter 2 and elaborated upon in Chapter 5, is used in this chapter to assess market failure. The definitions of marginal social benefit, marginal social cost, and deadweight loss are used explore the provision of public goods and mixed goods that have external benefits. Where we are going: Chapter 17 continues the analysis by studying the inefficiencies that result when private markets produce mixed goods with external costs and allocate common resources. It also considers methods that can be used to fix the misallocation. Chapters 18 and 19 cover the labor and other resource markets and the resulting distribution of income. Redistribution of income is addressed as a possible role for government in this chapter. Chapter 20 discusses risk and uncertainty.

N e w i n t h e Tw e l t h E d i t i o n In this edition, the focus and analysis of health care issues has been updated and expanded. Applications have also been updated. A new Worked Problem section has been added. The Worked Problem presents data on the marginal social cost of mosquito spraying and three consumers’ marginal benefit from the spraying. It then shows the students how to calculate the (total) marginal social benefit curve and the efficient quantity of spraying. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Public Choices, Public Goods, and Healthcare I.

Public choices • • •

A private choice is a decision that has consequences only for the person making it. A public choice is a decision that has consequences for many people and perhaps the entire society. Decisions by political leaders and senior public servants might improve efficiency, but, as was observed in prior chapters, these choices might also make things worse and lead to deadweight losses.

Why Governments Exist • • • • •

Governments establish and maintain property rights, provide nonmarket mechanisms for allocating scarce resources, and implement arrangements that redistribute income and wealth. Markets rely on property rights to function. Choices made pursuing self interest may not always be in the social interest and governments may reallocate resources. The market economy delivers a distribution of income and wealth that many people regard as unfair, so equity requires some redistribution. Government failure occurs when government action leads to inefficiency, which could be underprovision or overprovision of resources to a given activity.

Public Choice and the Political Marketplace • • • • •

The political marketplace is made up of many individuals each with their own economic objectives. Four groups of decision makers—voters, firms, politicians and bureaucrats—interact in the political marketplace. In the economic model of public choice, voters support the politicians whose policy proposals make the voter better off. Voters express their demand for policies by voting, helping in campaigns, lobbying, and making political contributions. In the economic model of public choice, firms also support the politicians who policy proposals make them better off and express their demand for public goods and services, but firms can’t vote. They do make political contributions and engage in lobbying activities. Politicians are elected persons at all levels of government. They make the policies that bureaucrats carry out. Politicians’ goals are to gain election and reelection, so voters to a politician are like profits to a firm. Bureaucrats are public servants who work in government departments. Their self interest is best served by larger budgets, which bring more authority and prestige.

Political Equilibrium • • •

All four groups make choices that are in their own self interest and are constrained by what is feasible. In a political equilibrium, the choices of all four groups are compatible and no group can see a way of improving its position by making a different choice. Allocative efficiency in the use of resources is possible but is not guaranteed.

The political marketplace does not work as smoothly as the private marketplace. Throughout this text students have learned that competitive markets can deliver an efficient resource allocation: • Individuals and firms act in their own self-interest, but in the private market (in the absence of externalities) individuals receive the full benefits of making good decisions with their resources, and bear the full costs of making poor decisions with their resources. Market prices and profits send signals to consumers and producers that coordinate their decisions. In the absence of price floors, price ceilings, quotas, monopoly, and taxes, the competitive pressures of the market determine an equilibrium price where the marginal social benefit is equal to marginal social cost, and the outcome is efficient. However, the political marketplace does not possess the same power as the competitive market to convert selfinterest into an efficient outcome: • Individuals still act in their self-interest. As James Buchanan, the Nobel Prize winning economist, once noted, when we pull the curtain closed in the voting booth to indicate which representative we wish to elect, we do not suddenly sprout the wings of angels and vote in the public interest. We vote our own best interests,

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

possibly to the detriment of the public interest. But one person, one vote does not ensure equal political influence over the resource allocation process. Some avenues to seek favor from politicians and bureaucrats require resources, which are unequally distributed. Individuals no longer receive the full benefits nor bear the full costs of their decisions over publicly provided resources, and so individuals are less motivated to act on the basis of complete information. The absence of price and profit signals and incentives to make wise decisions with publicly provided resources makes it difficult to coordinate the decisions of self-interested individuals to generate socially beneficial outcomes. Many political marketplace decisions over public goods provisions are inseparable, bundled together as a package, which decreases the competitive pressures that force individuals to respond to opportunity cost and marginal benefit.

What is a Public Good? Goods, services, and resources can be classified along several dimensions: • Excludability: A good or service is excludable if only the people who pay for it are able to enjoy its benefits. An automobile or watching an NFL game in person would be excludable. A good or service is nonexcludable if everyone benefits from it regardless of whether they pay for it. National defense or a town’s Fourth of July fireworks display are nonexcludable. • Rivalry: A good, service, or resource is rival if its use by one person decreases the quantity available for someone else. A blouse or a slice of pizza is rival. A good, service, or resource is nonrival if its use by one person does not decrease the quantity available for someone else. Watching television or national defense is nonrival. Examples: The more examples you give of each classification, the easier this topic will be for your students. Be sure to identify each characteristic for a given good. For example, a candy bar is a private good. It is excludable because, if you purchased it, you can decide who gets it. It is also rival because, once you eat it, there is less available for anyone else. Sunshine, on the other hand, is a public good. It is nonexcludable because you can’t determine who gets to use the sun and who can’t. It is nonrival because your use of the sun does not diminish the amount of sun available for anyone else. Ask your students to think of other goods and resources and evaluate each on the basis of these characteristics. More examples are included in the “Additional Discussion Questions” section. Is a highway a public good or a private good? Interstate highways are generally public goods. They are nonexcludable because anyone is permitted to drive on the interstate. When they are not congested, they are also nonrival because adding one more car to the interstate has little to no impact on the ability of other drivers to continue using the highway. However, interstate highways that charge a toll become excludable. And many interstates become rival goods during rush hour. If a highway charges a toll and is often jammed with traffic, it is actually a private good.

A Fourfold Classification Based on these differences, goods, services, or resources can be classified into one of four categories: • A private good is both rival and excludable. A cow owned by a dairy farmer is a private good. • A public good is both nonrival and nonexcludable. National defense is a public good. • A common resource is rival and nonexcludable. Fish in the ocean are a common resource. • A natural monopoly is nonrival and excludable. Cable television is a natural monopoly. Is every publicly provided good a “public good”? Students often think that, by definition, everything provided by the government is a public good. This belief is false. Point out to them that many government services are neither nonrival nor nonexcludable: Electricity provided by the TVA and many local governments, satellite launching services, and food stamps are three quick examples. Food stamps are provided as a means of redistribution. But for the goods and services that are rival and excludable (electricity and satellites) the private market ought to be able to provide the efficient allocation without government provision.

Healthcare •

Healthcare is actually two goods: Care supplied by doctors and other professionals and insurance.

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II. Providing Public Goods The Free-Rider Problem • •

A public good creates a free-rider problem—the absence of an incentive for people to pay for what they consume. The free rider problem leads private markets to produce an inefficiently small quantity of a public good; that is, the private market underproduces a public good. The marginal social benefit from the public good exceeds the marginal social cost and a deadweight loss arises.

Are you a free rider? Ask your students what they think would happen if Starbucks set up a serve-yourself coffee bar in the student union. No one would work the counter, and charges would be collected on the honor system. How many of your students would actually pay for coffee in that case? What free-rider problems do your students deal with on a daily basis? • In some classes the students are assigned to a group for completing a graded project, where the grade earned on the project is shared by each group member. Sharing the grade means that there are insufficient incentives for each group member to provide the level of effort that would achieve the highest potential grade for the group. • Waiting tables is a common part-time job for many students. Many restaurants make the wait staff share their tips with the other wait staff and busboys that clear the tables. Under this system, there are insufficient incentives for the busboys and less-motivated wait staff to provide the level of service that maximizes tipping from diners. • Public restrooms are generally recognized as being far less clean than the vast majority of users would like, especially compared to their own private bathrooms. There are insufficient incentives for each user of a public bathroom to keep it clean enough to appease most users.

Marginal Social Benefit from a Public Good •

Public goods have a marginal social benefit that differs from the marginal social benefit for a private good. Because everyone can consume services from the same unit of a public good, the marginal social benefit of a public good is the maximum amount that all the people are willing to pay for one more unit. The economy’s marginal social benefit curve for a public good is obtained by vertically summing each individual’s marginal benefit curve.

What is “vertical” vs. “horizontal” summation? Whether we add marginal benefit curves together vertically or horizontally is sometimes a source of confusion for students. Tell them to focus on the unit of measurement on each axis. When we are looking at private goods, we want to know how many units should be produced to satisfy market demand at a given price. Because private goods are both rival and excludable, each buyer must have his or her own units, so we must add together the number of units demanded by each individual. In other words, we’re adding the horizontal coordinates (quantities) of individual demand curves to get the market demand curve, and we say we are adding the individual demand curves or marginal benefit curves “horizontally.” For public goods that are nonrival and nonexcludable, anyone who purchases a good is providing that good to everyone. If every consumer in the market demands one unit of a good, we can’t simply add together all of those units. Once one unit is provided to anyone, it is provided to everyone. The benefit of that unit will be determined by the sum of individual marginal benefits for that unit. An individual’s marginal benefit is measured as the y coordinate of an individual demand curve, so to find the marginal social benefit, we add all of the individual marginal benefits together. We say we are adding the individual demand curves or marginal benefit curves “vertically.”

Marginal Social Cost of a Public Good •

The marginal social cost of a public good is determined the same way as that of a private good.

Efficient Quantity of a Public Good •

The efficient quantity of a public good is the quantity that sets the marginal social benefit equal to the marginal social cost. At this quantity, society’s net benefit from the public good is maximized.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Inefficient Private Provision •

A private market will produce an inefficient quantity of a public good because of the free rider problem. Consumers free ride by choosing not to pay for the public good, and instead use the funds to purchase private goods.

Efficient Public Provision • •

Competition in the political marketplace can result in the efficient provision of public goods. The Principle of Minimum Differentiation is the tendency for competitors (including political parties) to make themselves similar in order to appeal to the maximum number of customers. Consequently political parties tend to have similar policies in order to appeal to the maximum number of voters. • For the political process to deliver efficient outcomes in providing public goods, voters must be well informed, evaluate the alternatives, and vote in the election. Political parties must be well informed about voter preferences.

The Economics in Action feature considers the case of providing fire protection to extinguish the 2012 Colorado wild fires. While fire protection is provided by the government, it is often produced by private companies.

Inefficient Public Overprovision •

Bureaucrats translate the choices of politicians into programs, and control the day-to-day activities that deliver public goods. Bureaucrats may have other ideas and frustrate rather than facilitate the efficient outcome. By expanding the size and scope of their programs, bureaucrats gain more power, potentially greater management authority, and more lucrative compensation. Bureaucratic actions may lead to government failure.

•

Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Each voter is likely to be rationally ignorant about the efficient quantity of a public good. Rational ignorance, combined with special interest groups and bureaucrats seeking larger quantities of public goods, might lead voters to support political policies that generate inefficiently high levels of public goods.

Do politicians and bureaucrats make choices the same way voters do? Economists are comfortable with the assumption that, in their private lives, individuals make choices based on their own self-interest. As a result, many economists believe that the same assumption should be made about voters, politicians, and bureaucrats. If these groups make choices in their own self-interest, the assumptions of the public choice theory are upheld: voters will be rationally ignorant, bureaucrats will seek to increase the scale of their programs, and politicians will propose more than the efficient quantity of public goods.

III. The Economics of Health Care Health Care Market Failure • •

The market for health care consists of health care services and health insurance. Consumers underestimate the benefits of health care, underestimate their own future needs, and can’t afford the care they need, so the marginal social benefit exceeds the private willingness to pay for it. Consequently a private health care markets underproduces health care. •

•

The figure shows the market demand curve or perceived marginal benefit curve (MB) and the marginal social benefit curve (MSB) for health care. The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1. An unregulated market, however, produces where S = D. In the figure, the unregulated market

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•

equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure. This loss is unevenly spread across consumers leading to unfairness. Healthy, higher income earners can afford care. The long-term sick, the aged, and the poor can’t afford care and thus bear most of the deadweight loss.

Alternative Public Choice Solutions • •

•

Across nations, there is a wide range of public funding for health care. The text examines three approaches to supplementing or replacing the private market for health care: universal coverage, single payer; private and government insurance; and, subsidized private insurance. Universal Coverage, Single Payer • The model in the United Kingdom and Canada: is universal coverage with a single payer. The government is the sole buyer and everyone is covered. People access services a zero (or a low) price and the quantity available is set by the government, leading to excess demand. Services are allocated on a first-come, first-served basis, resulting in long delays for treatment. The quantity made available by the government is less than the efficient quantity, so a deadweight loss results. Private and Government Insurance • In the United States, most health care is provided privately and paid for by private health insurance, government, and patients. It is difficult to determine if healthcare is overprovided given the different payment types, but the scale of healthcare spending in the United States compared to other rich countries suggests it may be. Over provision leads to deadweight losses. Government spending on health care is dependent on the quantity of care demanded, not on a set budget. Without changes, an aging population will significantly increase this spending in the future.

The Economics in Action case breaks down the sources of payment for health care in the United States. •

Subsidized Private Insurance • Obamacare, or the Patient Protection and Affordable Care Act, uses a subsidized insurance market. To determine whether the outcome of the subsidy is efficient, we need to know the extent to which the marginal benefit of health insurance actually exceeds a household’s ability to pay.

The At Issue feature considers whether Obamacare is the answer to U.S. health care provision problems.

Vouchers a Better Solution? •

When marginal social benefits exceed the ability and willingness to pay, economists suggest vouchers can be used to attain efficiency. A voucher is a token that can be used to buy only the specified item.

•

A voucher program could replace most government health programs. The total value of vouchers would be set by government, but households would decide how to allocate healthcare spending.

•

The markets for health care services and health insurance would be free to work similarly to other competitive markets, which allocate resources efficiently.

An Economics in Action case considers the challenge of maintaining the U.S. transportation infrastructure given the decrease in gasoline taxes, which is the primary revenue source used to maintain the infrastructure. The analysis shows how the outcome might be an inefficient quantity of infrastructure being provided.

PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

Additional Discussion Questions 1. How “public” are government goods and services? Challenge your students to name public services provided by the government. In case the students miss them, mention the following services: • Postal Services: This is somewhat nonrival, in that the postman is walking by everyone’s house anyway, but definitely excludable—no stamp, no delivery. It is a natural monopoly rather than a public good. • Education: This is also somewhat nonrival, in that increased human capital benefits more than just the student. However, the private sector education industry is growing rather than shrinking over time, indicating that the private benefits are large compared to the public benefits. Also, it is excludable, meaning that it is not a public good. • Passenger Rail Service like Amtrak: Rail service is nonrival when the trains are not crowded because, in that case, one individual’s use of rail service doesn’t preclude others from also using the service. When the train is at its maximum carrying capacity, however, rail service is then rival because adding an additional consumer requires that another consumer be bumped. Train service is definitely excludable. As such, when the trains are not crowded it would fall into the category of natural monopoly, and when they are crowded they would be a public good. • National Parks and Forests: Given the vast size of our national parks and forests, use by one individual has little impact on the level of benefit others receive from using the same services. However, parks and forests that are overused and trashed become rival. Most national parks are excludable. Fees are charged for camping in them, for example. However, the large area covered by national parks and forests makes it more difficult to exclude others from using the parks and forests, even if fees aren’t paid, making them somewhat nonexcludable. National parks and forests may be public, private, common resources, or natural monopolies, depending on the extent of rivalry and excludability. 2.

Will resource allocation be efficient when the price mechanism is absent in the provision of public goods and services? Emphasize that when political equilibrium conditions separate the people who consume the services from the people who pay for the services, the valuable price signal is lost. Those that consume the good do not take into account the opportunity cost of consuming that good or service when making their own resource allocation decisions. Examples: Why are private schools and home schooling so prevalent when all children in the United States (even the children of illegal immigrants) are provided with free education? The student and his or her family receive the benefits of increased human capital but pay only a portion of the cost of providing it. The median voter is reluctant to support higher taxes for educational programs and rational ignorance implies that he or she is also unlikely to be motivated to see whether the existing funds are being utilized efficiently. This results in government delivering relatively poor public educational services. Also point out that the parents of children attending private school, or the parents who use their own labor to teach their children at home, all still pay local taxes to support public education. This implies that the high opportunity cost of consuming private education is still less than the perceived opportunity cost of sending their children to public schools. Why are private security companies so prevalent when each city has a legitimate, professional police force? The greatest benefactors of police protective services are usually those citizens living in the poorest neighborhoods with the lowest incomes. The median voter’s income level isn’t so far away from the average income voter that the level of protective service that he or she receives is above average. This means the median voter does not support a level of protective services that could effectively deal with the high crime areas as well as the less frequent incidence of crime that occurs in average or above average income neighborhoods.

Is government regulation better than an inefficient market result? The simple answer is “not necessarily.” Stress that when market failure brings pleas for political processes to replace the

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market process for resource allocation, it should be shown that the inefficiencies created by the market failure are greater than the inefficiencies inherent in the proposed political allocation process. Point out that when politicians and bureaucrats propose public sector policies to replace market allocation processes, they rarely discuss whether their policy prescriptions would pass such an analysis. Emphasize that when it comes to moving resource allocation decisions out of the private market and into the realm of political markets, there is still an opportunity cost to be weighed against the perceived benefits: there is no such thing as a free lunch! 4.

Are you a free-rider in your school’s computer lab? Many colleges and universities have run into problems with the amount of printing that occurs on their campuses. The more students print, the more paper expenses rise, and the more frequent repairs and maintenance will be for printers at the school. If a school does not charge students for printing in the computer labs, what incentive is there to minimize printing? While this may be an expense that is “included” in tuition and fees, because that cost is spread across all students, no single student bears the entire cost of his or her printing. As more books become available online as e-books, this problem has become more difficult to handle. Because e-books are typically cheaper than traditional paper books, many students simply buy the e-book and then print the entire book in the school computer lab, effectively pushing the cost of the book onto the school. To alleviate some of this free-rider problem, many schools have begun to charge their students for printing, or they have predetermined limits set on the number of pages students are allowed to print.

Does a democratic process ensure an efficient outcome? Many political science classes tout that democratic politics is the “art of compromise,” implying that the compromise solutions to conflicting objectives that are inherent in democratic decision processes necessarily generate efficient outcomes. The example in the table below illustrates why a democratic vote can fail to ensure the economic definition of efficiency. • If tax policy proposal A (a levy supporting education) were presented by itself, it would fail to receive support from the majority of voters. •

Likewise, if tax policy proposal B (a levy supporting the police force) were presented by itself, it would also fail to gain support from the majority of voters.

•

Yet, the politicians sponsoring each bill can act cooperatively and present an omnibus bill combining both policy proposals. This is known as logrolling—trading political favors to pass separate bills that would otherwise fail to achieve majority support on their own.

•

The majority of voters will support the omnibus bill, despite the fact that net benefits for all society would be higher if the omnibus bill had not passed. Policy Valuation by Voter A

Policy Valuation by Voter B

Policy Valuation by Voter C

A: Education

+$150

-$100

B: Police

-$100

+$150

-$100

Policy A + B

+$50

-$200

Policy Proposal

Does Vote Pass? Net Social Benefits No: (1-2) -$50 No: (1-2) -$50 Yes: (2-1) -$100

Snow and road plowing—when is it a public good versus a private good? If you teach in a part of the country that gets snow, state and local governments may spend significant resources plowing roads. Who plows which roads and parking lots? Why? If state and local governments ceased offering snow plowing services, what would happen in the local economies affected by snow?

C h a p t e r

EXTERNALITES

The Big Picture Where we have been: Achieving efficiency by equating marginal social benefit and marginal social cost introduced in Chapter 2 and elaborated upon in Chapter 5 is the key concept used in this chapter. Mixed goods with external costs and the problem of common resources were introduced in Chapter 16 as was the idea that public choices might improve resource allocation or might make things worse. Where we are going: The efficiency analysis introduced in Chapter 16 is extended in this chapter to the case where private and social costs diverge and where resources are common rather than private. Public choices about how to address the resulting misallocations of resources are also analyzed.

N e w i n t h e Tw e l f t h E d i t i o n This chapter has significantly revised the material dealing with pollution. Mandating clean technology is now discussed, along with taxes and the Coase theorem. A section dealing with the positive externality from knowledge is now included. The new Economics in the News examines how mandating a switch from generating electricity from coal to natural gas affects the deadweight loss from emissions leading to climate change. A new Worked Problem section has been added. The Worked Problem gives information on the price, marginal benefit, marginal cost, and marginal external benefit of exercise. It then shows the students how to calculate the competitive market quantity, the marginal social benefit schedule, and the efficient quantity. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Externalities I.

Externalities in Our Lives •

External costs result when actions cause negative effects on bystanders. This chapter considers why private markets might not act in the social interest and whether government action can offer incentives so that pollution and overuse of common resources is less likely to occur.

An Economics in Action detail points out that many types of air pollution are less serious today in the United States than they were in the past. But rising CO2 in the atmosphere has accompanied an increase in the global temperature.

Private Costs and Social Costs of Pollution A private cost of production is a cost that is borne by the producer. Marginal private cost (MC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service. • An external cost is a cost of producing a good or service that is not borne by the producer but is borne by other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls on people other than the producer. • Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost: MSC = MC + Marginal external cost. Have the students consider what is included in the idea of marginal external costs. Be sure that they understand that external costs are the costs of either cleaning up the damage caused by the polluting activity or the extra costs of having to take actions to avoid the damage in the first place. Emphasize that both actions require payment by people other than the producer or consumer, which is why the costs are considered “external.” •

The figure shows the marginal private cost curve (MC) and the marginal social cost curve (MSC) for a good with an external cost. The vertical distance between the two curves is the marginal external cost. • Because the marginal social cost includes the marginal private cost and the marginal external cost, the marginal social cost exceeds the marginal private cost (MSC > MC) for all quantities. • The efficient quantity of output occurs where the marginal social cost equals marginal benefit, that is, where MSC = MSB. In the figure, the efficient quantity is Q1. If the external cost reflects pollution, there is still some pollution created but it is the efficient quantity of pollution. • An unregulated market produces where S = D. In the figure, the unregulated market is at Q0. At this level of output, MSC exceeds MSB so there is inefficient overprovision and a deadweight loss, as illustrated in the figure.

An At Issue case considers whether more should be done to eliminate carbon emissions. While most agree that incentives need to change, there is fundamental disagreement about how to change incentives. One side, represented by the Stern Review, argues for taxes on prices on carbon emissions. The other side is taken by the Copenhagen Consensus, which argues that raising the price of carbon emissions today has high present costs and low future benefits.

EXTERNALITIES

Three Approaches to Address Negative Externalities Three approaches can be taken to address the misallocation of resources created by the negative externality • Establish property rights • Mandate clean technology • Tax or price pollution.

Establish Property Rights and the Coase Theorem •

Property rights are legally established titles to the ownership, use, and disposal of factors of production, goods, and services that are enforceable in the courts. Assigning property rights can reduce the inefficiency arising from an externality. Once property rights are given, polluters can respond by using an abatement technology or by producing less and thereby polluting less. • The Coase theorem is the proposition that if property rights exist, if only a small number of parties are involved, and if the transactions costs are low, then private transactions are efficient. Transactions costs are the opportunity costs of conducting a transaction. • A remarkable feature of the Coase theorem is that it does not matter if the property right is given to the creators of the externality (the polluters) or to the victims. In either case, the result will be efficient. If the polluters value the benefits from the activity generating the pollution more highly than the victims value being free from the pollution (that is, the cost of reducing the pollution exceeds the benefit from the reduction), then the efficient outcome is for the pollution to continue. If polluters are assigned the right to pollute, the victims are not able to pay enough to convince the polluters to stop. If the victims are assigned the property right to be free from pollution, then the polluters are able to pay the victims sufficient compensation to continue polluting. Either way, the pollution continues. If the victims value the benefits from being free from pollution more highly than the polluters value the benefits of the pollution, (that is, the benefit from reducing pollution exceeds the cost of the reduction) then the efficient outcome is for the pollution to stop. If the polluters are assigned the right to pollute, then the victims are willing to pay the polluters sufficient compensation to stop the pollution. If the victims are assigned the right to be free from pollution, then the polluters are not able to pay the victims enough to allow them to continue polluting. Either way, the pollution stops. The role of property rights in the market. Explain that when the property rights are well defined, the owner of that right receives the full social benefit and bears the full social cost of using that resource. Assigning property rights “internalizes” the externality. The best government policies emulate, rather than replace, the market process. Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it. In the case of negative externalities like pollution, the government can choose from three policies (emissions charges, pollution taxes, or cap-and-trade), all of which require the government to assess the marginal social costs and benefits to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in: i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

Mandate Clean Technology •

An abatement technology is a production technology that reduces or prevents pollution. Cutting production will also reduce pollution and avoid the expense of purchasing abatement technologies. Direct regulation that requires specific abatement technologies can and has reduced emissions, but economists are skeptical of this approach because it is not always the least cost alternative.

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Tax or Cap and Price Pollution •

Taxes: The government can set a tax equal to the marginal external cost, so that marginal private cost plus the tax equals marginal social cost: MSC = MC + Tax. In the figure, the appropriate tax equals the length of the double headed arrow. These sorts of taxes are called Pigovian taxes, in honor of the British economist Arthur Cecil Pigou, the British economist who first proposed this approach to externalities.

An Economics in Action case reviews the use of taxes in British Columbia, Ireland, and the United Kingdom. It concludes that whether it is overtly a carbon tax or simply a tax on gasoline, the taxes reduce carbon emissions. •

Cap-and-trade: The government sets a limit on the total amount of pollution allowed, ideally the efficient amount. Initially the government allocates the cap across the firms by issuing marketable permits, wherein each firm is assigned permits that allow it to emit a certain amount of pollution. The firms are allowed to trade the permits. The market in permits determines the price of a permit and firms will buy or sell permits until their marginal cost of pollution reduction equals the price of a permit.

An Economics in the News case thoroughly examines the Obama administration’s plan to cut carbon dioxide emissions from power stations, primarily by decreasing use of coal to generate power. Decreasing the use of coal decreases the deadweight loss from coal emissions. Switching to natural gas decreases the deadweight loss from generating electricity.

Coping with Global Externalities • •

The United States has made its own air much cleaner. But global warming and climate change cannot be solved by a single, albeit large, industrial economy. A lower CO2 concentration is a global public good and like all public goods leads to free rider problems. No mechanisms currently compel participation in global carbon reduction programs.

An Economics in Action case reviews the global prisoners’ dilemma in reducing carbon emissions. If a nation reduces carbon emissions, its costs are higher than its trading partners, making its exports less competitive. But if all nations reduced carbon emissions, all nations would be better off.

II. The Tragedy of the Commons • •

The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. When nobody owns a resource, each individual consumer fails to consider the full opportunity cost of consuming it, so the resource is consumed at a higher than inefficient rate. The example of the commons problem comes from medieval England. Grasslands near a town were called the commons because they were publicly accessible by all villagers to support their livestock. These grasslands were over-grazed and usually couldn’t support much livestock.

Are there examples of the “tragedy of the commons” on campus? Have the students consider the many problems arising from the many commons areas on campus: • Why does so much trash like candy wrappers, gum stuck to the pavement and cigarette butts litter the sidewalks and entry ways of all the buildings on campus? • Why does the library implement such a strict rule over the level of noise that students can make (no loud conversations, laughing, etc.) in the open areas in and around the library book shelves? • Why do some people talk incessantly at the back of a large classroom when they know it bothers most of the students around them?

Unsustainable Use of a Common Resource • • •

A renewable natural resource is one that replenishes itself by the birth and growth of new members of the population. For fish, the sustainable catch is the quantity of fish that can be caught year after year without depleting the stock. A common resource is being used unsustainably of its use decreases the stock of the resource. Sustainable use of a resource is the rate of production that can be maintained indefinitely. As more of a renewable resource is harvested, there is less left to reproduce and replace what has been harvested. If

EXTERNALITIES

•

heavy harvesting depletes the resource stock to levels that are too low to replace the amount harvested, then the size of the stock available for harvest declines over time and that harvest rate is not sustainable. If the quantity of fish harvested if less than the sustainable catch, the fish stock grows; if the quantity caught exceeds the sustainable catch, the fish stock shrinks; and if the quantity caught equals the sustainable harvest, then the fish stock remains constant and is available for future generations.

Inefficient Use of a Common Resource •

•

Marginal Private Cost: In the market for fish, the marginal private cost is the additional cost incurred by keeping a boat and crew at sea one more day. As the figure shows, marginal private costs, MC, increase as more fish are harvested due to diminishing returns. The marginal private cost curve is the same as the supply curve. Marginal External Cost: This is the cost per additional ton that one fisher’s production imposes on all other fishers. This cost also increases as the number of fish harvested increases. Marginal Social Cost: The marginal private cost plus the marginal external cost, MSC. Because both of its components increase as more fish are caught, marginal social cost increases with the quantity of fish harvested. The figure shows the MSC curve. Marginal Social Benefit and Demand: The marginal private benefit, MB, is the price consumers are willing to pay for an additional quantity of fish. If there is no external benefit, the marginal private benefit equals the marginal social benefit. As shown in the figure, the marginal private benefit (and hence the marginal social benefit) decreases as more fish are harvested and consumed. This curve is the same as the demand curve. Overfishing equilibrium: The market demand curve is the marginal social benefit curve because there are no external benefits. The market supply curve is the marginal private cost curve. In the figure the market equilibrium is 30 tons of fish. The efficient quantity sets the MSC equal to the MSB and is 20 tons of fish in the figure. The equilibrium quantity exceeds the efficient quantity. A deadweight loss occurs and the fish stock is depleted. Deadweight Loss from Overfishing: Every fish harvested for which the marginal social cost exceeds the marginal social benefit increases the size of the deadweight loss.

Achieving an Efficient Outcome

Society can use three different methods to achieve the efficient outcome for common resources: • Property rights: Property rights can be assigned to the common resource. The owner then will receive the marginal benefit of using the resource. The resource will be used efficiently and not overused. However, assigning property rights to some resources, such as the fish in the ocean, is not always feasible. • Production quotas: Quotas can be set for the efficient total catch, with the total divided among all users. However, it is in every user’s self-interest to cheat on the quota, so the quota might be ineffective. In addition, the marginal cost of using the resource varies across users, so an equal allocation of quotas generates an inefficient outcome. • Individual transferable quotas: An individual transferable quota scheme might be used. An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer the quota to someone else. • Less efficient users with higher marginal costs are willing to sell their quotas to more efficient harvesters who are willing to buy them. • The price of the quota will equal the difference between the marginal social benefit of the quota minus the marginal private cost of using the quota. In the figure, at the efficient quantity the price of an ITQ is $3 per pound. Note that marginal private cost + price of a quota = marginal social cost. • Users with the quotas will use the resource until the marginal social benefit equals the marginal private cost plus the price of the quota (the marginal private cost plus the price of the quota equals the marginal social cost). If the quota was set at the efficient quantity, the equilibrium is efficient.

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An Economics in Action application considers ITQs. Evidence from Iceland, New Zealand, and Australia suggests they work well to sustain fish stocks. But they also reduce the size of the fishing industry, making the industry oppose ITQs in every country in which they are proposed. The opposition was not large enough to block them in New Zealand and Australia but it did in the United States for a time. Since 2004 they have been used in 28 U.S. fisheries. Economists have found them to be an effective tool.

III. Positive Externality: Knowledge Private Benefits and Social Benefits • • •

A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the benefit from an additional unit of a good or service that the consumer of that good or service receives. An external benefit from a good or service is a benefit that someone other than the consumer receives. A marginal external benefit is the benefit from an additional unit of a good or service that people other than the consumer enjoy. Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else who enjoys a benefit—and is the sum of marginal private benefit and marginal external benefit: MSB = MB + Marginal external benefit.

•

The figure shows the marginal private benefit curve (MB) and the marginal social benefit curve (MSB) for a good with an external benefit. The vertical distance between the two curves is the marginal external benefit. • Because marginal social benefit includes marginal external benefit, the marginal social benefit exceeds the marginal private benefit (MSB > MB) for all quantities. • The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1. • An unregulated market, however, produces where S = D. In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure.

Government Actions in the Market for with External Benefits The efficient outcome is production of the quantity at which MSB = MSC. There are three main methods that the government can use to cope with external benefits: • Public production: One possibility is public production, when a public authority that receives its revenue from the government produces the good or service. (Public colleges are an example.) In this case, the government can fund the authority to produce the efficient quantity. • Private subsidies: A subsidy, a payment that the government makes to private producers, can be used. If the government pays the producer a subsidy equal to the marginal external benefit, then the quantity produced by the private firm increases to that at which the marginal cost equals the marginal social benefit and an efficient allocation of resources occurs. In the figure, the correct subsidy is equal to the length of the double headed arrow. • Vouchers: A voucher, a token that the government provides to households to buy specified goods or services, can be used. Households receiving a voucher pay a lower price to acquire the specific good or service, which increases their demand and increases the quantity consumed.

EXTERNALITIES

Bureaucratic Inefficiency and Government Failure •

• •

Government intervention might not make the marginal social benefit equal the marginal social cost. This situation is government failure. • Overproduction can result if bureaucrats seek to maximize their budgets and programs. • Underproduction can result if bureaucrats pad their budgets and have wasteful spending. In this case, the costs of enterprises run by bureaucracies often exceed the minimum efficient cost. Private subsidies might overcome some of the problems associated with bureaucracies, but the subsidy budget ultimately depends on bureaucracies. It is also in the best interests of those receiving the subsidies to try to maximize it, leading to rent seeking activities and lost resources. Vouchers have four advantages when it comes to insuring the efficient quantity of the good or service is produced: • They can be used for public or private provision, which creates competition. • Governments set the value and total size of voucher programs which can avoid bureaucratic padding and overprovision. • The public contribution is spread thinly across many participants, leaving little incentive for individual recipients to engage in rent seeking. • The final consumer has the buying power, forcing firms to compete by offering more and better services.

An Economics in Action case considers charter schools’ role in improving educational quality and controlling costs. Public provision, private subsidies and vouchers can all increase the quantity of education, but not necessarily the quality while controlling costs. Charter schools are funded as public schools, but set their own educational policies. When spaces for students in charter schools are allocated by lottery (thereby eliminating self-selection bias), charter school performance can be more easily tested. So far, charter schools are doing well both in terms of achieving educational standards and controlling costs.

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Additional Problems 1.

Fast-Food Trash Be Gone! To help clean up the city, the Oakland City Council is considering a tax on fast-food restaurants, gas station markets, liquor stores and convenience stores that serve take-out food or beverages. The revenue from the tax will be used to help pay the costs of clean-up crews picking up burger wrappers and soda cans. CNN, February 6, 2006 a. What is the external cost associated with takeout food and beverages? b. Draw a graph to illustrate and explain why the market for take-out food and beverages creates a deadweight loss. c. Use your graph to illustrate and explain how Oakland’s policy might improve efficiency.

The table shows the marginal benefit and marginal cost of driving a private car into central London. How many cars a day enter London? In 2004, the city introduced a congestion charge of £5 per car per day. How many cars a day entered London after the congestion charge was levied? What was the reduction in congestion and how much revenue did the congestion charge raise for the city?

Number of cars 10,000 30,000 60,000 90,000 120,000

Marginal benefit (pounds per car) 17 14 11 8 5

Marginal cost (pounds per car) 2 4 6 8 10

Solutions to Additional Problems 1.

a. b.

The external cost is the pollution from discarding the wrappers and beverage containers after use. Figure 17.1 shows the market for take-out food and beverages. The marginal social cost, MSC, exceeds the marginal private cost, MC, because of the marginal external cost of pollution. The MC curve, which is also the supply curve, lies below the MSC curve. The equilibrium quantity of take-out meals, which is determined at the intersection of the supply curve and the demand curve, is 50 million per month. The efficient quantity of take-out meals, which is determined at the intersection of the marginal social cost curve and the marginal social benefit curve, is 30 million meals per month. The resulting deadweight loss from the overproduction is equal to the area of the grey triangle illustrated in the figure. This deadweight loss occurs because the consumers of take-out meals do not pay the full marginal social cost of their take-out meals. As a result the quantity of take-out meals consumed exceeds the efficient quantity. Presuming the tax equals the marginal external cost, which in Figure 17.1 is $3 per meal, then in Figure 17.1 the tax shifts the S = MC curve so that it is the same as the MSC curve. In this (optimal) case, the equilibrium quantity becomes the same as the efficient quantity and there is no deadweight loss. Before the congestion charge, 90,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both equal £8.) After the congestion charge, the marginal cost to the driver increased by £5, the amount of the charge. So after the

EXTERNALITIES

congestion charge, 60,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both now equal £11.) The congestion was reduced by 30,000 cars per day. The city gains £5 per car entering central London. 60,000 cars now enter central London, so the city gains revenue of £5 per car  60,000 cars, which is £300,000 per day.

Additional Discussion Questions 1.

Do good fences make good neighbors? To illustrate the role of property rights and prices in promoting efficient resource allocation within a market, tell this story of a hearty apple tree that adorned the central square on the campus of a local university. Each spring, an economics student watched as the beautiful white apple blossoms transformed into little green spheres that could eventually become juicy red delicious apples—if they were allowed to mature. But he never once in his four years at school saw a single mature apple hanging from that tree. Ask students why they think that was the case. A few students will recognize that apples were often picked before they were fully ripe. Every student wanting an apple assumed that waiting to pick one when it was truly ripe would be futile, because someone else would surely pick it one or two days earlier when it was almost as ripe and still somewhat delicious. However, those people would think picking it only two days earlier would also be futile, because someone else might pick it a day or two days earlier than that when the apples were still somewhat good for eating if they were allowed to ripen on the shelf. In this way the “best” harvest day for the apples regressed until the very first day that any one apple would even be worth trying to eat if it were left on the shelf to ripen. Every apple on the tree was harvested before it was allowed to ripen sufficiently to create the highest possible quality. How else could the apples have been brought to their highest valued use to society? The problem was that no individual had an ownership claim, or property right, to the tree and the apples upon it. Perhaps, because it was a state university, all the state taxpayers could lay claim to the tree. Either way, no one could realistically expect to receive the full benefits that fully mature apples could bring by protecting and maintaining the tree. This reality is at the heart of the phrase, “What everybody owns, nobody takes care of.” A lack of property rights meant that nobody would be held responsible for the full opportunity cost of failing to wait until the apples were mature. Many different individuals acted in a way that destroyed all the potential value of those apples to society, and none were held accountable for their actions. Do property rights motivate socially beneficial behavior using a “carrot” or a “stick”? The answer is both. If someone were granted the property rights to the apple tree and its fruit, pilfering would be an illegal and punishable offence. The owner would receive the full benefits from maintaining the tree and waiting to harvest the apples until they were mature and would maximize profit by picking the apples when their marginal cost equals their marginal benefit.

What is the optimal penalty for skipping class? Some professors penalize students with excessive, unexcused absences by making a portion of a student’s course grade depend on his or her attendance record. One reason behind such a policy is that students interact in class and benefit each other with their insightful remarks and questions, creating a positive externality. So a student missing classes deprives other students of these external benefits. To draw a similar perspective on the issues of recycling and pollution abatement, ask if a zero-tolerance policy giving an F to any student with even one unexcused absence is optimal for the class. Just as a rule requiring zero absences seems overly harsh, so would a rule requiring zero pollution. Zero pollution can be achieved only by stopping all production, all transportation, and, literally, all human activity. Clearly a balance between the marginal social costs and marginal social benefits is required.

Evaluate the statement: “If this program saves even one life, it will have been worth the money.” Ask the following questions: Is the value of one life saved truly immeasurable? What is the opportunity cost of expending resources to save one life? Could more than one life have been saved if the same resources were used for a different policy? Should we try to fund all policies that

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could potentially save one life? Students should see the problem with this idea. Just because something has value doesn’t mean we should use resources to produce it. We must compare the value with its cost. 4.

Can you apply the Coase theorem in your own life? Ask your students if they’ve ever had the experience of studying for an important exam when a neighbor decides to throw a party or play music loudly. At the very least, students should understand that a party could interfere with their ability to study effectively, generating an external cost. According to the Coase theorem, this externality can be effectively dealt with by private transactions. The student studying can offer the partying student money to stop the party (or at least move the party elsewhere). The partying student will accept the money if the value of that money is at least as great as the cost of moving or stopping the party. Whether the transaction takes place will depend on how much the quiet time is worth to the studying student and how much the party is worth to the partying student. If efficiency would result in more quiet time and less partying, then this private transaction will result in the efficient outcome.

Are laws that ban smoking economically efficient? Many cities are banning smoking in all public places including bars and restaurants. Consider alternate solutions to a complete ban, especially given an application of Coase’s theorem to smoking in shared offices. If smokers owned the air, would smoking necessarily occur? What if nonsmokers owned the air?

C h a p t e r

MARKETS FOR FACTORS OF PRODUCTION

The Big Picture Where we have been: Chapter 18 uses the productivity and cost definitions and concepts introduced in Chapter 10 and the conditions for maximum profit introduced in Chapter 11. It builds on these concepts to explain value of marginal product and to show how factor markets work. Where we are going: Chapter 18 explores the workings of factor markets and the resulting distribution of income. The labor, capital, and natural resource markets are introduced here and Chapter 19 studies the implications of factor market equilibrium for the distribution of income and trends in the distribution.

N e w i n t h e Tw e l f t h E d i t i o n The material in the chapter is largely unchanged from the previous edition. The focus remains on the job market and the case studies and applications have been updated. A new Worked Problem section has been added. The Worked Problem shows the students how to calculate the marginal product of labor and the value of marginal product. It then demonstrates how to use the results to maximize profit and how the profit-maximizing quantity of labor changes when the age rate changes. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Markets for Factors of Production • • •

Firms choose the quantities of factors they demand in order to maximize their profit. Households choose the quantities of factors they supply. The interaction of demand and supply determines factor prices.

The Anatomy of Factor Markets The four factors of production are labor, capital, land (natural resources), and entrepreneurship. Labor services are traded in the labor market. The price of labor is the wage rate. Most labor services are traded on a job contract. • Capital goods are traded in goods markets. Capital services are traded in rental markets. The services of capital that a firm owns have an implicit price that arises from depreciation and interest costs. Firms that buy capital and use it themselves are implicitly renting the capital to themselves. • The price of the services of land is a rental rate. Nonrenewable natural resources are resources that can be used only once. • Entrepreneurs receive the profit (or loss) that results from their business decisions and their services are not traded in markets. •

Looking back Before you jump into the content of this chapter, provide your students with some context and perspective. 1. Recall the big issues of microeconomics discussed in Chapter 1. Point out that the course so far has addressed the first two questions: “What?” and “How?” and that you’re now going to address how markets determine the answer to the third question: “For whom?” 2. Spend a minute or two reviewing the course so far. Point out that Chapters 3–7, demand and supply and its extensions and applications studied the flows of goods and services from firms to households. Chapters 8 and 9 studied the choices of households. Chapters 10–15 studied the choices of firms. Now, we’re going to study the flow of goods and services from firms to consumer households in the product market and the flow of factors of production from households to firms in the factor markets. 3. Understanding choices at the margin, demand and supply, and market forces that bring equilibrium and coordinate activity to produce efficiency are all used in this chapter. Emphasize the power of the economic tools that the students already know and the payoff from keeping on top of the entire course.

II. The Demand for a Factor of Production The Value of Marginal Product •

•

The demand for a factor of production is called a derived demand because it is derived from the demand for the goods and services produced by the factor. The value to the firm of hiring one more unit of a factor of production is called the factor’s value of marginal product. It is equal to the price of a unit of output multiplied by the marginal product of the factor of production: VMP = P  MP The table shows the calculation of the VMP for a firm whose output has a price of $7 per unit.

Labor (hours per day)

Output (units per day)

200

1,000

300 400

A Firm’s Demand for Labor • •

Marginal product of labor (units per day)

Value of marginal product (dollars)

140

3,000 4,000

500 4,500 The firm hires the quantity of labor that maximizes its profit by comparing the value of one more worker (the VMP) to the cost of employing one more worker, the wage rate. As more labor is employed, the MP diminishes (as shown in the table above). So as more labor is employed, the VMP diminishes.

MARKETS FOR FACTORS OF PRODUCTION

•

If VMP of labor exceeds the wage rate, the firm increases its profit by employing one more worker; if VMP is less than the wage rate, the firm increases its profit by employing one less worker; and, if VMP equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

A Firm’s Demand for Labor Curve The value of marginal product curve is the firm’s labor demand curve. • Because the VMP of labor diminishes as the quantity of labor employed increases, the demand curve for labor is downward sloping. The profit-maximizing level of inputs implies the profit-maximizing level of output. If you wish to go beyond the analysis in the book, you can take a bit of time to show your students the basic math of the equivalence of the two conditions for maximum profit—MR = MC and W = VMP—and give them a good intuitive grasp of what is going on. There are six steps: 1. The cost of producing one more unit, MC, equals the cost of one more worker, W, divided by that worker’s marginal product, MP. That is: MC = W/MP. 2. The revenue from selling one more unit, MR, equals the revenue from hiring one more worker, VMP, divided by that worker’s marginal product, MP. That is: MR = VMP/MP. 3. Setting these two equations side by side: MC = W/MP and MR = VMP/MP is a tiny step to see that MC = MR implies W = VMP. 4. Just write MC = MR implies W/MP = VMP/MP; multiply by MP and W = VMP. 5. Now put in some numbers to make the student who freezes on symbols more comfortable. 6. Finally, just talk about what the equations mean. Explain that the marginal worker costs $x and generates a revenue of $x, so that worker is just worth hiring. Hiring one more worker costs $x but generates less than $x in revenue, so is not worth hiring. Hiring one fewer worker saves $x but forgoes more than $x in revenue, so profit falls. Go on to point out that one unit of output produced by the marginal worker sells for $p and it costs $x/MP, which equals marginal cost.

Changes in a Firm’s Demand for Labor Three factors can change the demand for labor and shift the labor demand curve: • If the price of the firm’s output changes, the VMP changes, which changes the demand for labor. An increase in the price of the output increases the demand for labor and shifts the demand curve rightward. • If the prices of other factors of production change, in the long run the demand for labor changes. An increase in the price of a substitute factor leads the firm to increase the demand for labor. • If a change in technology increases the productivity of one type of labor, the demand for this labor increases and the demand curve shifts rightward.

III. Labor Markets A Competitive Labor Market • •

The market demand for labor is determined by adding together the quantities of labor demanded by all the firms in the market at each wage. The market supply of labor is derived from the supply of labor decisions made by individual households.

Aren’t households demanders? Point out that in the labor market, the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumer of goods and services is now on the supply side of the market. •

A person’s reservation wage is the lowest wage rate for which the person is willing to supply labor. As the wage rate rises above the reservation wage, there is a substitution effect and an income effect. The substitution effect occurs because a higher wage rate increases the opportunity cost of leisure, which increases the quantity of labor supplied. The income effect occurs because an increase in the wage rate increases the person’s income and so increases the demand for leisure, which decreases the quantity of labor supplied.

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•

At lower wage rates, the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At higher wage rates, the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied and the supply of labor curve bends backward.

What’s your reservation wage? Ask the students if they would be willing to work 40 hours each week at a wage rate of $20 per hour (which is about $40,000 per year). Next, ask them whether they would increase their labor supplied to 48 hours per week if they could earn $40 per hour (about $80,000 per year, if working 40 hours per week). Most students would be willing to work more hours per week at this wage rate. Then ask them how many hours per week they would work if they were paid $10,000 per hour. In this case, working only one day per week would garner them about $8 million per year, leaving the remaining six days of each week to enjoy their high income. Many would not be willing to continue working 48 hours a week, thereby creating a backwardbending supply of labor curve. • •

The supply of labor increases (shifts rightward) when the adult population increases and when capital and technology used in the home increase. Labor market equilibrium determines the wage rate and employment.

Comparing competitive output markets with competitive input markets. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land.

Differences and Trends in Wage Rates • • •

Differences in demand and supply across labor markets make wage rates unequal. The highest wage rates are earned in markets where the value of marginal product is high and where few people have the ability and training for the job. Because the value of marginal product increases over time as new capital and new technologies increase labor productivity, wage rates also increase over time. Wage inequality has increased recently with high wage rates increasing more rapidly than low wage rates. Some low wage rates have stagnated or fallen. The new information technologies increased the productivity and wage rates of already high-paid workers. Globalization has brought increased competition for low-skilled workers and lowered the wages of already low-paid workers.

An Economics in Action case has been updated with current Bureau of Labor Statistics data on U.S. wages. The difference between median and mean income is highlighted as more Americans earn less than the average income. The application also notes that higher than average wage jobs typically require college and post graduate degrees. An Economics in the News case considers how college majors affect job prospects. Biomedical engineering earns the top rating for starting median salary combined with anticipated job growth. With both demand and supply increasing, the number of biomedical engineers is expected to grow 60 percent between now and 2020. The case takes students through the analysis of the changes in demand and supply and helps them understand why both the number of jobs and salaries are expected to increase.

A Labor Market with a Union A labor union is an organized group of workers that aims to increase the wage rate and influence other job conditions. The text analyzes how unions impact the labor market equilibrium for union workers and how this impacts nonunion workers. • To reach their goals, unions attempt to restrict the quantity of labor available for the firm to employ (shifting the labor supply curve leftward).

MARKETS FOR FACTORS OF PRODUCTION

•

Unions also attempt to influence the demand for labor and to increase the demand for labor (shifting the labor demand curve rightward) with the following strategies: • Increase the marginal product of union members to increase the demand for their labor. • Encourage import restrictions to increase the demand for union-made U.S. products. • Support minimum wage laws to raise the cost of non-union low-skilled labor. • Support immigration restrictions to decrease the supply of competitive labor. In equilibrium, if a union decreases the supply of labor, there will be fewer jobs at higher wages. If it is able to also increase the demand for union labor, this will further increase wages and offset some of the decrease in employment. The market for nonunion labor will also be effected workers unable to get union jobs increase the supply.

Monopsony in the Labor Market • •

A monopsony is a market in which there is a single buyer. For a monopsony, the marginal cost of labor exceeds the wage rate because the monopsony faces an upward-sloping labor supply curve. To attract one more worker, the monopsony must offer a higher wage rate, and it must pay this higher wage rate to all its workers.

Example: The idea that the marginal cost of labor is somehow different from the wage rate is often confusing for students. Be sure to go through the intuition and the math calculations for the marginal cost of labor several times. As in the table below, if employment rises from 200 to 300 hours per day, the wage rate will rise from $3 to $6. The total cost of labor rises from $600 to $1,800, a difference of $1,200. The change in total cost divided by the change in employment will be $1,200/100 = $12. Intuitively, all 200 hours of labor were earning a wage of $3 per hour until the next 100 hours of labor were employed. To entice those units of labor to supply their services, the wage rate rose to $6 for all 300 units of labor. As a result, the firm pays $6 for the new 100 hours of labor, and pays an additional $3 for the 200 hours of labor it was previously employing. That’s $600 for the new 100 units of labor and an additional $600 for the wage increase paid to the original 200 units of labor, for a marginal cost of labor equal to $1,200/100 = $12 again. What about “wage discrimination”? Monopolies faced a downward-sloping demand curve for their output, resulting in a marginal revenue curve that was below the demand curve. To sell more output, monopolies had to lower the price. The story for monopsony is similar. Because a monopsony faces an upward-sloping supply curve for labor, to hire more labor, monopsonies have to raise the wage, resulting in a marginal cost of labor curve that is above the labor supply curve. Some of your especially attentive students will remember that marginal revenue and demand were the same when the firm could practice perfect price discrimination. In the basic model of monopsony, we’re assuming there’s no “wage discrimination.” Every worker is paid the same wage, just as every customer in a single-price monopoly is charged the same price. •

•

The first two columns of the table show the labor supply schedule and the last column has the marginal cost of labor, MCL, schedule. The MCL curve is upward sloping and lies above the labor supply curve. To maximize its profit, a monopsony hires the quantity of labor where its MCL is equal to VMP and then pays the wage rate necessary to attract that quantity of labor. In the figure, the monopsony employs 300 hours of labor per day and pays a wage rate of $6 per hour.

Labor (hours per day) 200

Wage rate (dollars per hour)

Marginal cost of labor (dollars per hour)

3 12

300

6 18

400

9 24

500

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•

A monopsony hires less labor and pays a lower wage rate than it would if it were operating in a competitive labor market. In the figure, in a competitive labor market 400 hours of labor would be employed and the wage rate would be $9 per hour.

A Union and a Monopsony •

If a union, a monopoly seller of labor services, faces a monopsony buyer of labor services, the situation is called bilateral monopoly. In a bilateral monopoly, the wage rate is determined by bargaining and depends on the costs that each party can inflict on the other if they fail to agree upon a wage rate.

Examples of bilateral monopoly: Have the students consider the relationship between professional team owners (NBA, NFL, etc.) and the players who work for these owners. Such markets are classic examples of bilateral monopoly. Team owners operate a legal cartel and maintain strict rules for hiring labor (drafting and trading players) that prevent most of the competition among team owners who might want to sign the same player. So the owners are close to a monopsony. The best players with uniquely talented skills cannot be duplicated in the short run, so these players have a monopoly on their skills. The resulting bilateral monopoly equilibrium is such that player’s wages in general are high compared to most all other professions. This observation might surprise the students because it suggests that bargaining position of the players is greater than that of the owners.

Monopsony and Minimum Wages •

The imposition of a minimum wage in a monopsony labor market might increase both the wage rate and employment. The minimum wage makes the supply of labor perfectly elastic over some range of employment. Over this range the supply curve is horizontal and the MCL of an additional employee equals the minimum wage rate. If this part of the supply curve of labor intersects the monopsony’s VMP curve, the minimum wage increases both the quantity of labor employed by the monopsony and the wage rate paid by the monopsony. The wage rate equals the minimum wage rate.

The At Issue case presents the argument over whether monopolies are always bad, focusing on the NCAA. Robert Barro argues that the NCAA monopoly hurts the market for college athletics. Richard McKenzie and Dwight Lee argue that the NCAA monopoly has helped college athletics.

IV. Capital and Natural Resource Markets • •

Capital rental markets and land rental markets can be understood using the same basic ideas from the competitive labor market. Markets for nonrenewable natural resources are different.

Capital Rental Markets • •

The demand for capital is equal to the value of the marginal product of capital, and equilibrium in the market for capital occurs where the value of the marginal product of capital is equal to the rental rate of capital. Whether a firm rents or buys capital depends on a comparison of the cost of a purchase relative to the stream of rental costs incurred over some future period. The Mathematical Note develops this result and the concept of present value.

Land Rental Markets • •

The demand for land is based on the value of marginal product of land, and equilibrium in the market for land occurs where the value of the marginal product is equal to the rental rate of land. The supply of land is fixed, so the supply curve is vertical.

MARKETS FOR FACTORS OF PRODUCTION

Nonrenewable Natural Resource Markets •

• •

•

Oil, gas, and coal are examples of nonrenewable natural resources that are used to produce energy. • The demand for oil is determined by the value of the marginal product of oil—the fundamental influence on demand—and the expected future price of oil—the speculative influence on demand. The opportunity cost for a trader of buying and holding oil is the interest rate that could be earned as an alternative. • The supply of oil is determined by known oil reserves, the scale of current oil production facilities, and the expected future price of oil. The marginal cost of extracting oil increases, which results in an upward-sloping supply curve for oil. The market fundamentals price of oil is determined by the value of marginal product of oil and the marginal cost of extraction. Speculative forces based on expectations of the future price also can affect the current price. When expectations are revised so that the price is expected to be higher in the future, the current demand increases and the current supply decreases. Speculation can drive a wedge between the equilibrium price and the market fundamentals price. The Hotelling Principle states that traders expect the price of a nonrenewable natural resource to rise at a rate equal to the interest rate. The actual path of a nonrenewable natural resource will not necessarily rise at this rate because the actual path depends on exploration and technological changes.

An Economics in Action case considers the U.S. and world market for oil. It analyzes why energy independence for U.S. oil production won’t mean the U.S. is not affected by changes in the global price of oil. When will we run out of oil? Students are very interested in the doomsday issue. When will we run out of nonrenewable resources such as the hydrocarbon fuels? (Minerals are different because they can be recycled. They are nonrenewable, but somewhat durable.) Some numbers for your class: At the current usage rate and the current growth rate of usage and assuming that we will discover no new reserves, the world runs out of coal in 2082, natural gas in 2043, and oil in 2030. But, assure them this will never happen and explain the reasons: As the resource becomes more scarce, the price increases, causing a number of actions: 1) society is more willing to explore previously unexplored areas which were “too expensive” to explore before the price increase, and new deposits will be discovered, 2) the remaining level of resources in existing deposits that were “too expensive” to extract are now more affordable to extract and will be made available, 3) Alternate resources that were “too expensive” to use as a substitute resource before the price change to be efficient are now efficient to use, decreasing the rate of use of the initial resource. With an increase in resource prices, the “empty tank” keeps on extending. Doomsday and the Hotelling Principle: Another really neat bit of analysis that addresses the doomsday scenario head-on is the Hotelling Principle. The textbook keeps this material as simple as possible without losing the point. You can elaborate a bit and explain the end-game a bit more fully if you wish. To do so, you draw a demand curve for coal that hits the y-axis at the so-called “choke price.” Explain that today’s expectation of the choke price and today’s expectation of the year that the resource runs out determines today’s price. That price, P, is the expected choke price, PCHOKE, discounted by the expected number of years to running out, T. So P = T PCHOKE/(1 + r) . (Your students will likely have to have had some exposure to the concept of present value to understand this.) No one actually performs the calculation of this equilibrium price, but rational owners of reserves of the natural resource behave as if they performed the calculation. At each point in time, the future price is expected to rise at a rate equal to the interest rate. But the actual price fluctuates because expectations about the choke price and the number of years left fluctuate. And historically, the prices of many resources have fallen because the T has continually become unexpectedly longer. Economics in the News considers why salaries in charter schools are lower than those in public schools. The case looks at data from an Indiana school district. Charter schools had non-union, less experienced teachers. Public school teachers were unionized and had more years on the job. Budgets were smaller at charter schools and teacher turnover rates were higher. Those demand and supply factors are used to analyze the markets for unionized public school teachers and for charter school teachers.

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Mathematical Note Present Value and Discounting Rent-versus-Buy Decision Firms must compare the current cost of buying capital with the future cost of renting the capital

Comparing Current and Future Dollars •

The returns to capital come in the future, so the firm must convert the future marginal revenue product of capital to a present value. The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account. Discounting is converting a future amount of money into a present value.

Compound Interest Compound interest is the interest on an initial investment plus the interest on the interest that the investment has already earned. • To illustrate present value, begin with the relationship between an amount invested today (Present value), the interest income that it earns (Interest income), and the amount it grows to in the future (Future amount): Future amount = Present value + Interest income • The interest in the first year is equal to the present value multiplied by the interest rate, r, so Amount after 1 year = Present value + (Present value  r) = Amount after 1 year = Present value  (1 + r). • The amount after 2 years is equal to the amount after 1 year multiplied (1 + r), so Amount after 2 years = Present value  (1 + r)2 • Similarly, the amount of money that a person has n years in the future equals: Amount after n years = Present value  (1 + r)n. • Example: $100 saved for 5 years at 6 percent interest equals $100  (1 + 0.06)5 = $133.82.

Discounting a Future Amount To discount a future amount into its present value, the formulas above need to be rearranged. • Rearranging the formula for the amount of money after 1 year shows that: Present value = •

In turn, rearranging the formula for the amount of money after 2 years shows that: Present value =

•

Amount of money 2 years in the future . (1 + r)2

Similarly, the present value of an amount of money n years in the future is: Present value =

•

Amount of money 1 year in the future . 1+ r

Amount of money n years in the future . (1 + r)n

Example: $300 to be paid in 4 years when the interest rate is 5 percent per year for each year has a present value of $300/(1 + 0.05)4 = $246.81. As a check, $246.81  (1 + 0.05)4 = $300.

Present Value of a Sequence of Future Amounts • •

If money payments are to be paid at several times in the future, the present value of this stream of payments is equal to the sum of the present value of each money payment. Example: $100 is paid for the next three years at the end of each year. The interest rate is 6 percent. The present value equals $100/(1 + 0.06) + $100/(1 + 0.06) 2 + $100/(1 + 0.06)3 = $267.30.

The Decision •

Renting a unit of capital will require payments to be made in the future. The present value of this stream of payments is compared to the price of buying the unit of capital. If the price is greater than the present value of rental payments, the capital is rented while if the price is less than the present value of the rental payments, the capital is purchased.

MARKETS FOR FACTORS OF PRODUCTION

Additional Problems 1.

Barry makes party ice. He employs workers to bag the ice who can produce the quantities of ice in an hour that are listed in the table. The market for ice is competitive and Barry can sell ice for 50¢ a bag. The labor market is competitive and the equilibrium wage rate of baggers is $10.00 an hour. a. Calculate the marginal product of the workers. b. Calculate the value of marginal product of the workers. c. Find Barry’s demand for labor curve. d. How much ice does Barry sell?

Number of workers 1 2 3 4 5 6 7 8

Quantity of ice (bags) 40 100 180 240 290 330 360 380

Back at Barry’s ice making plant described in problem 1, the price of party ice falls to 25¢ a bag but baggers’ wages remain at $10.00 an hour. a. What happens to Barry’s marginal product? b. What happens to his value of marginal product? c. What happens to his demand for labor curve? d. What happens to the number of baggers that he employs?

Back at Barry’s party ice shop described in problem 1, baggers’ wages increase to $20 an hour, but the price of ice remains at 50¢ a bag. a. What happens to his value of marginal product? b. What happens to Barry’s demand for labor curve? c. How many baggers does Barry employ?

What is discounting? What is present value? How do the two relate?

Solutions to Additional Problems 1.

Marginal product of labor is the increase in total product that results from hiring one additional bagger. For example, if Barry increases the number of baggers hired from 2 to 3, total product (the quantity of ice) increases from 100 to 180 bags. The marginal product of 2.5 baggers is 80 bags of ice. The table shows the remainder of these marginal products.

Number of workers 1

Quantity of ice (bags) 40

100

180

240

290

330

360

380

Marginal product (bags) 60 80 60 50 40 30 20

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c. d.

a. b.

d. 3.

b. c.

The value of marginal product of labor is the increase in Value of total revenue that results from hiring one additional Marginal marginal bagger, which equals the marginal product multiplied by Number product product the price. The second table shows that the marginal product of 2.5 workers is 80 bags of ice. Barry sells the of workers (bags) (dollars) ice for 50¢ a bag, so this worker’s value of marginal 1.5 60 30 product is 80 bags  50¢ a bag = $40. The schedule 2.5 80 40 showing the value of marginal products in the table are 3.5 60 30 calculated similarly. 4.5 50 25 Barry’s demand for labor curve is the same as his value of 5.5 40 20 marginal product curve. 6.5 30 15 Barry sells 370 bags. Barry hires the number of baggers 7.5 20 10 that makes the value of marginal product equal to the wage rate of $10 an hour. When Barry hires 7.5 baggers, marginal product is 20 bags of ice in an hour, which Barry sells for 50 cents a bag. The value of marginal product is $10—the same as the wage rate. Barry hires 7.5 baggers and produces 370 bags of ice an hour. The marginal product does not change. The marginal product that results from hiring 2.5 baggers an hour is still 80 bags of ice. The value of marginal product decreases. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice. Now Barry sells the ice for 25 cents, so the value of marginal product is 80 bags  25¢ a bag = $20, down from $40. Barry’s demand for labor decreases, and his demand for labor curve shifts leftward. Barry is willing to pay the baggers their value of marginal product, and the fall in the price of ice has lowered their value of marginal product. Barry will hire fewer baggers. At the wage rate of $10.00, the number of baggers Barry hires decreases to 5.5 as the demand for labor curve shifts leftward. The value of marginal product does not change. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice and Barry sells the ice for 50 cents a bag, so the value of marginal product remains at $40. Barry’s demand for labor remains the same because the value of marginal product of labor has not changed. Barry will hire fewer baggers. At the wage rate of $20 an hour, Barry hires the number of baggers that makes the value of marginal product equal to $20 an hour. Barry now hires 5.5 baggers an hour—down from 7.5 an hour. The marginal product that results when Barry hires 5.5 baggers is 40 bags of ice an hour, and Barry sells this ice for 50 cents a bag. The value of marginal product is $20 an hour, which is equal to the wage that Barry must now pay. Discounting is converting a future amount of money into a present value. If a firm did not receive money today but instead received that money in the future, the firm would forgo the interest that this sum of money would have earned over that period. The present value of a future amount of money is the amount that, if invested today, grows to be as large as that future amount when the interest that it earns is taken into account. If a person is to receive a number of periodic payments in the future, then that person can use discounting to establish the present value of that future income stream.

Additional Discussion Questions 1.

Do advances in technology replace jobs with capital and increase unemployment? Emphasize that the firm’s demand curve for labor depends on the value of marginal product (VMP) of labor, which is comprised of both the marginal product (MP) of labor and the value to the firm of the goods or services labor helps produce, which is price (P). Have the students mentally work

MARKETS FOR FACTORS OF PRODUCTION

through the following series of impacts that an increase in the MP of capital has on the labor market in the long run: What happens to the demand for labor when capital becomes more productive? Point out that if the firm substitutes capital for labor, then some labor is unemployed, but the remaining labor is more productive (higher effective capital to labor ratio) and earns a higher wage (VMP = W). Who gains from increased productivity? The competitive firm passes on the cost savings to the consumers through lower prices. The rise in consumer buying power and the higher incomes of those remaining employees increase the overall demand for goods and services in the economy. What happens to the level of employment? Because most firms are experiencing increased demand for their goods and services, the price facing firms in these markets rises. The result is that the value of marginal product for labor in those markets increases with output, increasing the overall demand for labor in the labor market. 2.

Why do college graduates earn, on average, so much more than non-graduates? Part of the benefits of earning a degree in higher education is that the graduate has acquired additional critical thinking skills that make him or her much more productive (better able to contribute towards making goods and services that the rest of society values more highly than those goods and services that non-graduates can make). The existence of a significant wage differential between these two groups of people over time is contributing evidence that a college education is a good signal to employers of a value of marginal product of labor. Looking at the unemployment rates for those with a college education versus those without a college education as we have gone through the financial crisis and the recession will bring this home even more than wages.

Do union actions impose the costs of increased labor benefits onto the consumer? Ask the students to identify the opportunity cost associated with employment levels and wage rates in unionized labor markets. • Emphasize that labor unions try to raise demand for their labor by appealing to governments to raise import quotas on foreign goods and services and to restrict immigration of labor. All of these activities are aimed at increasing the wages paid to union laborers through increasing the price of the goods and services produced by union labor. This increases their value of marginal product and the wage the firm is willing to pay. • If the firm is a perfectly competitive firm, then the increase in labor costs leads some firms to exit the industry, and the equilibrium market price that consumers must pay for the goods and services rises and both producer surplus and consumer surplus decrease. • You can make the point that unions are similar to monopolies in that both violate Adam Smith’s “Invisible Hand” idea. In particular, for both unions and monopolies, people looking out for only their self-interest take actions that harm society. So for both unions and monopolies, decisions made in the private interest do not further the social interest. •

You might look at General Motors or Ford pre-financial crisis and the concessions that unions made to change the costs of care production.

Why do unions support the minimum wage? Union members earn much more than the minimum wage, so why do unions support the minimum wage? The answer is that low-skill labor that earns the minimum wage and high-skill union labor are substitutes. A rise in the minimum wage induces a substitution effect—a decrease in the quantity of low-skilled labor demanded, and an increase in the demand for union labor. With an increase in demand for union labor, the wage rate of union labor rises.

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ECONOMIC INEQUALITY

The Big Picture Where we have been: Chapter 18 explained how factor markets allocate income based on demand and supply for land, capital, and labor. Chapter 19 examines how the factor market outcomes influence the distribution of income and wealth in society. This chapter explains how we measure the degree of inequality, the characteristics of households at different places in the distribution, trends in inequality, and redistribution policies. A theme of the chapter is the role played by human capital and the resulting increase in productivity in affecting the distribution of income. Where we are going: The following chapter is the last of the microeconomic theory chapters. It focuses on risk and uncertainty and market efficiency in the face of uncertainty.

N e w i n t h e Tw e l f t h E d i t i o n More data and analysis about inequality in the distribution of wealth have been included. The introduction and conclusion consider the high pay packages that have been awarded to female executives in technology industries. A new Worked Problem section has been added. Using data from Norway and South Africa, the Worked Problem takes the students through the creation of a Lorenz curve. Then it shows the students how to use Lorenz curves to compare economic inequality and what would be necessary to make the distribution of income more equal. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Economic Inequality • • • •

Incomes are distributed unequally. In large part, features of the labor market account for the unequal distribution of income. Other factors also affect income inequality. The government has policies that redistribute income.

Economic Inequality in the United States •

Money income equals market income plus cash payments to households by the government. Market income equals wages, interest, rent, and profit earned in factor markets before paying income taxes. In the United States in 2012, the median income was $51,017, and the mean income was $71,274.

Where are you in the income distribution? Ask the students to place themselves in the U.S. income distribution by estimating their household income. Be sure to remind them to add together the income of both of their parents if they live with both and both earn income. Many students will be surprised that they are from upper-middle income families, even if they suspected that they were middle income to lower middle income families.

The Distribution of Income •

The distribution of income in the U.S. is positively skewed, so that the distribution of incomes has a long tail of high income households. In 2012, • the poorest 20 percent of households received 3.2 percent of total income • the middle 20 percent of households received 14.4 percent of total income • the richest 20 percent of households received 51.1 percent of total income.

The Income Lorenz Curve • •

An income Lorenz curve graphs the cumulative percentage of income earned against the cumulative percentage of households. The table below has the (approximate) income shares for the United States and the figure graphs the resulting Lorenz curve.

Households (percentage) Lowest 20 Second 20 Middle 20 Next highest 20 Highest 20 •

Income (percentage) 3 9 15 23

Income (cumulative percentage) 3 12 27 50

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The “Line of Equality” shows what the distribution of income would be if incomes were equally distributed. The closer the Lorenz curve to the line of equality, the more equal is the distribution of income and the farther away the Lorenz curve from the line of equality, the less equal is the distribution of income.

Interpreting the Lorenz curve. Emphasize that the Lorenz curve measures economic equality within a given population. Ask: which is more unequal, the distribution of income in the United States or the distribution of income among the 849 major league baseball players? After a minute or two of discussion, you can provide the data in the table below. Make the point that although income is much more unequally distributed among major league baseball players, in 2009 the poorest earned $400,000 a year, which is more than twice the average of the fifth quintile in the United States, $180,000. Relate this reality to a comparison of countries to the United States.

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Get the students to consider the fact that the average income person living in the poorest quintile in the United States is still enjoying a higher level of income than the median income individual living in any of a majority of other countries around the world. Quintile U.S. Households Major league baseball players percentage of income percentage of income Lowest 3.2 1.8 Second 8.3 2.8 Middle 14.4 8.2 Fourth 23.0 24.0 Highest 51.1 63.3

The Distribution of Wealth •

Wealth is the value of all the things that are owned by a household at a given point in time. The distribution of wealth can be examined with a Lorenz Curve. Because human capital is not included in measured wealth, the distribution of wealth is more unequal than the distribution of income and the income distribution is a more accurate measure of economic inequality.

Annual or Lifetime Distribution of Wealth? • •

Household income varies over the life cycle, typically starting out low, growing to a peak at retirement, and then falling after retirement. Wealth follows a similar pattern. Inequality in annual income and wealth data overstates life time inequality because households are at different stages in their life cycles.

Trends in Inequality •

The Gini ratio is based on the Lorenz curve and equals the ratio of the area between the line of equality and the Lorenz curve to the entire area beneath the line of equality. The larger the Gini ratio, the more unequal the distribution. The Gini ratio shows that since 1970 the distribution of income in the United States has become less equal.

Economics In Action considers the growing inequality of U.S. incomes. It notes the steady increase in income share for the richest Americans. In 2012 67 percent of Americans surveyed said that incomes were too unequal when in 1991 only 21 percent said this. The Economics in Action feature also presents data on the impact of education, type of household, age, race, and region on incomes.

Poverty •

Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. In 2012, the poverty level calculated by the Social Security Administration for a four-person family was $23,492.

•

In 2012, 46 million Americans, 15 percent of the population, lived below the poverty level.. • Race: In 2012, 13 percent of white Americans lived in poverty compared to 26 percent of Hispanicorigin Americans and 27 percent of black Americans. • Age: Poverty rates are 22 percent for children and 9 percent for seniors over age 65. • Work Experience: The poverty rate for those with jobs is 7 percent or for those without 33 percent. • Physical Ability: 29 percent of people with disabilities are poor. • Household Status: 28 percent of households headed by women with no husbands present experience poverty.

The Economics in Action considers whether the American Dream is still alive. It uses data to examine mobility up and down the income distribution. The analysis concludes that between 2007 and 2009 most households did not move from one quintile to the next. But there is still mobility, to both higher and lower quintiles.

II. Inequality in the World Economy Income Distribution in Selected Countries •

Countries such as Brazil and South Africa have more unequally distributed incomes, with the average person in the highest quintile receiving 32.5 times the income of the average person in the lowest quintile.

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The United States lie somewhere in the middle globally, with the average person in the highest quintile receiving 10 times the income of the average person in the lowest quintile. Finland and Sweden have more equally distributed incomes, with the average person in the highest quintile receiving 4.4 times the income of the average person in the lowest quintile. • Brazil and South Africa are somewhat extreme and have relatively small and rich European populations and relatively large and poor indigenous populations. • Finland and Sweden are also somewhat extreme, but less unusual. They are similar in income distribution to many European countries where governments pursue aggressive income redistribution policies.

Global Inequality and Its Trends • • • • • •

The global distribution of wealth is much more unequal than the distribution within any one country. Many nations are still pre-industrial and very poor, while others are sophisticated industrial producers and accordingly quite rich. 3 billion people or 50 percent of the world’s population live on $2.50 per day or less. 2 billion people or 30 percent of the world’s population live on more than $2.50 and less than $10 per day. That means 5 billion people or 80 percent of the world’s population live on $10 per day or less. An average person in the United States has an income of $115 per day. The average person in the highest quintile in the industrialized countries has $460 per day. The average American earns 46 times the income of half the world’s population and 11.5 times the income of 80 percent of the world’s population. The world Gini ratio in 2009 is about .64. The U.S. Gini ratio is about .47. These Gini ratios mean the world’s Lorenz curve lies much farther to the right (away from the line of equality) than the U.S. curve. Over time, incomes have become more unequal in the United States and the same trend can be found in most economies. But while incomes are more unequal within countries, the world distribution of income as a whole is becoming less unequal. The average incomes in poor countries are rising faster than the average incomes in rich countries, narrowing the gap across countries.

Is capitalism heartless? Emphasize that there are no societies where income or wealth is equally distributed. Society has two main concerns: prosperity and equality. Private enterprise (capitalist) societies are, in general, more prosperous, and in most cases (but not all) have no less equal an income distribution than socialist societies. Ask which is better for a family, to be the poorest in a rich but unequal society or equal with everyone else in a poor society.

III. The Sources of Economic Inequality Human Capital In labor markets, differences in human capital as well as discrimination can lead to differences in incomes. • In general, people with more human capital are high-skilled workers. Skills affect both the demand and supply side of the labor market: • High-skilled workers have a larger VMP than low-skilled workers, so the demand for highskilled workers exceeds the demand for lowskilled workers. • High-skilled workers must incur the cost of acquiring their skills, so the supply of highskilled workers is less than the supply of lowskilled workers. • As the figure shows, the combination of higher demand (DH compared to DL) and lower supply (SH compared to SL) for high-skilled workers versus low-skilled workers leads to a higher wage rate for high-skilled workers. • The wage differential between high-skilled and lowskilled workers has widened over time because technological changes and globalization have

ECONOMIC INEQUALITY

increased the demand for high-skilled workers and decreased the demand for low-skilled workers. (Technological change has been a complement for high-skilled workers and substitute for low-skilled workers.)

Discrimination •

• •

Discrimination is another possible source of income inequality. The VMP of the group being discriminated against is less than the VMP of the other group, so discrimination can lower the wage rate of the group being discriminated against. Economists disagree to the extent that discrimination actually affects wage rates. One line of reasoning states that those firms that practice discrimination face higher costs than those firms that do not. As a result, the profits of the discriminating firms will be lower and the market price of their goods and services will be higher so that these firms cannot survive in competitive markets. How much workers choose to specialize primarily in a career versus spending more time and energy on home life affects wages. This factor explains part of the wage gap between married men and other types of workers. When the wages of never married men and never married women with the same amount of human capital were compared, wages of the two groups were the same.

Contests Among Superstars • • •

Some of the really large differences in wages cannot be accounted for by differences in human capital. Contests among superstars can explain this difference. Contests with prizes do a good job of allocating scarce resources efficiently when the efforts of participants are hard to monitor and reward directly. This describes the case for CEOs and other stars. The prizes are so different because they need to induce enough effort. • In sports, globalization has increased the total revenue generated by sports. The total prize money has increased and, to generate enough effort amongst all the players, the share going to winner has increased. • In business, more businesses are global in nature so the number of executives vying for the top positions has increased. To generate enough effort amongst all the executives, the salary paid the CEO—the “winner” of the “contest”—has increased.

What demographic characteristics are correlated with household income? List the demographic characteristics that tend to be correlated with household income: level of education, size of household, and marital status, for example. These result from individual choices and not from characteristics outside the individual’s control (age or race). Emphasize that not all who are living in the lowest (or highest) income quintile will remain in that same economic situation in the long term. Emphasize that private enterprise democracies create dynamic socio-economic pathways for their citizens. Investing in human capital today (deferring current consumption) ensures a much more prosperous life for tomorrow. Advise your students that this investment is much harder to implement after reaching middle age than as a young adult.

Unequal Wealth Greater wealth inequality arises from two sources: life cycle saving patterns and transfers of wealth from one generation to the next. • Life-Cycle Saving Patterns: Wealth is built over one’s lifetime, so much of the wealth is owned by people in their sixties. • Intergenerational Transfers: Households that inherit wealth are likely to transfer that wealth to the next generation. • Marriage and Wealth Concentration: Assortive mating (“like attracts like”) implies that wealthy people seek wealthy partners, so wealth becomes concentrated in a small number of families.

IV. Income Redistribution •

Governments in the United States use three main ways to redistribute income: taxes, income maintenance programs, and subsidized services.

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Income Taxes •

All levels of government collect income taxes. Income taxes may be progressive, regressive, or proportional. A progressive income tax is one that taxes income at an average rate that increases with income. A regressive income tax is one that taxes income at an average rate that decreases with income. A proportional income tax (also called a flat income tax) is one that taxes income at a constant average rate, regardless of income.

The U.S. federal income tax is progressive. Ask the students if they think they know the tax burden paid by the richest 1 percent, 5 percent, and 10 percent of taxpayers. The students usually underestimate how progressive the income tax rate system is. IRS figures based on income tax returns collected for the year 2008 reveal that: • The richest 1 percent paid 38 percent of all income taxes collected. • The richest 5 percent paid 58.7 percent of all income taxes collected. • The richest 10 percent paid 69.9 percent of all income taxes collected. • The lowest 50 percent paid 2.7 percent of the total income tax collected. Clearly the progressive nature of the federal tax system redistributes income away from richer households.

Income Maintenance Programs There are three major types of programs that redistribute income by making direct payments to people in the lower part of the income distribution: • Social security programs: Old Age, Survivors, Disability, and Health Insurance (OASDHI) makes monthly cash payments to retired or disabled workers or their surviving spouses and children. • Unemployment compensation: Every state government has established an unemployment compensation program that taxes all workers in the state and gives unemployed workers in the state a periodic cash benefit for a specified period of time. • Welfare programs: Welfare programs provide incomes for people with incomes below a specified level and who do not qualify for social security or unemployment programs. These programs include the Supplementary Security Income (SSI) program, the Temporary Assistance for Needy Households (TANF) program, the Food Stamp program, and Medicaid.

Subsidized Services •

A great deal of income redistribution takes place in the United States through the provision of subsidized services, services provided by the government at prices below the cost of production. Examples include primary and secondary public education, as well as state colleges and universities. Medicare and Medicaid are other examples of subsidized services.

An Economics in Action feature presents data that shows how government taxes and benefit programs redistribute income and make the distribution more equal.

The Big Tradeoff •

Redistributing income leads to a tradeoff between equity and efficiency, known as the big tradeoff. Programs to redistribute income lead to inefficiency because the process of income redistribution uses up resources and, more importantly, because redistribution decreases the incentives for the taxpaying workers to provide labor and decreases the incentives for the benefit recipients to provide labor.

What are the costs of redistributing income? Emphasize that there is an opportunity cost to redistributing income in any society: when a dollar is taken from a rich person, a poor person receives less than a dollar. The size of the economic pie shrinks because: • Productive resources are consumed to implement the program rather than produce goods and services, • Redistribution requires taxation of income or exchange, which imposes a dead weight loss to society, and • The incentives facing the recipient of supplemental income are altered, delaying re-entry into the work force. Economics in the News: Using a recent hire by Apple as its launching point, the application considers trends in incomes of the superrich and why the prizes may be larger for the winners than they were in the past.

ECONOMIC INEQUALITY

Additional Problems 1.

How does the minimum wage affect the distribution of income?

Compared to the United States, managers in Hong Kong and Malaysia are paid much more than the low-skilled factory workers that they supervise. What accounts for this difference in relative pay?

Many pets in rich nations eat better than people in poor nations. To equalize the international distribution of income, do you think that rich nations should tax their citizens and give the income to the poor of very poor nations? Would this policy be fair?

Solutions to Additional Problems 1.

The minimum wage affects the distribution of income in several ways. First, workers who without the minimum wage would be paid less, receive a higher income than otherwise with the minimum wage. Because these workers are low-income workers, the minimum wage makes the distribution of income a bit more equal. Second, some workers lose their jobs when a minimum wage is imposed. These workers’ incomes fall and the minimum wage makes the distribution of income less equal. Finally, the minimum wage probably decreases some firms’ profits and so decreases their owners’ incomes. Because owners are generally higher-income earners, the minimum wage makes the distribution of income more equal.

The difference in pay is a result of the fact that managerial skills are in much smaller supply in Hong Kong and Malaysia. There are many low-skilled factory floor workers in Hong Kong and Malaysia. There are few high-skilled managers. As a result, the equilibrium wage rate paid to the few high-skilled managers in Hong Kong and Malaysia is many times greater than the wage rate paid to the many low-skilled factory floor workers.

It is indeed the case that people in rich nations are much better off than people in poor nations. Rich nations are better off because their citizens are more productive because they have immensely greater amounts of physical and human capital. The question of redistributing income from one nation to another has a big tradeoff associated with it. In particular, while the transfer of income to poorer nations equalizes income among nations, it lessens the poor nations’ incentives to develop and so slows their economic growth. In addition, the issue of fairness comes into play. The “fair results” approach to fairness argues that it is definitely fair to transfer resources to poor nations. But the “fair rules” approach to fairness suggests that these transfers aren’t fair. Taking tax revenue from people in rich nations to transfer the funds to poor nations is not a voluntary exchange and so is unfair.

Additional Discussion Questions 1.

What is the difference between poverty and an unequal income distribution? Ask the students to consider each of these measures of economic inequality by asking the following set of questions: How would you define poverty? Get the students to realize that poverty is a relative measure, rather than a positive measure of economic inequality. The minimum quantity of food, clothing, and shelter to a U.S. student is likely to be considered as abundant riches to the average citizen of developing countries. Does an unequal income distribution imply that poverty exists? Does poverty imply that an unequal income distribution exists? The upper-income people in some developing countries have annual incomes that are less than the monthly income of the typical unskilled laborer living in the U.S. Because poverty is a relative measure, there is little direct relationship between unequal income distribution and the incidence of poverty. Is it necessarily a bad thing for the Gini Ratio to increase over time? Ask the students what the implications are for a society in which: 1) workers are rewarded based on merit, 2) most

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workers make good decisions over their lifetime, (invest in human capital, maintain a good work ethic, etc.) some workers make bad decisions (drop out of school, waste their life on drugs, crime, etc.), and 3) those that make good decisions in life become more productive and earn higher wages than those that make bad decisions in life. Point out that even in a “perfect world” where race or gender discrimination was completely absent, and no “bad luck” situations were to ever affect anyone, the Gini Ratio would still increase over time as this merit-based economy continues to reward those who make good decisions more highly than those who make bad decisions. This implies that an increasing Gini Ratio is not necessarily a bad indicator for those concerned about equity as well as efficiency. 2.

If you were a benevolent dictator, how would you deal with the Big Tradeoff? Ask the students to choose a degree of economic inequality they think should be the maximum that our society must endure (in terms of lost efficiency). Have them justify this level of economic inequality by using the economic concepts of marginal benefit and marginal costs: How would you measure the marginal cost to society of an unequal income distribution? Point out that before we embark on a program to rectify the problem of economic inequality, we first must assess the degree of the problem: How should we measure the social cost of unequal economic opportunities? Many economic studies have attempted to do this, but without much success in gaining wide acceptance of the methodology. How would you measure the marginal cost to society of implementing an income redistribution program? Once we are comfortable with our measure of the social cost of economic inequality, we turn to the alternative: What amount of prosperity would we all be willing to give up as a society to increase economic equality in our society (how much smaller would we want the economic pie to be)? More importantly, what cost would we be willing to impose on others in society to rectify economic inequality? How should this decision be made? Help the students to see how complex the issue of economic inequality really is in the world. There are no simple solutions.

If two different but equally “important” occupations in society were to earn very different levels of income, is this necessarily reflective of discrimination? Remind students that while it is true that firms’ demand for labor is partially derived from society’s demand for the product generated from the occupation’s labor force, the wages that firms pay for that labor is also determined by the households’ willingness to supply labor to that occupation. Much of the observed differences in wages across equally “important” occupations can be attributed to the relative unwillingness of households to supply as much labor for the higher paid occupation as for the lower paid occupation. This is a different reality than assuming that firms’ are largely unwilling to pay a wage equal to the value of the true VMP of labor to a certain class of laborers that tend to dominate the lower paid occupations.

4. Are prizes on shows like American Idol unfair? Discuss whether the unevenness in the rewards for shows induces more effort or are unfair. 5. Are there fewer women CEOs and do women CEOs make lower wages because they are not giving enough to their careers as they try to maintain family responsibilities? Recently the CFO of Facebook wrote a book that garnered a lot of press and sparked conversation about what women need to be giving to the labor market to succeed. Supportive and critical opinion pieces on this topic are widely available and might spark a good classroom conversation.

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UNCERTAINTY AND INFORMATION

The Big Picture Where we have been: Chapter 20 uses the general economic reasoning featured in many of the previous chapters. For instance, Chapter 20 uses the concepts of marginal utility first covered in Chapter 8. It concludes with a general discussion of efficiency in information markets, which draws upon material first covered in Chapter 2 and expanded upon in Chapter 5. Where we are going: Chapter 20 is the final chapter in the microeconomics section. This chapter is important because it relaxes many of the implicit assumptions concerning information that bother students about the efficiency of the market. Chapter 20 provides some interesting, real-life examples of market processes in an uncertain world.

N e w i n t h e Tw e l f t h E d i t i o n The chapter has been lightly revised to help enhance students’ understanding. An application on subprime loans is incorporated. A new Worked Problem section has been added. The Worked Problem shows how to calculate expected wealth and utility. It also demonstrates how to compare a risky choice to a no-risk opportunity and how to calculate the cost of risk. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Uncertainty and Information • • • •

People need to make decisions in the face of uncertainty and risk. Markets allow people to buy and sell risk. Some people may have private information. Markets must cope with incomplete information, which can lead to moral hazard and adverse selection.

Decisions in the Face of Uncertainty

Expected wealth • •

Expected wealth is the money value of what a person expects to own at a given point in time. An expectation is an average calculated by using a formula that weights each possible outcome with a probability (chance) that it will occur.

Risk aversion •

Risk aversion is the dislike of risk. Most people are risk averse.

Utility of Wealth •

Wealth yields utility, but the marginal utility of wealth diminishes as wealth increases, as shown in the figure. Because the slope of the utility of wealth curve diminishes as wealth increases, the utility gained from a $1 increase in wealth is less than the utility lost from a $1 decrease in wealth.

Expected utility •

This is the utility value of what a person expects to own at a given point in time. It is calculated by using a formula that weights each possible outcome with the probability that it will occur. • In the figure, suppose a person is faced with two investments: One offers wealth of $26,000 with no uncertainty and so has utility of 40 units with no uncertainty. The other option has, with a 0.50 probability, wealth equal to $40,000 and utility of 50 units; or, with another 0.50 probability, it has wealth of $20,000 and utility of 30 units. Expected utility from this second option is 0.50  50 units + 0.50  30 units = 40 units. If given the choice between $26,000 with certainty and a 50:50 chance of having $40,000 or $20,000, the person is indifferent between the two choices because both have the same (expected) utility, 40 units. • The expected wealth from the second option is 0.50  $40,000 + 0.50  $20,000 = $30,000, which is $4,000 more than the certain wealth of $26,000 from the first option. The $4,000 difference is called the cost of risk.

Making a Choice with Uncertainty • •

Faced with uncertainty, people choose the option with the highest expected utility. By comparing the expected utility from a risky prospect with the expected utility from a safe prospect, you can choose the one that maximizes expected utility.

UNCERTAINTY AND INFORMATION

II. Buying and Selling Risk Both buyers and sellers gain from exchanging risk as they would any product. What they are trading is avoiding risk. A buyer of risk avoidance is transferring the risk to the seller. The seller is willing to assume the risk because the costs of risk are lower to the seller than what the buyer is willing to pay.

Insurance Markets • • •

How insurance reduces risk: People pool and share risk. When people buy insurance against the risk of an unwanted event, they pay an insurance company a premium. If the unwanted event occurs, the insurance company pays out the amount to the insured. Why people buy insurance: People buy insurance because they are risk averse. If premiums are not too high, loss of utility from paying the premium for the insurance is less than the expected utility loss if the adverse event were to occur. How insurance companies earn a profit: • Everyone pays into the insurance pool, but only the small fraction of people who actually suffer a loss are paid from these funds. • Although the probability of any particular individual suffering a loss is quite small, for a large number of people the total number and the total amount of losses can be estimated very accurately. • Insurance companies earn a profit because the insurance company can collect a premium that is high enough to at least break even, and customers who are risk averse are willing to pay that premium.

A Graphical Analysis of Insurance •

•

Risk Taking Without Insurance: In the figure, suppose the person has a 50 percent chance of keeping $40,000 of wealth and a 50 percent chance of having $20,000 of wealth. As seen before, the expected wealth is $30,000 and the expected utility is 40. The figure shows that the person is willing to accept a lower wealth with certainty, $26,000, which will give the same utility, 40, as the risky case. The Value and Cost of Insurance: The key point is that the certain wealth with utility of 40 ($26,000) is less than the expected wealth with utility of 40 ($30,000). As long as the person can buy insurance for less than $14,000, the individual is better off (has higher expected utility) from the purchase of insurance than from the uncertainty of wealth with no insurance. Ignoring any operating costs, if there are many people in the same situation the insurance will cost the insurance company $10,000 per person, the expected loss per person. As long as the company can sell the insurance for more than $10,000, the insurance company is better off by selling the insurance. Gains from Trade: Both the insurance company and the person will be better off if insurance can be bought and sold for between $14,000 and $10,000.

Why are men (especially young men) charged more for auto insurance? Have the students consider the difficulty of providing insurance with affordable premiums to consumers, yet be profitable enough to encourage producers to accept the risks involved. For example, car insurance companies charge higher premiums to unmarried young men than they charge unmarried young women, even if two such individuals have the same driving records. This difference is based on statistical probabilities calculated by the insurance company keeping record of large samples of loss claims. Ask the students if this difference is “fair?” Then ask how a drivers’ risktaking behavior might change once he or she is insured. This last question is a good introduction to the following material on private information and moral hazard.

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Risk That Can’t Be Insured • •

If risks are not independent, they cannot be insured (e.g., private markets will not insure homeowners in a flood plain because the occurrence of a flood negatively affects everyone in that area). Risks must be observable to both the buyer and the seller in order to be insurable.

Economics in Action considers insurance in the United States, both private and public such as Medicare, Social Security, and unemployment insurance.

III. Private Information Asymmetric Information: Examples and Problems • •

Private information is information about the value of the item being traded that is possessed by only buyers or sellers. A market in which buyers or sellers have private information has asymmetric information. Asymmetric information creates two problems: • Adverse selection is the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party. • Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less-informed party.

The Market for Used Cars • • • •

The owner of a used car has private information about the quality of the car. If the buyer cannot determine the quality of the car before the purchase, moral hazard occurs when the seller claims that each car is high quality but in truth offers “lemons” for sale. Because consumers are unable to distinguish between a “lemon” and a good vehicle, they must assume that all used vehicles for sale are “lemons,” and used car dealers must price their cars at the highest price that consumers will pay for a “lemon.” The problem that in markets in which it is not possible to distinguish reliable products from lemons, there are too many lemons and too few reliable products traded is called the lemons problem. However, used car dealers can overcome the lemon problem by offering a warranty on the vehicle, which is a signal that the car is of high quality. Signaling occurs when an informed person takes actions that send information to uninformed persons. • An equilibrium in a market when only one message is available and an uninformed person cannot determine quality (as with the market for lemons) is called a pooling equilibrium. • An equilibrium when signaling provides full information to a previously uninformed person (as in the used car market with warranties) is called a separating equilibrium.

The Market for Loans •

•

Some borrowers are low risk, and will likely repay their loans, and others are high risk, and will likely default on their loans. The risk that a borrower might not repay a loan is called credit risk or default risk. Banks want to charge low-risk borrowers a low interest rate and high-risk borrowers a high interest rate, but banks cannot immediately distinguish between the two classes of borrowers. If banks cannot charge different interest rates to different individuals with varying default risks, the result is an inefficient pooling equilibrium. • Banks use signals, such as length of time on the job, marital status, age, and other factors correlated with low-risk borrowers to try to determine the risk of loaning funds to each individual borrower. Borrowers may have an incentive to mislead lenders, so banks often require that borrowers provide relevant information about the likelihood the loan will be repaid (salary, wealth, tenure on the job, for example). Inducing an informed party to reveal private information is called screening.

An Economics in Action examines the sub-prime credit crisis. Prior to the crisis the supply of funds to the subprime market was much greater than during the crisis.

UNCERTAINTY AND INFORMATION

The Market for Insurance •

Moral hazard occurs when insured people have less incentive to be careful and avoid risky behavior. And adverse selection arises because people who create greater risks are more likely to buy insurance. • Insurance companies seek out signals (such as an auto insurer looking at an individual’s driving record) to limit the extent of the adverse selection problem. • Deductibles, where the insured person also must pay part of the expense of an incident, can reduce the moral hazard problem.

Moral hazard in game shows. The television show, “Who Wants to Be a Millionaire?” was insured by an insurance company that reimbursed the producers of the show when a contestant answered all the questions correctly and won a big dollar pay-out. This insurer had some serious disagreements with the show’s producers after the show ran on national television for the first year, claiming concerns over moral hazard. In particular, the insurer claimed that the producer eased the questions asked of the contestants in order to guarantee that some contestants won and thereby boosted the show’s excitement and ratings. The insurer wanted greater control over the difficulty of the questions being asked of the contestants.

IV. Uncertainty, Information and the Invisible Hand Information as a Good • •

Obtaining more information has increasing opportunity costs and consuming more information has decreasing marginal benefits. The efficient amount of information is the amount at which the marginal benefit from information equals the marginal cost. It is hard to determine whether a competitive market for information would produce it at the efficient level.

Monopoly in Markets that Cope with Uncertainty • •

Large economies of scale probably exist is providing services to reduce uncertainty and to provide better information. Therefore insurance markets are highly concentrated. Monopoly leads to inefficient results, even in the absence of uncertainty, so underproduction of information is thus likely.

Economics in the News considers the case of grade inflation. Grade inflation makes it more difficult for employers to determine who is outstanding and who is not.

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Additional Problem 1.

How might adverse selection discourage firms from underpaying their workers?

How might moral hazard discourage firms from offering workers a fixed wage?

Baseball players often seek contracts with a “no-trade” clause so that the player cannot be traded from his current team without his permission. a. Provide an example of private information that a baseball player who wants a no-trade clause possesses. b. Does a baseball player with a no-trade clause present a moral hazard to his baseball team? c. Does a baseball player with a no-trade clause present adverse selection problems to his baseball team?

How does health insurance and flood insurance result in both a moral hazard and adverse selection problem?

How do insurance companies use premiums and deductibles in an attempt to resolve these problems?

Solutions to Additional Problems 1.

If a firm gets the reputation for underpaying its workers, only low quality workers will apply to work at the firm, thereby presenting the firm with a severe adverse selection problem.

If firms offer workers a fixed wage regardless of their effort workers have the incentive to shirk, that is, to work less hard than otherwise.

a. b.

A player could know that he was injured or that he had not healed as well as possible from an injury. A player with a no-trade clause presents a moral hazard problem. The player can claim to be more badly injured than is truly the case to avoid playing some games. The player can make this claim knowing that even if he often does so, his team cannot trade him and must continue to pay his salary. If there are two types of contracts—contracts with the no-trade clause and contracts without it—then there is a potential adverse selection problem. Players who know they are more inclined to want to skip a game or two will be eager to sign a no-trade contract because this contract lessens their cost of feigning injury to take leisure.

Health and flood insurance both present moral hazard and adverse selection problems. Adverse selection is present because less healthy people will be more likely to buy health insurance and people living in flood prone areas will be more likely to buy flood insurance. Moral hazard is present because people with health insurance become more prone to take risks and people with flood insurance become less prone to build flood resistant structures.

Insurance companies use premiums and deductibles in an effort to create a separating equilibrium. The companies offer policies with high deductibles and low premiums to attract low-risk customers, that is people who are not likely to be susceptible to diseases or people who have not built in a flood plain. Simultaneously the companies also offer policies with high premiums and low deductibles to appeal to highrisk customers, that is people who are prone to contracting certain ailments or who have built in a flood plain.

Additional Discussion Questions 11. What does being risk averse mean? Get the students to consider why a risk premium must be paid to overcome the consumer’s cost of risk.

UNCERTAINTY AND INFORMATION

12. Why do people prefer the utility arising from a level of income known with certainty more than the utility arising from the same value of expected income arising from a risky choice? Get the students to understand that the consumer will never achieve the expected level of income arising from a risky decision when confronted with a single choice. Expected income is the value of income that is averaged over numerous outcomes under the same circumstances. For any one point in time, knowing utility from a given outcome is preferred to the expected utility of a risky outcome, despite the two having the same expected level of income. 13. Would insurance companies prefer a higher or lower degree of risk aversion among consumers? Point out to students that the more concave the utility of wealth schedule, the higher the cost of risk, and the greater the risk premium that the consumer is willing to pay to avoid risk. 14. Why will private insurance companies sell health insurance that pays for unexpected illness but not unemployment insurance that pays for unexpected unemployment? Explain that adverse selection motivates high risk workers who know they are likely to be laid off will be willing to pay a high risk premium for unemployment insurance, but low risk workers who know they are unlikely to be laid off will only pay a low risk premium. By offering insurance premiums that are desirable to the low risk workers, high risk workers will buy the insurance as well, preventing the insurance companies from knowing which workers are high risk and which are low risk. This burden on insurance carriers is not as evident in offering health insurance because the insurers can seek out signals from consumers which reveal who has low-risk lifestyle and who have a high-risk lifestyle (such as determining whether the potential health insurance customer is a smoker, or is older, or is overweight, etc.) 15. What are some examples of goods that require “information” for consumers to enjoy and goods that require “private information”? All goods require consumers to have access to price and availability information. However, private information relates to goods that consumers cannot completely understand until they commit to purchasing the good. Goods in this category include used cars, long-wearing and comfortable shoes, high-end consumer electronics, good homes in pleasant neighborhoods, etc. Markets for these goods typically create opportunities for middlemen (like realtors, retailers and car dealers) to supply advice and match consumer tastes with producer goods. 16. Is the use of signals to discern between high and low risk consumers “fair”? Ask the students whether charging 17-year-old, unmarried males higher auto insurance premiums than 35-year-old, unmarried females “fair”? Is it “fair” for individuals with pre-existing health conditions to pay higher insurance bills? Is it “fair” for employers to pay women less because women are (obviously) more likely to give birth? On the other hand, is the use of signals “efficient”? Get the students to consider the tradeoff between pooling risk (making avoiding risk affordable) and avoiding moral hazard (making careful, thoughtful consumers pay for the mistakes of careless, thoughtless consumers). 7.

Health care reform uses “pools” of individuals to help to reduce health care costs for those currently without insurance. How is this intended to help and why was it designed so people could not “opt out” of having insurance? The larger the pool, the more risk is spread out. If younger, healthier workers less likely to have claims can avoid participation, the expected outlays for the insurance company are spread across a smaller pool, risk rises for the insurance company, and customers have to pay higher premiums.

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MEASURING GDP AND ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 4 does not directly use the material developed in the previous chapters. Where we are going: Chapter 4 is the first of the macroeconomic chapters. It provides some basic definitions (GDP, real GDP, aggregate expenditure, potential GDP, and business cycles) that are used in virtually all the remaining chapters. The circular flow model and the national income accounting explained in this chapter serve as a general framework for macroeconomic analysis. The fact that aggregate expenditure equals aggregate income equals the value of production is the key to understanding why changes in aggregate expenditure change aggregate income, which then changes aggregate expenditure. The components of aggregate expenditure provide an underpinning for the theory of aggregate demand in Chapter 10 and the aggregate expenditure model and multiplier in Chapter 11.

N e w i n t h e Tw e l f t h E d i t i o n The content within the chapter is substantially the same as the 11th edition but there are special icons indicating problems that use real-time data. All of the data within the chapter have been updated to use 2014 data. The current event topic is under the ‘Economics in the News’ section and discusses the continuing expansion in the United States during 2014. The Worked Problem presents some national accounts and then asks the students to calculate GDP using both the expenditure and income approaches, net domestic income at factor cost, and net domestic income at market prices. The solutions show step-by-step how to calculate the required answers. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 21 in Economics.

MEASURING GDP AND ECONOMIC GROWTH

Lecture Notes

Measuring GDP and Economic Growth • • •

GDP is a measure of total production and total income. Real GDP measures production of goods and services. GDP can be used to make comparisons over time and across countries.

Gross Domestic Product •

GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period.

How do you add apples and oranges? You can pick any goods you like but I think it is helpful to show GDP as an equation early on. You can start with real goods and then generalize to “n goods”: GDP = PAQA + POQO + … GDP = P1Q1 + P2Q2 + P3Q3 + … + PNQN GDP = ∑ PiQi You may find it useful to add slang while you discuss GDP, “GDP is the dollar value of all ‘stuff’ made over one year.” Be sure to repeat the definition as you move through all the chapters rather than assuming the your students always remember what is in GDP and how it is measured. A solid understanding of GDP is crucial for other material to make sense. •

• • • •

The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute $300,000,000 to GDP. Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be). A final good is an item that is bought by its final user. It contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. To avoid double counting, GDP includes only final goods and services (no intermediate goods and services are directly counted). Only the goods and services produced within a country are counted. A Honda produced in North Carolina is counted in U.S. GDP. GDP is measured over a period of time, typically a quarter of a year or a year.

Gross Domestic Product. The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. Working through issues with GDP is vital since it serves as the basis of measurement of the standard of living, economic welfare, and making international comparisons. Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. When the 1996 GDP was recalculated to include software as a final good, GDP increased by $115 billion, or 1.5 percent.

GDP and the Circular Flow of Expenditure and Income • •

The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, governments, and the rest of the world—in two aggregate markets—goods markets and factor markets. In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP:

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• • • •

The total payment for goods and services by households in the goods markets is consumption expenditure, C. The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I. Governments buy goods and services, called government expenditure or G, from firms. Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X − M.

Government transfer payments, such as Social Security payments, are not part of government expenditures because government expenditures include only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures. •

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

The Circular Flow Model. Start with a simpler picture than Figure 4.1—just households and firms, and just income and consumption. Explain that you are starting from the basics, in which all goods and services produced are sold to consumers. Explain that even beyond the assumption that all goods and services are consumption goods and services, we’re simplifying things in the picture but are not omitting anything that leads us into a misleading conclusion. For instance the picture envisages all the income being paid to households. Nothing is lost and clarity is gained by this device. Emphasize that the blue flows are incomes and the red flows are expenditures on final goods and services. Clearly in this simplest case aggregate income equals aggregate expenditure. Then add investment. It is still the case that aggregate expenditure (which is now C + I) equals aggregate income. Next add the government and the flow of government expenditure. Finally add the rest of the world and the flow of net exports. In both cases you can continue to make the crucial point at aggregate expenditure equals aggregate income.

GDP Equals Expenditure Equals Income •

•

Aggregate expenditure equals C + I + G + (X − M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.) Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP.

Why “Domestic” and Why “Gross”? •

•

Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. The total amount spent on purchases of new capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is net investment. Net investment = Gross investment − Depreciation. The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP.

MEASURING GDP AND ECONOMIC GROWTH

II.

Measuring U.S. GDP

Most of the income data used by the BEA to measure GDP come from the IRS. Expenditure data come from a variety of sources.

The Expenditure Approach •

The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X − M). So GDP = C + I + G + (X − M) or, in 2014 and in billions of dollars, $11,729 + $2,714 + $3,139 + −$538 = $17,044.

The Income Approach •

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.”

Measuring U.S. GDP, the low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion! Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies’ reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to stock holders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if, when AOL files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts are adjusted appropriately.

Nominal GDP and Real GDP • • •

The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher. Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

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Calculating Real GDP • •

• •

Data for 2014

Traditionally, real GDP is calculated using prices of the reference base year (the year in which real GDP=nominal GDP). The tables to the right show this method of calculating real GDP for an economy that produces only books and coffee. If 2014 is the reference base year, nominal GDP in 2014 in the top table equals real GDP in 2014 Real GDP in 2014 is $3,000. The second table shows the calculation for nominal GDP in 2015. Real GDP in 2015 is in the bottom table. It values 2015 production using the prices from the reference base year, 2014. Real GDP in 2015 is $4,250.

Item

Quantity

Price

Market Value

Books

$25

$1,000

Coffee

1,000

$2,000

Nominal GDP

$3,000

Data for 2015 Item

Quantity

Price

Market Value

Books

$30

$1,500

Coffee

1,500

$4,500

Nominal GDP

$6,000

2015 Quantities and 2014 Prices Item

Quantity

Price

Market Value

Books

$25

$1,250

Coffee

1500

$3,000

Real GDP (2010 dollars)

$4,250

You may want to mention the GDP deflator at this point even though coverage of it is in next chapter. Stress the separation of the “quantity effect,” measured by real GDP, and the “price effect,” measured by the price level. Real GDP will be used to compute the economic growth rate while the price level will be used to compute the inflation rate.

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP •

• •

•

The top table to the right has data for 2014 GDP Data for 2014 for an economy that produces only books Item Quantity Price Market Value and coffee. In 2014, nominal GDP is $3,000. The second table to the right has the same Books 40 $25 $1,000 data for 2015. (These tables are the same as Coffee 1,000 $2 $2,000 used above to calculate real GDP using the Nominal GDP $3,000 standard method.) In 2015, nominal GDP is $6,000. GDP Data for 2015 Nominal GDP has doubled but how much has real GDP changed between these years? Item Quantity Price Market Value To determine how real GDP changes, Books 50 $30 $1,500 suppose that 2014 is the base year. Then we Coffee 1,500 $3 $4,500 need to determine the growth rate between 2014 and 2015 by calculating the value of Nominal GDP $6,000 production in both years using 2014 prices and also calculating it in both years using 2015 prices. Using 2014 prices, the value of production increases from $3,000 (the first table) to $4,250 (the third table). Using 2014 prices, the value of production has grown by 100  ($4,250 − $3,000)/$3,000 = 41.7 percent. Using 2015 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table). Using 2015 prices, the value of production has grown by 100  ($6,000 − $4,200)/$4,200 = 42.9 percent.

MEASURING GDP AND ECONOMIC GROWTH

•

The average growth rate is equal to (41.7 percent + 42.9 percent)/2 = 42.3 percent. So real GDP between these years has grown by 42.3 percent. If 2014 is the base year, real GDP in 2011 is $3,000  1.423 = $4,269. Similar calculations are made for each pair of adjacent years from the reference base year onwards. This procedure chains real GDP back to the reference base year.

III. The Uses and Limitations of Real GDP The Standard of Living Over Time •

• •

2015 Quantities and 2014 Prices Item

Quantity

Price

Market Value

Books

$25

$1,250

Coffee

1500

$3,000

Value of production (2010 dollars)

$4,250

2014 Quantities and 2015 Prices Item

Quantity

Price

Market Value

Books

$30

$1,200

Coffee

1,000

$3,000

Value of $4,200 One measure of the standard of living production over time is real GDP per person, or real (2011 dollars) GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be.

The Importance of the Lucas Wedge. It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge. Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important. This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with 3 percent growth, the income would be $47,037 and with 4 percent growth the income would be $51,809. This difference of about $4,500 might not seem like much. But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000. Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for an incredibly major difference in incomes, which should easily capture your students’ attention. • Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity. Each cycle is categorized by: trough, expansion, peak, recession. The Business Cycle. Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons. First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while. Second, the data that must be used always are at least a bit out-of-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later. Although economists’ forecasts are much better than those of others, forecasting GDP with

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complete accuracy is unlikely. Conclude by mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies. The Business Cycle, Part 2: The business cycle and its dating are interesting to students, especially when the economy is in or near a recession. If you have the capacity to show or assign Web pages, look at the NBER Business Cycle Dating Committee’s page at http://www.nber.org/cycles/recessions.html. You might like to look at the dating of the cycle in other countries. This dating is done by the Economic Cycle Research Institute (ECRI). You can find their Web site at http://www.businesscycle.com/. Another page on the ECRI Web site shows the cycle peak and trough dates for 18 countries from 1948 nicely aligned in a table. You can compare the timing of cycles internationally. You can also compare the severity of U.S. cycles over time. Note that the recession that the NBER dates as beginning in March 2001 and ending in November 2001 was incredibly mild on all criteria except the labor market. The “Great Recession” that started in 2007, however, is one of the worst since the great depression.

The Standard of Living Across Countries •

•

Real GDP can be used to compare living standards across countries. But two problems arise in using real GDP to compare living standards: • First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country. Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.

Big Mac Index (http://www.economist.com/content/big-mac-index): This is an impressive and interactive site for measuring PPP of the Big Mac. Students will immediately relate to this example and you can ask them what country they want to check on. International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.

Limitations of Real GDP •

Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are: • Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity. • Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate. • Health and Life Expectancy: Better health and long life are not directly included in real GDP. • Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it. • Environmental Quality: Pollution does not directly lower the economic growth rate. • Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP.

MEASURING GDP AND ECONOMIC GROWTH

The At Issue feature debates whether GNNP (Green net National Product) should replace GDP. Advocates say that a green measure is needed to take account of environmental damage that results from production; opponents say that other omissions from GDP are more important than environmental damage. An Economics in Action describes the United Nation’s broader measure of wellbeing, the Human development Index. The Economics in the News section discusses the rapid growth in the second quarter of 2014 and the role played by business inventories in the expansion. YouTube Video: This is a wonderful video that should get anyone excited about data and its ability to help tell a story. Hans Rosling's 200 Countries, 200 Years, 4 Minutes - The Joy of Stats - BBC Four http://youtu.be/jbkSRLYSojo

Measuring Real GDP and Economic Growth. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if you mow your own lawn, the value of your production doesn’t show up in GDP. But if you hire a student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are the cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

CHAPTER 4

Additional Problems

Figure 4.1 shows the flows of expenditure and income for a small nation. During 2014, flow A was –$15 million, flow B was $40 million, flow C was $90 million, and flow D was $45 million. Calculate a. Aggregate expenditure. b. Aggregate income. c. GDP.

The transactions in Jupiter last year are in the table to the right. a. Calculate Jupiter’s aggregate expenditure. b. Calculate Jupiter’s net exports. c. Calculate Jupiter’s government expenditure.

Item GDP Consumption expenditure Taxes Transfer payments Profits Investment Exports Saving Imports

Dollars 1.400,000 700,000 350,000 150,000 300,000 350,000 400,000 400,000 350,000

MEASURING GDP AND ECONOMIC GROWTH

The table shows data from the United Kingdom in 2005. a. Calculate GDP in the United Kingdom. b. Explain the approach (expenditure or income) that you used to calculate GDP.

Desert Kingdom produces only Quantities dates and camel rides. The base Dates year is 2014, and the tables give Camel rides the quantities produced and the prices in 2014 and 2015. Prices Calculate Desert Kingdom’s Dates a. Nominal GDP and real GDP Camel rides in 2014 and 2015. b. Real GDP in 2015 in terms of the base-year prices.

Item Wages paid to labor Consumption expenditure Taxes Transfer payments Profits Investment Government expenditure Exports Saving Imports

Billions of pounds 685 791 394 267 273 209 267 322 38 366

2014 1,000 pounds 50 rides

2015 1,100 pounds 60 rides

$1 per pound $100 per ride

$2 per pound $120 per ride

Desert Kingdom (described in problem 3) decides to use the chain-weighted output index method of calculating real GDP. Using this method, calculate a. The growth rate of real GDP in 2015. b. Compare and comment on the differences in real GDP in terms of the base-year prices and real GDP calculated using the chain-weighted output index method.

Solutions to Additional Problems 1.

b. c. 2.

a. b. c.

Aggregate expenditure is $160 million. Aggregate expenditure is the sum of consumption expenditure, investment, government expenditure, and net exports. In the figure, flow C is consumption expenditure, flow D is investment, flow B is government expenditure, and flow A is net exports. So aggregate expenditure equals $90 million plus $45 million plus $40 million minus $15 million, which is $160 million. Aggregate income is $160 million. Aggregate income equals aggregate expenditure, which from part a is $160 million. GDP is $160 million. GDP equals aggregate expenditure, which from part a is $160 million. Jupiter’s aggregate expenditure is $1,400,000. Aggregate expenditure equals GDP and Jupiter’s GDP is $1,400,000. Jupiter’s net exports equal $50,000. Net exports equal exports, $400,000, minus imports, $350,000. Jupiter’s government expenditure was $300,000. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports. That is, $1,400,000 equals $700,000 plus $350,000 plus government expenditure plus $400,000 minus $350,000. Solving this equation for government expenditure gives $300,000.

a. b.

GDP in the United Kingdom was £1,223 billion. The expenditure approach was used; that is, GDP was calculated by adding consumption expenditure, investment, government expenditure, and exports, and subtracting imports.

In 2014, nominal GDP is $6,000. In 2009, nominal GDP is $9,400.

CHAPTER 4

Nominal GDP in 2014 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2014. Expenditure on dates is 1,000 pounds at $1 a pound, which is $1,000. Expenditure on camel rides is 50 rides at $100 a ride, which is $5,000. Total expenditure is $6,000, so nominal GDP in 2014 is $6,000. Nominal GDP in 2015 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2015. Expenditure on dates is 1,100 pounds at $2 a pound, which is $2,200. Expenditure on camel rides is 60 rides at $120 a ride, which is $7,200. Total expenditure is $9,400, so nominal GDP in 2015 is $9,400. Real GDP in 2015 in terms of base-year prices is $7,100. To calculate real GDP in 2015 in terms of base-year prices, we calculate market value of the 2015 quantities at the base-year prices of 2014. To value the 2015 output at 2014 prices, expenditure on dates is 1,100 pounds at $1 a pound (which is $1,100), and expenditure on camel rides is 60 rides at $100 a ride (which is $6,000). So real GDP in 2015 in terms of base-year prices is $7,100. The growth rate of real GDP in 2015 is 17.9 percent. The chain-weighted output index method uses the prices of 2014 and 2015 to calculate the growth rate in 2015. The value of the 2014 quantities at 2014 prices is $6,000. The value of the 2015 quantities at 2014 prices is $7,100. We now compare these values. The increase in the value is $1,100. The percentage increase is ($1,100  $6,000)  100, which is 18.33 percent. The value of the 2014 quantities at 2015 prices is $8,000. The value of the 2015 quantities at 2015 prices is $9,400. We now compare these values. The increase in the value is $1,400. The percentage increase is ($1,400  8,000)  100, which is 17.5 percent. The chain-weighted output index calculates the growth rate as the average of these two percentage growth rates. That is, the growth rate in 2015 is 17.9 percent Real GDP in 2015 in terms of base-year prices is $7,100. Real GDP in 2015 using the chain-weighted output index method is $7,074. Real GDP growth is fastest when real GDP is measured in terms of baseyear prices.

Additional Discussion Questions 11. To estimate GDP you add the value of all the goods and services produced, both final and intermediate goods. Is this procedure correct? Why? Adding all the goods and services produced is incorrect because it will lead to significant double counting. Intermediate goods and services will be double counted. For instance, if a CPU produced by Intel and then used in a Dell computer is counted both as a CPU from Intel and as part of the computer from Dell, the CPU has been double counted. 12. What is the relationship between aggregate income and aggregate production? Why does this relationship exist? Aggregate income equals aggregate production. The circular flow shows this result: The flow of production out of business firms equals the flow of expenditure into business firms. The flow of expenditure into business firms equals the flow of costs out of business firms. And the flow of costs out of business firms is the same as the flow of aggregate income to households. 13. Does my purchase of a domestically produced Ford automobile that was manufactured in 2010 add to the current U.S. GDP? Why? How about my purchase of a domestically produced, newly produced Ford? Why? The purchase of the used Ford does not add to the current U.S. GDP though it did add to U.S. GDP in 2010 when the car was newly produced. GDP measures production within a given time period and the used Ford was not produced within the current year. A new Ford automobile, however, is counted in current U.S. GDP because it was produced in the current year.

MEASURING GDP AND ECONOMIC GROWTH

Does my purchase of 100 shares of stock in Google add to the nation’s GDP? Why? Purchasing shares of stock does not add to the nation’s GDP. GDP measures production. Shares of stock are not the production of a good or service and therefore are not included in GDP.

If a homeowner cuts his or her lawn, is the value of this work included in real GDP? Suppose that the homeowner hires a neighborhood kid to cut the lawn. Is this activity included in real GDP? Comment on your answers. The homeowner’s work around his or her home is not included in GDP because home production is excluded. Hiring a neighborhood kid to cut the lawn is, in theory, included in GDP because it is a service that has been sold in a market. This difference in the treatment of these two activities shows a flaw in how GDP is computed. In both cases the precise same lawn is mowed. But in one case GDP is unaffected and in the other GDP increases. It is paradoxical that the effect on GDP of producing the same service depends on who produces the service.

In 1900, the average work week was 65 hours; today it is approximately 35 hours. How did this change affect real GDP within the United States? How did it affect the standard of living within the United States? Comment on your answers. The decrease in the average work week decreases real GDP from what it would have been if the work week had remained at 65 hours because less time is spent at production of goods and services. Taken by itself, the decrease in real GDP means that the standard of living within the United States is lower. However the fall in the average work week also means a significant increase in people’s leisure time, which raises the standard of living. For many people it is likely the case that their standard of living is higher with the shorter work week—and hence lower level of real GDP—that it would be with the longer work week because they value their leisure more than the goods and services that would have been produced. But at the least, looking only at the change in real GDP as the sole measure of the standard of living is incorrect because that view ignores the gain in the standard of living from the increased leisure.

In the United States, many children receive day-care from commercial providers. In Africa, this is unknown; children are almost all cared for by relatives. How would this difference affect comparisons of GDP per person? This difference means that U.S. GDP per person is biased higher than GDP per person in African countries. In both the United States and in Africa children are cared for so the same service is produced in both regions. But in the United States this service is included in GDP because it is purchased in a market; however, in Africa the service is not included in GDP because it is performed as household production.

C h a p t e r

MONITORING JOBS AND INFLATION**

The Big Picture Where we have been: Chapter 5 finishes introducing macroeconomic issues and describing how key macroeconomic variables are measured. The link developed in this chapter between employment and real GDP is an important concept that helps serve as a foundation for the presentation of the aggregate production function in the next chapter. Perhaps more significantly, the explanation of the natural rate of unemployment and its relationship to potential GDP are important building blocks for the AS-AD model developed in Chapter 10 and the Phillips curve framework developed in Chapter 12. These topics also recur in Chapters 13 and 14 when fiscal and monetary policy is covered. Where we have been: This chapter increases students’ understanding of the types and sources of unemployment. It also provides students with detail on the use of the CPI to measure inflation. Alternative price measures also are introduced.

N e w i n t h e Tw e l f t h E d i t i o n The content in Chapter 5 is substantially the same as in the 11th edition. The multiple graphs and data in this chapter have all been updated through 2014. The current event topic, which can be found in the ‘Economics in the News’ section, discusses improvements in unemployment along with labor force participation in the United States for 2014. The Worked Problem describes 5 people’s labor-market situation and then asks how the BLS would classify each person and what happens to the labor force, unemployment rate, and labor force participation rate if the people’s situation changes. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 22 in Economics.

CHAPTER 5

Lecture Notes

Monitoring Jobs and Inflation • • • •

The unemployment rate, the employment-to-population ratio, and the labor force participation rate are key labor market indicators. The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment. The unemployment rate fluctuates over the business cycle. The price level and the inflation rate are measured using the CPI as well as other price indexes.

Employment and Unemployment

Current Population Survey •

•

The U.S. Census Bureau measures the population, labor force, and amount of employment. The working-age population is the total number of people aged 16 years and over who are not in jail, a hospital, or some other form of institutional care. The labor force is the sum of the employed and the unemployed. Unemployment occurs when someone who wants a job cannot find one. To be counted as unemployed, a person must be available for work and must be in one of three categories: • Without work but has made specific efforts to find a job within the previous four weeks • Waiting to be called back to a job from which he or she has been laid off • Waiting to start a new job within 30 days

Ask the students, “If I was to assign a homework assignment of estimating the unemployment rate in your city, how would you do it?” You will probably get an answer of “Google it,” but tell them that this is not an Internet mining project! Try to have some of your students suggest an in-person survey or a phone survey. Now you can walk through some of the issues economists face with data collection (questions to ask, sample size, bias, etc.). Discuss how a grocery store may be a decent place to get a random sample of people from all demographics and how a phone survey might miss some poor, unemployed person without a phone or students who do not have a land-based phone.

Three Labor Market Indicators •

The unemployment rate is the percentage of the people in the labor force who are unemployed. It equals

Number of people unemployed ´100 and Labor force = Number of people employed + Labor force

Number of people unemployed. Between 1980 and 2014 the unemployment rate averaged 6.5 percent. •

The employment-to-population ratio is the percentage of people of working age who have jobs. It equals

Number of people employed ´100. In recent years the employment-to-population ratio has Working-age population

been about 62 percent. It has fallen since 2000 and in June 2014 was 59 percent. •

The labor force participation rate is the percentage of working-age population who are members of the labor force. It equals

Labor force ´100. The labor force participation rate has been Working-age population

declining since it reached about 67 percent in 2000 and in June 2014 was 62.9 percent. Jobs and home production. It is interesting to ask students to think about appropriate measures of labor force participation over long periods of time or in very different economic arrangements. The technical definition involves spending time working for gain, or seeking work for gain. In the United States, this usually equates to work outside the home. Ask students whether women who are unpaid family workers on farms are in or out of the labor force; and then ask whether they are if they don’t work outside the home, but cook, make and wash clothing, and otherwise maintain the household for a family.

MONITORING JOBS AND INFLATION

•

• •

Marginally attached workers are people who are available and willing to work but currently are neither working nor looking for work. These workers often temporarily leave the labor force during a recession and decrease the labor force participation rate. Because they are no longer counted as unemployed, marginally attached workers lower the unemployment rate. A discouraged worker is a marginally attached worker who has stopped looking for work because of repeated failures to find a job. Economic part-time workers are people who are working part-time but would like to find full time work. These workers are not unemployed by the U-3 standard but are considered “part-unemployed.” Marginally attached workers (and discouraged workers) as well as economic part-time workers who want a full-time job are not counted as unemployed in the official unemployment rate.

Real World Examples from the Class: Ask the class if anyone has an example of a ‘discouraged worker’ or someone who has taken a part-time job even though he or she wants a full-time job. It would be unusual if no one had a story to tell.

Alternative Measures of Unemployment

The BLS creates several alternative measures of unemployment to take account of the long-term unemployed (who lose the most from unemployment) and marginally attached workers: • U–1: includes only those unemployed for 15 weeks as unemployed. • U–2: includes only job losers as unemployed. • U–3: the official unemployment rate. • U–4: adds discouraged workers to the official unemployment rate. • U–5: adds all marginally attached workers to the official unemployment rate. • U–6: adds part-time workers who want full-time jobs to the U-5 unemployment rate. • Long-term unemployment (U–1) and unemployed job losers (U–2) are about 40 percent of the unemployed on average but 60 percent in a deep recession. • Adding discouraged workers (U–4) makes very little difference to the unemployment rate, but adding all marginally attached workers (U–5) adds about one percentage point. • A really big difference is made by adding the economic part-time workers (U–6). In June 2014, adding these workers to the U-5 unemployed increased the underemployed rate to 12 percent.

II. Unemployment and Full Employment Types of Unemployment •

•

Frictional unemployment is the unemployment that arises from normal labor turnover. These workers are searching for jobs. The unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labor market or when unemployment compensation payments increase. Structural unemployment is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally lasts longer than frictional unemployment. Minimum wages and efficiency wages create structural unemployment. Cyclical unemployment is the fluctuating unemployment over the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion.

Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment. Look at your local examples. If you live in a steel-producing or car manufacturing area, for example, you can talk about local structural unemployment arising from the closing of factories due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs.

CHAPTER 5

Work through each type of employment asking whether it is good or bad for society (call to their attention that it is usually bad for the individual, but may be good long term for society) • Frictional? Good because a healthy, dynamic, economy needs new entrants to the labor force , such ascollege graduates, and freedom for people to quit a job they don’t like. • Structural? Good because a healthy, growing economy has technological change that makes some jobs obsolete. • Cyclical? Bad because it is unfortunate to have unemployment strictly because of the cyclical nature of the economy. If it were possible to maintain the same level of economic growth with less fluctuation, we would have less cyclical unemployment with a higher level of welfare. Can and should the cycle be managed? This is a big question in Macroeconomics that we will continue to tackle!

“Natural” Unemployment • •

Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment—when all the unemployment is frictional and structural. Natural unemployment as a percentage of the labor force is called the natural unemployment rate. Full employment is defined as a situation in which the unemployment rate equals the natural unemployment rate.

What Determines the Natural Unemployment Rate? • • •

•

The Age Distribution of the Population An economy with a young population has a large number of new job seekers every year and has a high level of frictional unemployment. The Scale of Structural Change The scale of structural change is sometimes small but sometimes there is a technological upheaval. When the pace and volume of technological change and when the change driven by international competition increase, natural unemployment rises. The Real Wage Rate The natural unemployment rate increases if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract the most productive workers and motivate them to work hard and discourage them from quitting). Unemployment Benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search.

There are two controversies that surround the natural unemployment rate. The first is the use of the term “natural,” which offends many who believe any unemployment is always a bad thing. From the perspective of an unemployed individual who has yet to find the job he or she wants, unemployment is bad. However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and workers and allow for technological changes that lead to economic growth. The second controversy is what level of unemployment corresponds to the natural rate. Because this number is unobserved, it must be estimated. Some estimates imply the natural rate is stable and changes only slowly over time. Others imply that most of the fluctuations in unemployment are “natural”. These differences are important for macroeconomic policy because one of the typical goals of policy is to keep the unemployment rate from making wide swings around the natural rate.

Real GDP and Unemployment Over the Cycle •

When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP. The gap between real GDP and potential GDP is called the output gap.

Students often have an innate sense of an asymmetry in business cycle fluctuations around potential GDP. In particular, students often think that the economy is almost always below potential GDP. It is important for students to understand that it is possible for the economy to temporarily rise above potential GDP so that the unemployment rate is less than natural unemployment rate. One (small) example of this state of affairs occurred in Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of a

MONITORING JOBS AND INFLATION

new job (often at higher pay!) within a few days. Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs.

III. The Price Level, Inflation, and Deflation The price level is the average level of prices. The average level of prices can be rising, falling, or stable. Inflation occurs when the price level persistently rises; deflation occurs when the price level persistently falls. The inflation rate is the percentage change in the price level.

Why Inflation and Deflation are Problems •

• •

Unexpected inflation or deflation is a problem for society because they redistribute income and wealth. Unexpected inflation benefits workers and borrowers; unexpected deflation benefits employers and lenders. They motivate people to divert resources from producing goods and services to forecasting and protecting themselves from the inflation or deflation. Unexpected deflation hurts businesses and households that are in debt (borrowers) who in turn cut their spending. A fall in total spending brings a recession and rising unemployment. Hyperinflation is an inflation rate of 50 percent a month or higher

The Consumer Price Index • • •

The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed “basket” of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics. The CPI is defined to equal 100 for a period called the reference base period. The current reference base period is 1982-1984, so the average CPI during that period was 100. In June 2014, the CPI was 237.7. Thus, since 1982-84, prices increased by 137.7 percent.

In June 2008, the CPI was 218.8 so the economy experienced deflation between June 2008 and June 2009. Deflation is very uncommon but it does occur.

Constructing the CPI •

The BLS conducts an infrequent survey of consumers to determine the average “basket” of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost Cost in the base period. Item Quantity Price (dollars) • For example, suppose the initial survey shows that the Books 2 $30 $60 CPI basket is 2 books and 20 coffees. The initial base Coffee 20 $2 $40 period prices and quantities are in the table to the Basket $100 right. In this base period, say 2005, the cost of the CPI basket is $100. • Next suppose that the BLS survey taken one month in 2015 reveals that the price of a book is $35 and the price of a coffee is $3. These 2015 prices and the initial base period quantities are in the table to the right. In this period the cost of the CPI basket is $130. Cost • Using these data, the CPI equals ($130  $100)  100, Item Quantity Price (dollars) or 130. So between the base period and the current Books 2 $35 $70 period, the CPI has risen by 30 percent. Coffee 20 $3 $60 Basket $130 Measuring the Inflation Rate • The inflation rate is the percentage change in the price level from one year to the next. In a formula,

æ CPI this year - CPI last year ö Inflation rate = ç ÷´100. CPI last year è ø

•

In June 2014, the CPI was 237.7. In June 2013, the CPI was 232.9. Using the formula, between 2013 and 2014, the inflation rate was 2.1%.

CHAPTER 5

The Biased CPI •

The CPI has four biases that lead it to overstate the inflation rate. The biases are: • New Goods Bias: New goods are often more expensive than the goods they replace. • Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation. • Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases. • Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently.

The Magnitude and Consequences of the Bias • •

The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about 1.1 percentage points a year. Any bias in the CPI matters because many contracts and payments are indexed to the CPI, including Social Security. Close to 1/3 of government outlays are linked to the CPI.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is hard to adjust social security payments for the bias, so the current plan is reduce the measurement bias in the CPI, for instance by revising the basket more frequently to reflect new goods and substitution changes. In 2010, President Obama proposed a two year wage freeze on all federal employees. Their pay is traditionally linked to the CPI and this freeze was estimated to save the federal government $2 billion dollars! Alternative Price Indexes • Three alternative to the CPI are: • Chained CPI: The chained CPI is calculated similarly to chained GDP (discussed in the Mathematical Note to the previous chapter.) The chained CPI incorporates both new goods and the substitution of one good for another and so overcomes these sources of bias. But the difference between the chained CPI and regular CPI is small: on average, since 2000 the chained CPI is 0.7 percentage points lower per year. • Personal Consumption Expenditure Deflator (PCE deflator): The deflator from nominal and real consumption expenditure. The PCE deflator equals

•

Nominal consumption expenditure ´100. Real consumption expenditure

The basket of goods in the PCE deflator is broader than the basket in the CPI because it includes all consumption expenditure. GDP Deflator: Similar to the PCE deflator, the GDP deflator is from nominal and real GDP. The GDP deflator equals

Nominal GDP ´100. The difference between the GDP deflator and regular CPI is Real GDP

small: on average, since 2000 the GDP deflator is 0.4 percentage points lower per year.

Core CPI Inflation •

The inflation rate is often volatile. To strip out the volatile elements and focus on the underlying trend inflation, the core inflation rate is used. The core inflation rate is the CPI inflation rate excluding volatile elements. The core CPI inflation rate equals the percentage change in the CPI excluding food and fuel prices.

Real Variables in Macroeconomics •

Real variables are measured in constant prices and can be considered to be measured in units of “goods and services.” In general nominal variables, such as the nominal wage rate and nominal GDP, are deflated to become real variables using the formula real variable =

Nominal variable ´100. The exception to Price level

this rule is the nominal interest rate. (In two chapters the students see that the real interest rate = nominal interest rate − inflation rate.)

MONITORING JOBS AND INFLATION

The Economics in the News discusses “Job Growth in the Recovery.” It shows how the unemployment rate has fallen but there has been little change in the labor force participation rate.

CHAPTER 5

Additional Problems 1.

Michigan: Unemployment Record Holder Michigan now holds a dubious record: It leads the U.S. in joblessness. The state’s unemployment rate was 8.5% in May while the U.S. unemployment rate was only 5.5%. The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour. But even though the official unemployment numbers look awful, the reality is worse. The official number does not reflect those who have given up looking for a job. Business Week, June 24, 2008 In 2010, at 13.6 percent of the state’s labor force, Michigan had the nation’s highest official unemployment rate. But in 2012, Michigan’s unemployment rate fell to 9 percent, a larger fall than that in the United States as a whole. Around 11,000 businesses in Michigan produce high-tech scientific instruments and components for defense equipment, energy plants, and medical equipment. a. Why was the reality of the unemployment problem in Michigan actually worse than the 8.5 percent unemployment rate statistic in 2008? b. Was this higher unemployment rate in Michigan frictional, structural, or cyclical? Explain. c. What factor led to the favorable 2012 employment results in Michigan compared to the U.S. average? Was this a frictional, structural or cyclical factor? Explain.

The Great Inflation Bias In 1996 the Boskin Commission was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%. The commission described four biases in the way the CPI was determined. Fortune, April 3, 2008 a. What are the main sources of bias that are generally believed to make the CPI overstate the inflation rate? By how much did Boskin estimate the CPI overstates the inflation rate? b. Do the substitutions among different kinds of meat make the CPI biased up or down? c. Why does it matter if the CPI overstates or understates the rate of inflation?

Solutions to Additional Problems 1.

c. 2.

The unemployment problem is worse than the 8.5 percent unemployment rate indicates for three reasons. First, the unemployment rate does not include marginally attached workers, such as discouraged workers. Second, the unemployment rate does not include part-time workers would want full-time jobs. Finally the unemployment rate counts only workers who are currently unemployed. If a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the unemployed. The higher unemployment rate in Michigan is structural. Consumers are decreasing the number of U.S.made large cars in favor of foreign-made smaller cars. And to the extent that consumers are buying U.S.made cars, they are generally smaller cars, many of which are not manufactured in Michigan. So the skills possessed by Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs. The improved labor statistics for Michigan reflected a structural factor in that industries with goods in high demand were able to move to Michigan and use retrained skilled workers for their production. The Boskin Commission presented four reasons why the CPI overstates the inflation rate. The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices

MONITORING JOBS AND INFLATION

rise). The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points. Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions. For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to chicken. Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef. The CPI ignores this substitution and assumes that people buy the same amount of beef as before. Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef. The article says that when consumers respond to a change in relative price by switching from one type of meat to another, the price of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one. However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat. Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change. Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions. For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them. Conversely if the CPI understates inflation, then workers are paid too little. Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate.

Additional Discussion Questions 1.

Should discouraged workers be counted as part of the unemployment rate? By definition, discouraged workers should not be counted as “officially” unemployed because they are not searching for employment. However, the real issue is whether the definition is appropriate. On the one hand, these people have given up looking for a job because they cannot find one. On the other hand, because these people have given up looking for a job they are quite unlikely to find one. Discouraged workers are different from other unemployed workers because discouraged workers are unlikely to find work since they have stopped search. All in all, it is probably better that discouraged workers not be counted directly with other unemployed workers because their low likelihood of finding work makes them fundamentally different than other unemployed workers.

What harm is there in calling a part-time worker that wants full-time work unemployed? Unlike discouraged workers or marginally attached workers, these people are employed. Interpretation of these statistics needs to be mindful that people may have a distorted view of what they want versus what they will do. The U-3 standard is based on their current situation and gives us actual knowledge of the current state of employment. The U-6 measure, which includes these part-time workers, might have more uncertainty in its level. Nonetheless, it is helpful to see how all of the various alternative measures compare and useful data can be obtained from all of them.

“Unemployment is bad for the unemployed individual and bad for the nation. Hence the government should force the unemployment rate to 0 percent.” Comment on this assertion, discussing both its feasibility and its desirability. The assertion is highly unfeasible. The laws necessary to drive the unemployment rate to 0 percent would be draconian. For instance, no college student would be allowed to graduate until he or she had a job lined up. Once employed, workers would be forbidden to change jobs unless they had another job already arranged. Furthermore consumers would be forbidden to change their consumption baskets because if enough people changed, a firm might go bankrupt…allowing its workers to become unemployed. The assertion is similarly undesirable. Some unemployment is productive for the individual because

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it allows the worker to leave one job from which he or she is dissatisfied, to look for another job that will be a better match for the worker’s talents and skills. 4.

How can the unemployment rate be less than the natural rate? The unemployment rate can be less than the natural unemployment rate when the cyclical unemployment rate is negative. This outcome can occur when the economy is in a strong expansion. When the economy is growing rapidly, unemployed workers find jobs quickly. In many instances the match between worker and job will be poor: The firm is eager to find a worker and the worker accepts the offered job to end his or her spell of unemployment. But then as time passes the match is discovered to be poor— the worker does not perform well and/or dislikes the job. This situation is bad for the business and bad for the worker.

How do you think the business cycle affects the duration of unemployment? On the average, unemployment has a longer duration in recessions and a shorter duration in expansions.

Why is a change in the age structure of the population, increasing the proportions of young or old workers in the labor force, likely to change the natural unemployment rate? When the proportion of young workers increases, the natural unemployment rate rises because young workers change jobs more frequently than experienced workers. As these young workers change their jobs, frictional unemployment and, therefore, natural unemployment rise. Older workers are less prone to change jobs because they have had more time to find a good job match. The frictional unemployment rate is lower and so, too, is the natural unemployment rate when the proportion of old workers in the labor force is higher.

What is the natural unemployment rate? What is the controversy concerning its measurement? The natural unemployment rate is the unemployment rate when the economy is at full employment. The natural rate is comprised of frictional and structural unemployment. One controversy arises because it is difficult to measure frictional and structural unemployment. Another controversy arises because the issue of whether discouraged workers and marginally attached workers should be included in the natural rate is unclear. While the number of these workers can be measured with reasonable accuracy, whether they should be included in the natural rate is controversial.

C h a p t e r

ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 6 focuses on economic growth. It uses the definitions and concepts of aggregate income and real GDP presented in Chapter 4 as well as tying economic growth in the macroeconomy to the PPF of Chapter 2. Where we are going: Chapter 6 is the first of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on finance and investment, money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 6 provides the long run fundamental variables and results that need to be remembered as various other models are developed in future chapters. Chapter 6 (and Chapter 7) is particularly useful in Chapter 13 when the supply-side effects of fiscal policy are covered.

N e w i n t h e Tw e l f t h E d i t i o n

The chapter’s content and coverage are about the same as the 11 edition. All the data are updated through 2014. The Worked Problem gives data about China’s real GDP and population in two years and then asks the students to calculate the growth rate of China’s real GDP growth rate and its standard at living. The question also asks the students to use the Rule of 70 to approximate how long it will take for China’s standard of living to double. The solutions work step-by-step through the calculations necessary to answer the questions. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 23 in Economics.

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Lecture Notes

Economic Growth You can start your discussion of this chapter by listing on the board or on an overhead various countries ranked from highest per capita real GDP to lowest. It is a real eye opener for students to consider income per person because it really shows how fortunate we are in the United States. Tell your students that in the 1960s countries like Hong Kong, Singapore and Japan used to rank around where China ranks today. Explain that this extraordinary growth is part of what motivated economists over the last 20-30 years to try to deduce how this type of growth can occur. Is it possible the United States could do something differently to grow at those growth rates? Is the neoclassical model correct in its prediction that there will be a global equilibrium in which all nations have the same real GDP per person? Then leave your students with the fact that China is 200 times the population of Hong Kong and 4 times the population of the United States. This brings the obvious question: Should we be concerned? • • •

Economic growth leads to large changes in standards of living from one generation to the next. Economic growth rates vary across countries and across time. There are different economic theories to explain these variations in growth rates.

The Basics of Economic Growth •

The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to: Real GDP growth rate =

Real GDP in current year - Real GDP in past year ´100 Real GDP in past year

•

The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person. • The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate. Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an expansion phase of the business cycle or potential GDP might be increasing. •

The movement from point A to point B reflects an expansion phase of the business cycle. It occurs with no change in production possibilities. Such an expansion is not economic growth.

•

The increase in aggregate production reflected by the movement from point B on PPF0 to point C on PPF1 is economic growth—it reflects an expansion of production possibilities shown by an outward shift of the PPF.

The Rule of 70 is useful for determining how long it will take for a variable to double. The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable. Run through an example of the rule of 70 that does not relate to economic growth. Examples: If tuition rates rise at 6 percent per year, how long will it take it to double? 70/6 = 11.67 years. If you invest $10,000 at 12 percent interest, how long will it take to double your money? 70/12 = 5.83 years. Compound Interest: You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per

ECONOMIC GROWTH

person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year.

II. Long-Term Growth Trends Long-Term Growth in the U.S. Economy The growth of real GDP per person in the United States has fluctuated but has averaged 2 percent per year over the last century. The growth rate was 1.8 percent prior to the Great Depression and 2.1 percent after World War II.

Real GDP Growth in the World Economy Economic growth varies across countries. Among richest countries, there seems to be some convergence of real GDP per person but most other countries show less evidence of convergence. The “Asian Miracle” is the fast rate of convergence for Hong Kong, Singapore, Taiwan, Korea, and China. Is there convergence or divergence in standards of living? What is the role of economic growth for economic inequality? These are highly controversial questions. Most anti-globalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living over the past 50 years. This fact is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity. Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” by becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest. This result might not be a coincidence.

III. How Potential GDP Grows Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the fullemployment amount. To determine potential GDP we use the aggregate production function and the aggregate labor market.

The Aggregate Production Function •

•

The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. The figure shows an aggregate production function. The additional real GDP produced by an additional hour of labor when all other influences on production remain the same is subject to the law of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases. The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes.

The Labor Market The Demand for Labor • The demand for labor is the relationship between the quantity of labor demanded and the real wage rate. • The real wage rate equals the money wage rate divided by the price level. The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns.

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•

Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces. There is a negative relationship between the real wage rate and the quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward sloping. The Supply of Labor • The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. • An increase in the real wage rate influences people to work more hours and also increases labor force participation. These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping. Labor Market Equilibrium and Potential GDP • In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded. In equilibrium, the labor market is at full employment. In the figure, the equilibrium quantity of employment is 200 billions of hours per year. • Potential GDP is the level of production produced by the full employment quantity of labor. In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 200 billion hours per year means that potential GDP is $13 trillion.

What Makes Potential GDP Grow? Potential GDP grows when the supply of labor grows and when labor productivity grows. Growth of the Supply of Labor • The supply of labor increases if average hours per worker increases, if the employment-to-population ratio increases, or if the working-age population increases. Of these factors, in the United States over the past years the first two have offset each other. • Only increases in the working-age population can cause persisting economic growth. Persisting increases in the working-age population result from population growth. • An increase in population increases the supply of labor, which shifts the labor supply curve rightward. The real wage rate falls and the quantity of employment increases. The increase in employment leads to a movement along the production function to a higher level of potential GDP. An Increase in Labor Productivity • An increase in labor productivity increases the demand for labor and shifts the production function upward. • As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate, from $20 to $30 per hour in the figure, and increases the level of employment, from 200 billion hours per year to 300 billion hours per year. • The bottom figure shows that the production function has shifted upward, from PF0 to PF1. Combined with the increase in employment to 300 billion hours per year, the increase in labor productivity increases potential GDP from $10 trillion to $15 trillion. • An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living.

ECONOMIC GROWTH

IV. Why Labor Productivity Grows Preconditions for Labor Productivity Growth •

•

The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied. Property rights create incentives save and invest in new capital and develop new technologies. Monetary exchange creates incentives for people to specialize and trade. Persistent growth requires that people face incentives to create: • Physical Capital Growth: Saving and investing in new capital expands production possibilities. • Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance. • Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth.

The Causes of Economic Growth: A First Look; The limits of economics. The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about. The preconditions. The three preconditions for growth—markets, property rights, and monetary exchange—are all essential to create acceptable levels of risk and low enough transaction costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example. Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.

V. Is Economic Growth Sustainable? Theories, Evidence, and Policies. Classical Growth Theory Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. •

A problem with the classical theory is that population growth is independent of economic growth rate.

Classical growth theory is based on the work of Thomas Malthus, an economist from the early nineteenth century. Very few modern-day economists would refer to themselves as Malthusians. But, as the textbook says, there are many other people today who are Malthusians. The persistence of this viewpoint represents what one can only refer to as the triumph of despair over experience. At some point in history, Malthusian theory might

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have been applicable. But certainly since the industrial revolution, parents have chosen to concentrate on the quality of children not the quantity. And this shift in emphasis only gets stronger as economic growth advances. Thus, the assumption that the population growth rate is primarily determined by economic growth with a positive relationship has no basis in reality. Indeed, some of the richest countries in the world, such as Sweden and Japan, have some of the lowest birth rates.

Neoclassical Growth Theory Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. • • • • •

A technological advance increases productivity. Real GDP per person increases. The technological advances increase expected profit. Investment and saving increase so that capital increases. The increase in capital raises real GDP per person. As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic growth stops. The improvement in technology permanently increases real GDP per person. A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level. But in reality, convergence does not seem to be taking place for all nations.

An Economics in Action detail discusses the key role played by intellectual property rights. The section focuses on the start of the Industrial Revolution and looks at how England’s patent system helped sustain the revolution.

New Growth Theory New growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely. • • • • • •

•

The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition then destroys the profit. It also stresses that knowledge can be used by everyone at no cost and knowledge is not subject to diminishing returns. The ability to innovate means new technologies are developed and capital accumulated as in the neoclassical model. The production function shifts upward. Real GDP per person increases. The pursuit of profit means that more technological advances occur and the production function continues to shift upward. Nothing stops the upward shifts of the production function because the lure of profit is always present. The ability to innovate determines how capital accumulation feeds into technological change and the resulting growth path for the economy. Productivity and real GDP constantly grow.

The Classical Model. Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises. You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor— complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before. New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the conversion of media to digital formats for all of our digital devices.

ECONOMIC GROWTH

Historical development of theories and an aside. The three growth theories studied in this chapter—classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.) Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory. Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth also is exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference—the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model. New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances. Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.)

The Empirical Evidence on the Causes of Economic Growth •

Economists have studied the growth rate data for more than 100 countries for the period since 1960 and explored the correlations between the growth rate and more than 60 possible influences on it. The conclusion of this data crunching is that most of these possible influences have variable and unpredictable effects, but a few of them have strong and clear effects. Amongst the strongest are: • International Trade: Nations that are open to trade grow more rapidly • Investment: Nations that have more investment in human capital and physical capital grow more rapidly. • Market Distortions: Nations that have more exchange rate controls, price controls, and black markets grow more slowly. • Economic System: Capitalist nations grow more rapidly. • Politics: Nations that support the rule of law and protect civil liberties grow more rapidly. Nations that have revolutions, military coups, or fight wars grow more slowly. • Region: Nations located far from the equator grow more rapidly; nations in Sub-Sahara Africa grow more slowly.

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Policies for Achieving Faster Growth •

Growth theory and the empirical evidence suggest some policies that might stimulate growth: • Stimulate saving, to increase capital accumulation • Stimulate research and development, to increase technology • Improve the quality of education, to increase human capital. • Provide international aid to developing nations. However studies show that aid tends to get diverted to consumption. If the objective is to increase growth, then the aid must be carefully directed. • Encourage international trade, to increase international specialization

Economic Freedom of the World Index: http://www.freetheworld.com/powerpoint.html I like to bring in Economic Freedom to the discussion of this chapter. The website link above brings you to power point presentations that refer to the data collected on five categories that make up a single index number that allows the researchers to rank countries according to the amount of economic freedom. Students relate very easily to the correlations drawn between economic freedom and important variables like life satisfaction, income, life expectancy, political rights, civil rights, etc. The chapter concludes with an Economics in the News analysis of economic growth in South Africa compared to its neighbor, Botswana. Botswana’s economic growth is significantly more rapid than that in South Africa because Botswana has well defined and respected property rights. One political party in South Africa proposes distributing shares in government owned companies, promoting joint ownership in the agricultural sector, and overhauling the nation’s labor market by increasing workers’ skills.

ECONOMIC GROWTH

Additional Problems 1.

If in 2008 China’s real GDP is growing at 9 percent a year, its population is growing at 1 percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2008?

Underinvesting in the Future For the past half century, South Korea, Hong Kong, Taiwan and Singapore have averaged the highest consistent economic growth rates in the world. But in one vital respect these countries may have the worst record of investment in the future since homo sapiens evolved: They have the lowest fertility rates in the world. For economic growth, raising children is at least as raising new buildings. International Herald Tribune, July 7, 2008 a. Explain why the rapid growth rates of these Asian economies might be masking a misallocation of resources that will result in lower income per person in the future. b. Explain the difficulties in balancing goals for immediate economic growth and future economic growth.

Solutions to Additional Problems 1.

China’s real GDP is growing at 9 percent a year and its population is growing at 1 percent a year, so China’s real GDP per person is growing at 8 percent a year. The rule of 70 tells us that China’s real GDP per person will double in 70/8 = 8¾ years. So at this rate China’s real GDP per person will be twice what it is in 2008 in 2017. a.

The new growth theory concludes that population growth increases economic growth because population growth means more people to develop new knowledge and new technologies. The Asian economies are currently growing rapidly but their population growth is extremely slow. The new growth theory predicts that the slow population growth means that in the future their economic growth rates will slow. People have a limited amount of time, which they can spend at work, perhaps developing new knowledge or new technology, or at home, raising children. If they spend their time at work, immediate economic growth will be higher than if they spend the time at home. But if they spend their time at home raising children, the future economic growth will be higher as the population growth is higher.

Additional Discussion Questions 11. What has been the average annual growth in real GDP per person in the United States over the last 100 years? Over the past 50 years, during which periods has annual growth been more rapid than the average? When has it been slower? The average annual growth rate in real GDP per person in the United States has been 2 percent over the past 100 years. Growth was most rapid in the 1960s. It was also rapid in the 1990s. Growth slowed in the 1970s. This slowdown is the “productivity growth slowdown.” 12. What is an aggregate production function? A change in what factor or factors cause a movement along the aggregate production function? A change in what factor or factors shifts the aggregate production function? The aggregate production function shows the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. Changes in employment create movements along the aggregate production function. Changes in other factors of production, such as capital, as well as changes in technology, shift the aggregate production function. 13. Define labor productivity. Why is labor productivity important? Labor productivity is equal to real GDP divided by aggregate labor hours, so it tells the quantity of real GDP produced by an

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hour of labor. Labor productivity is important because it is directly related to the standard of living. The standard of living is real GDP per person so labor productivity is essentially the “standard of living per worker.” Therefore an increase in labor productivity means there is an increase in the standard of living. 14. Explain why reducing uncertainty with respect to property rights is regarded as likely to stimulate economic growth. Necessary preconditions for economic growth are physical capital growth, human capital growth, and technological advances. However people are willing to invest in physical capital and human capital only if they believe they will be able to reap the rewards from their investment. If property rights are unsecure, so that investors are unsure if they will gain from the investment, then people are much less likely to invest in either physical capital or human capital. Uncertainty about property rights therefore will dramatically slow economic growth because it will slow growth in physical and human capital. The story about technology is similar: People are willing to invest in new technology only if they believe they personally will reap the rewards. Once again, reducing uncertainty about property rights will increase people’s incentives to develop new technology, which will lead to more rapid economic growth. 15. What role do technological advances play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person. But whether the increase is temporary or permanent differ among the models. In the classical growth model a technological advance temporarily raises economic growth and real GDP per person. After the advance economic growth ceases. And the ensuing increase in population drives real GDP per person back to the subsistence level. In the neoclassical growth model a technological advance temporarily raises economic growth and permanently raises real GDP per person. After the advance economic growth ceases. But the increase in the capital stock brought about by the advance allows real GDP per person to remain permanently higher. In the new growth theory a technological advance permanently increases economic growth and real GDP per person. In the new growth theory a technological advance creates new profit opportunities so that pursuit of profit leads to still more technological advances and investment in capital. As a result economic growth persists. And with the persistence of economic growth, the increase in real GDP per person is permanent and increasing over time.

C h a p t e r

The Big Picture

FINANCE, SAVING, AND INVESTMENT**

Where we have been: This chapter builds on the definition of real GDP from Chapter 4 to explain how investment is financed. It also uses the demand and supply model explained in Chapter 3. The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment. It also discusses how government actions affect this market. Where we are going: Chapter 7 is the second of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 7 is used in many of the following chapters. For instance the result that the real interest rate is determined in the loanable funds market is important in the next chapter to help determine the long-run effects from changes in the quantity of money. The loanable funds model also is used in Chapter 13 when examining the supply-side effects of fiscal policy.

N e w i n t h e Tw e l f t h E d i t i o n A substantial change in this chapter is the omission of the global financial market section which has been moved to Chapter 9. The chapter now concentrates exclusively on the domestic loanable funds market. There also have been substantial changes to the Economics in Action boxes in this chapter reflecting data and events that have occurred since 2008 but the main content and flow of the chapter is very similar to the 11th edition. The Federal Reserve was added as a key financial institution. The first Economics In Action box has been expanded with new graphs added highlighting home mortgage debt. Two new Economics In Action boxes show real vs. nominal interest rates and the allocation of loanable funds to various agents. The Global Loanable Funds Market Section has been moved to chapter 9. The Economics In The News has 2014 article discussing interest rates on government bonds. The Worked Problem explores the loanable funds market by giving data on the nominal interest rate, real interest rate, investment, and government budget deficit in 2005 and 2007. The questions ask the students the inflation rate in the two years, how the price of bonds changed between the years, and what happened to the demand for loanable funds between the years. It also asks them about crowding out and its effect on saving and investment. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 24 in Economics.

CHAPTER 7

Lecture Notes

Finance, Saving, and Investment • •

The supply and demand for loanable funds determine the real interest rate and the quantity of loanable fund and investment. Government budget deficits might also affect the real interest rate and quantity of investment.

Financial Institutions and Financial Markets

Finance and Money; Capital and Financial Capital •

•

Finance and money differ: • Finance refers to providing the funds used for investment. • Money refers to what is used to pay for goods and services. Capital and financial capital differ: • Capital consists of physical capital, the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services. • Financial capital is the funds that firms use to buy physical capital.

Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

Capital and Investment; Wealth and Saving •

The quantity of capital changes because of investment and depreciation. Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.

A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables. Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept, such as wealth and saving. For use with the capital stock, draw a bucket with a “K” on it. At a point in time there is fixed amount of capital in the bucket. Over some time period, investment flows in the top and depreciation flows out. The net effect of these two flows leaves the bucket higher or lower at the end of that time period. •

Wealth is the value of all the things people own; saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Wealth also changes when the market value of wealth changes.

Financial Capital Markets Financial markets transform saving and wealth into investment and capital. • Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market. • Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgage-backed securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008. • Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit.

Financial Institutions •

A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks,

FINANCE, SAVING, AND INVESTMENT

government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies. Financial Crisis: The Economics in Action section studies the Fall of 2008 and the biggest financial crisis since the Great Depression. Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.

Insolvency and Illiquidity • •

A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business. A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.

Interest Rates and Asset Prices • •

Stocks, bonds, short-term securities, and loans are financial assets. The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price.

$2.50 ´100=5.0 $50.00

•

If an asset’s price is $50 and it pays $2.50 in interest, the interest rate is

•

percent. If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.

It is helpful to show explicitly how the market price of a bond is determined by the current interest rate. Using an example of government bond will be useful for future chapters on monetary and fiscal policy. Explain that a bond is an “IOU” from the issuer and its basic components of are its term, face value and coupon payment. For example, a bond might have a $10,000 face value with a coupon payment of $500 for the next 5 years. Point out to your students that this coupon payment means that the bond is essentially paying an interest rate of 5 percent for the next five years…at least as long as its price is $10,000. Explain how the bond can be traded in the secondary market and ask them what they think the bond’s price would be if the market interest rate rose to 6 percent. Make clear that when the interest rate rises to 6 percent, which means that “new” government bonds with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment. Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment. Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen from $10,000 to something less. In other words, an increase in the interest rate has lowered the price of (old) bonds!

CHAPTER 7

II. The Loanable Funds Market The loanable funds market is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.

Funds that Finance Investment • •

The funds that finance investment are from household saving, the government budget surplus, and international borrowing. Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X − M). Combining shows that C + S + T = C + I + G + (X − M), which can be rearranged to show how investment is financed:

I = S + (T − G) + (X − M).

This formula shows that investment is financed using private saving, the government budget surplus, (T − G), and borrowing from the rest of the world, (X − M ). • The sum of private saving, S, plus government saving, (T − G), is national saving. • If we export less than we import, (X − M) is negative and we borrow (M − X) from the rest of the world. • If we export more than we import, (X − M) is positive and we loan (X − M) to the rest of the world.

The Real Interest Rate •

The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.

Giving a numeric example of why the real interest rate and nominal interest rate differ can be enlightening for your students. Suppose you have $100 this year and you can invest it at a (nominal) interest rate of 10 percent. One year later you will have $110, that is, 10 percent more dollars. If the price of a cheeseburger is $1 this year you can buy 100 cheeseburgers. But if one year later the price level rose from 100 to 108 and the price of cheeseburgers rose at this average rate, then the cheeseburgers will cost you $1.08. Next year your $110 will only buy about 102 cheeseburgers ($110/$1.08). The purchasing power of your 10 nominal interest rate is only about 2 more cheeseburgers, a 2 percent real interest rate! Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.

The Demand for Loanable Funds •

•

The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment. Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit.

FINANCE, SAVING, AND INVESTMENT

•

The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. • The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate. • Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism. The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.

The Supply of Loanable Funds • • • •

The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving. The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping. Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward.

Equilibrium in the Loanable Funds Market •

As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied. In the figure, the equilibrium real interest rate is 5 percent and the equilibrium quantity of loanable funds is $2.0 trillion.

Changes in Demand and Supply •

Changes in either demand or supply change the real interest rate and the price of financial assets. • If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase. • If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase. • Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.

•

The Economics in Action feature uses the loanable funds market to examine the home price bubble that helped lead to the financial crisis. Between 2001 and 2005, a massive increase in the supply of loanable funds lowered the real interest rate and led to many people purchasing homes. As the price of homes rose, the demand for loanable funds increased to try to take advantage of the price rise. The increase in the demand increased the real interest rate, which put many homeowners in financial difficulty and ultimately lead to defaults and foreclosures.

CHAPTER 7

III. Government in the Loanable Funds Market A Government Budget Surplus •

Changes in the government surplus can shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow ($0.4 trillion). The surplus adds to private saving and so the supply of loanable funds curve becomes SLF. Without the budget surplus, the real interest rate is 6 percent and the quantity of loanable funds and investment is $2.0 trillion; with a budget surplus, the real interest rate is 5 percent and the quantity of loanable funds and investment is $2.2 trillion.

A Government Budget Deficit •

• •

Changes in the government deficit can shift the demand for loanable funds curve. In the figure, PDLF is the private demand for loanable funds curve. The government has a budget deficit equal to the length of the arrow ($0.4 trillion). The deficit adds to private demand and so the demand for loanable funds curve becomes DLF. Without the budget deficit, the real interest rate is 5 percent and the quantity of loanable funds and investment is $2.0 trillion; with the budget deficit, the real interest rate is 6 percent, the quantity of loanable funds is $2.2 trillion, and investment is $1.8 trillion. The tendency for a government budget deficit to decrease investment is called a crowding-out effect. The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit. To the extent that the RicardoBarro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit.

The Economics in the News section examines how interest rates on government securities fell during 2014. The analysis points out that the supply of loanable funds increased in 2014 while the demand decreased. These changes lowered the real interest rate.

FINANCE, SAVING, AND INVESTMENT

Additional Problems 1.

Government expenditure decreases by $100 billion. a. If there is no Ricardo-Barro effect, explain how loanable funds, saving, investment, and the real interest rate respond to this fiscal policy. b. How does your answer in part a depend on the strength of the Ricardo-Barro effect?

Figure 7.1 shows the market for loanable funds. The government is running a budget surplus of $900 billion. a. Show the effect of a $400 billion decrease in the government budget surplus if there is no RicardoBarro effect. How much investment is crowded out by the fall in the surplus? b. How does the Ricardo-Barro effect change the results?

IMF Warning Over Slowing Growth Turmoil in the world’s financial markets may well slow global economic growth. BBC News, October 10, 2007 Explain how turmoil in global financial markets might affect the demand for loanable funds, investment, and global economic growth in the future.

Solutions to Additional Problems 1.

The decrease in government expenditure by $100 billion increases the supply of loanable funds, which increases the equilibrium quantity of loanable funds. Compared to what otherwise would have been the case, the decrease in government expenditure lowers the real interest rate and increases investment. The stronger the Ricardo-Barro effect, the less the increase in the supply of loanable funds as taxpayers expect future taxes to be lower due to the decrease in government expenditures. The smaller the increase in the supply of loanable funds, the smaller the changes in loanable funds, the real interest rate, and investment.

CHAPTER 7

Figure 7.2 shows the effect of the $400 billion decrease in the government surplus. The government deficit decreases saving by $400 billion and so shifts the supply of loanable funds curve leftward by $400 billion. As the figure shows, the equilibrium real interest rate rises from 5 percent to 6 percent and the equilibrium quantity of loanable funds decreases from $2.0 trillion to $1.8 trillion. So the $400 billion decrease in surplus crowds out (decreases) $200 billion of investment. b. The Ricardo-Barro effect says that people change their saving to offset the effect of changes in the government budget balance. In the extreme, people increase their saving by the full amount of the decrease in surplus, in which case the supply of loanable funds curve does not shift and so investment and the real interest rate do not change. In a less extreme case, the saving increase offsets only some of the decrease in surplus, so the supply of loanable funds curve still shifts leftward, but by a smaller amount. As a result, the real interest rises less and investment decreases less that they would in the absence of the Ricardo-Barro effect. The turmoil in financial markets leads some people to decrease their saving because of fear that they might lose these funds due to the turmoil; in other words, default risk increases. As a result, the supply of loanable funds decreases, which pushes up the real interest rate. The primary source demanding loanable funds is business firms who want these funds to make investment. If the real interest rate rises, the quantity of loanable funds demanded decreases as businesses cancel no-longer profitable investments. With less investment there will be less capital and so the growth in potential GDP slows.

Additional Discussion Questions 11. What is the difference between “insolvency” and “illiquidity”? Insolvency occurs when a firm has negative net worth; that is, the firm’s liabilities—what it owes—exceed the firm’s assets—what it owns. Illiquidity occurs when a firm does not have enough cash to meet a sudden demand for repayment of what it has borrowed. The situations are different: A firm can be insolvent and liquid. A firm can also be solvent and illiquid. 12. Explain why and how investment depends on the real interest rate. The real interest rate is the opportunity cost of investment. A firm that borrows funds to make an investment faces the real interest as the opportunity cost of its investment because the real interest rate determines the purchasing power—the amount of goods and services—that a firm must repay on its loan. A firm that uses its own funds to make an investment also faces the real interest rate as the opportunity cost of its investment because the firm could loan the funds to others and collect as its return the real interest rate. Because the real interest rate is the opportunity cost of investment, an increase in the real interest rate decreases the quantity of investment firms demand. 13. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the real interest rate to the equilibrium real interest rate? If the real interest rate is higher than the equilibrium real interest rate, there is a surplus of loanable funds. In this case lenders cannot loan all the funds they want. In order to loan their funds, loaners reduce the real interest rate they charge and the real interest falls to the equilibrium real interest rate. If the real interest rate is lower than the equilibrium real interest rate, there is a shortage of loanable funds. In this case borrowers cannot borrow all the funds they want. In order to borrow their funds, borrowers raise the real interest rate they will pay and the real interest rises to the equilibrium real interest rate.

C h a p t e r

MONEY, THE PRICE LEVEL, AND INFLATION**

The Big Picture Where we have been: Chapters 6 and 7 focused on the markets for labor and capital, both real resources used in the production of real GDP. This chapter now shifts gears to study money and how money impacts markets. Because Chapter 8 is the first chapter on money, it introduces a lot of new material. The discussion of the market for money relates back to the supply and demand model in Chapter 3. Where we are going: Chapter 8 is the first of two chapters that examine money and the economy. This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money. Chapter 14 returns to these topics to study monetary policy. Chapter 8 also is the 3rd of 4 chapters that cover the economy in the long run. The next chapter looks at the exchange rate and balance of payments.

N e w i n t h e Tw e l f t h E d i t i o n An At Issue feature discusses fractional reserve requirements and the history of supporters of 100 percent reserve banking. The data and figures in the chapter are updated to reflect 2014 data. The section “What Do Depository Institutions Do” has been slightly modified to more clearly define commercial bank assets. The Economics In The News feature has a 2014 article about banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing. The Worked Problem at the end of the chapter gives data about the amount of currency, checkable deposits, savings deposits, time deposits, and money market mutual funds and other deposits in June 2014. The students are asked to calculate of M1, M2, the monetary base, the currency drain and banks’ reserve ratio, and the M1 and M2 money multipliers. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 25 in Economics.

CHAPTER 8

Lecture Notes

Money, the Price Level, and Inflation • • • •

Money is anything that is used as a means of payment. Banks play a major role in creating money but this process is ultimately controlled by the Federal Reserve. In the short run, equilibrium in the money market determines the nominal interest rate. In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate.

What Is Money?

The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why. •

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions: • Medium of exchange • Unit of account • Store of value

Medium of Exchange A medium of exchange is any object that is generally accepted in exchange for goods and services. Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services. The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell. When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for Michael was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction. Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock. By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

MONEY, THE PRICE LEVEL, AND INFLATION

Unit of Account Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services.

Store of Value Money serves as a store of value because it can be held and exchange later for goods and services. During the Great Depression there was deflation so the real return on money was positive. Thus, many people held money as an asset and did not immediately use it to spend on goods and services. This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it. Concerns about deflation have been revived in recent years. Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation. One of the more interesting suggestions by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon. It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is interesting.

Money in the United States Today • • •

•

Money consists of currency (the notes and coins held by individuals and businesses) and deposits at banks and other depository institutions. Deposits are also money because they can be converted into currency and because they are used to settle debts. M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses. M2 consists of M1 plus time deposits, saving deposits, and money market mutual funds and other deposits. M2 is much larger than M1, $11,423 billion versus $2,857 billion in June, 2014. M2 includes liquid assets that are not means of payment. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. The assets in M2 are generally quite liquid. Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits. Credit cards are not money—they are IDs that allow an instant loan.

Fiat money. Pull out a dollar bill, wave it at the class and ask, “What backs our currency?” You should get someone to state gold. Tell them, “Yes, I have heard about all the gold stored in Fort Knox, but none of it is there for a trade-in value. We went off the gold standard with Nixon. If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want. Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer?

II. Depository Institutions •

A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

Commercial Banks • •

A commercial bank is a firm that is licensed to receive deposits and make loans. In 2014 there are about 6,800 commercial banks but that number has been trending downward. The deposits of commercial banks account for 50 percent of M1 and 71 percent of M2. Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S. government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets. As a percentage of deposits, on June 30, 2014 cash assets were 28.0 percent, securities were 27.6 percent, and loans were 75.4 percent. (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 50 percent of deposits.)

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Because of concerns about the financial crisis and bank runs, banks increased their reserves from the more typical 0.6 percent of deposits in June 2008 to 14.3 percent in June, 2010 and to 28.0 percent in June, 2014.

Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions.

Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills.

The Economic Functions of Depository Institutions •

Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions: • Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn less-liquid funds into more liquid funds.

A bank run is a liquidity crisis in the sense that banks can have the deposits backed by assets such as mortgage loans, but the assets are less liquid than the deposits. This scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy Stewart. As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions. Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008 and this fear likely accounted one reason why the Fed responded so strongly to the crisis. • • •

Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders. Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans. Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

What do banks do? Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Financial Innovation •

The development of new financial products is called financial innovation. Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s. Others, such communications networks which have spread the use of credit cards, are the result of advances in technology. Still others, such as sub-prime mortgages, were developed during the 2000s.

MONEY, THE PRICE LEVEL, AND INFLATION

III. The Federal Reserve System The central bank of the United States is the Federal Reserve System. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation. By adjusting the quantity of money, the Fed can change interest rates. Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment. What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns. But the directors of the regional banks are hardly key players in the Federal Reserve System. Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable. Regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC.

The Structure of the Fed • • •

The Board of Governors has seven members, including the chairman (currently Ben Bernanke). There are 12 regional Federal Reserve banks. The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks. The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy. In practice, the chairman has the largest influence on policy.

The Fed’s Balance Sheet • •

The Fed’s two main assets are U.S. government securities and loans to depository institutions. The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’ deposits.

The Economics in Action detail discusses how the Fed’s balance sheet changed dramatically as a result of the financial crisis in 2008. U.S. government securities soared from less than $1,000 billion to approximately $2,500 billion and currency from less than $1,000 trillion to approximately $1,300 trillion. Banks now hold almost $3,000 billion reserves. The monetary base quadrupled in size! •

The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. The major parts of the monetary base, Federal Reserve notes and depository institution deposits, are liabilities of the Federal Reserve. Changes in the monetary base lead to changes in the quantity of money.

The Fed’s Policy Tools • •

Required Reserve Ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios. The Fed sets the required reserve ratio. A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money. Last Resort Loans: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed. The interest rate charged on these loans is the discount rate. In 2008 the Fed changed its policy and encouraged depository institutions to borrow

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•

from it. A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money. Open Market Operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market. The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures. An open market purchase leads to an increase in the money supply.

IV. How Banks Create Money Creating Deposits by Making Loans When a bank makes a loan, it makes a deposit to finance the loan. Because deposits are money, the bank has created money. For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase. The increase in deposits increases the quantity of money. Three factors limit the amount of deposits that the banking system can create: •

•

The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency. The monetary base sets a limit on the sum of these two. Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created. Alternatively, the monetary base limits the amount of the banking systems’ reserves. Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve. The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that banks want to hold. Actual reserves minus desired reserves are excess reserves. Excess reserves can be loaned and can thereby create money. Desired currency holding: The other use of the monetary base involves the public’s holding it as currency. When banks create new money by creating new deposits, the public wants to hold some of this money as currency. As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans. The currency drain is the ratio of currency to deposits. Banks use excess reserves to make loans. In the process, banks create money. • For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves. The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process.

The Money Creation Process • • •

• •

The monetary base increases and banks have excess reserves. Banks lend the excess reserves and thereby create new deposits, that is, create new money. The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain. The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have excess reserves to loan. Banks lend these excess reserves and the process continues. Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves. The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes).

MONEY, THE PRICE LEVEL, AND INFLATION

A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused. The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance. Mark Rush (our study guide author and supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money.”) Label this piece of paper a “$100 bill.” In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has excess reserves of $90. Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound— coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.” An Economics in the News detail defines, describes, and analyzes QE2, that is, the second round of quantitative easing the occurred in 2011.

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V. The Money Market A picky point. The textbook is careful to not use the term “money supply” in this chapter. Instead, it talks about the “quantity of money.” The term “money supply” is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention.

The Influences on Money Holding The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money. The quantity of money that people plan to hold depends on: •

• • •

The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles. • Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level. The quantity of real money demanded is independent of the price level. The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded. Real GDP: An increase in real GDP increases the quantity of money people plan to hold. Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts).

The Demand for Money Curve The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal. As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

Shifts in the Demand for Money Curve •

A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve. An increase in real GDP increases the demand for money and shifts the demand for money curve rightward.

The Demand for Money Students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form of “money.” Students often find it straightforward to think about their behavior and the quantity of cash they hold in their wallet when dealing with the factors that change the demand for money and shift the demand for money curve. But they frequently get confused about the effect the interest rate has on the quantity of money demanded, probably because their holdings of money are not large. So tell your students to imagine themselves in the job of treasurer of a corporation with large liquid resources and to think how their behavior with respect to those funds might differ according to the short-term interest rates available on non-money alternatives, such as bonds. It is easier for them to see that a treasurer will surely shift $5 million dollars into non-money assets in order to reap the higher interest-rate reward when the interest rate rises.

MONEY, THE PRICE LEVEL, AND INFLATION

Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. The quantity of money supplied is determined by the Federal Reserve. •

•

Short Run: On any given day, the quantity of real money is fixed, so the supply of money curve is vertical. The nominal interest rate adjusts to establish equilibrium in the money market. The equilibrium nominal interest rate equates the quantity of real money demanded with the fixed quantity of real money. In the figure, the equilibrium interest rate is 5 percent. The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded. With a surplus of money holding, people enter the loanable funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate. Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate. That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market. The factor that adjusts in the long run is the price level: The price level adjusts to make the real quantity of money equal to the real quantity of money demanded. In the long run, an increase in the quantity of money raises the price level by the same proportion.

VI. The Quantity Theory of Money • • •

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M. The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true. It becomes the quantity theory of money by adding two assumptions: • The velocity of circulation is not influenced by the quantity of money. • Potential GDP is not influenced by the quantity of money.

A 4:33 minute Youtube video that shows how Keynesians and Monetarists view the equation of exchange. On Youtube, search “Economics: New Keynesians versus Monetarists” and select the video created by Mindbites. •

The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money. • In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) − (Real GDP growth rate). If velocity does not grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

Historical Insight. When Milton Friedman’s quantity theory of money was brought to the attention of policymakers during the 1960s, he was labeled an ivory tower academic with his head in the clouds. When his predictions of inflation came true in the 1970s, he was crowned king of monetary theory.

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Evidence on the Quantity Theory of Money The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation. The idea that growth in the quantity of money causes inflation sounds obvious enough to students that they might miss just how controversial the idea is, at least outside of the economics profession. In an economy suffering from inflation, many observers blame “special circumstances,” such as hikes in the price of oil, bad crop harvests, import prices, or whatever. Economists from the central bank often lend their support to these assertions. The fact that central bank employees wish to divert attention away from their role in creating inflation is understandable if not commendable. But why do other observers go astray? Most often it is because they look at only their economy and do not consider what data from other economies indicates or data from their own economy over a long period of time shows. When looking at only one economy and one time period, it is always possible to find some price-increasing factor other than growth in the quantity of money and blame inflation on it. But when looking across economies or across time, the paramount role growth in the quantity of money plays in creating inflation is immediately apparent. So, contrary to the assertions emanating from the central banks and other analysts in nations with high inflation, almost surely their inflation is the result of high monetary growth and not some other “special, unique to them, unique to this time period circumstance!” The Economics in the News section deals with banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing. It uses the demand for M2 money to derive an estimate of what will be the deposit outflow when interest rates return to more normal levels.

MATHEMATICAL NOTE The mathematical note derives the formula for the money multiplier. •

Money is M, deposits is D, and currency is C. M=D+C

•

The monetary base is MB and banks’ reserves is R. MB = C + R

•

The money multiplier, mm, is equal to mm = M/MB = (D + C)/(R + C)

•

Divide all the variables on the right side of the money multiplier equation by D: mm = (1 + C/D)/(R/D + C/D)

• •

C/D is the currency drain ratio and R/D is the banks’ reserve ratio. The formula shows that the size of the money multiplier depends on the reserve ratio and the currency drain. In 2008, when times were more “normal,” for M1 the currency drain ratio, C/D, was equal to 1.24 and the

•

reserve ratio, R/D, was equal to 0.28, so the money multiplier for M1 was

1 +1.24 = 1.47. In 0.28 + 1.24

2008, for M2 the currency drain ratio was equal to 0.12 and the reserve ratio was equal to 0.03, so the money multiplier for M2 was •

1 +0.12 = 7.5. 0.03 + 0.12

In 2014, when banks are holding substantially more reserves than in past decades, for M1 the currency drain ratio, C/D, is equal to 0.81 and the reserve ratio, R/D, is equal to 1.69, so the money multiplier for

1 +0.81 = 0.72. In 2014, for M2 the currency drain ratio is equal to 0.13 and the reserve 1.69 + 0.81 1 +0.13 ratio is equal to 0.26, so the money multiplier for M2 was = 2.90. 0.126 + 0.13 M1 was

MONEY, THE PRICE LEVEL, AND INFLATION

Additional Problems 1.

Higher Reserve Requirement China’s central bank raised its reserve ratio requirement by one percentage point to 17.5 percent by June 25. China’s action was an attempt to decrease lending growth. People’s Daily Online, June 11, 2008 a. Compare the required reserve ratio in China and in the United States. d. Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change.

In Zimbabwe the growth rate of the quantity of money increased from 52 percent a year to 66,700 percent a year in 2007. Accordingly the inflation rate in Zimbabwe skyrocketed, from 56 percent a year in 2000 to 24,000 percent a year in 2007. The growth rate of real GDP between these years is harder to measure but was probably −30 percent per year. a. How do we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate? b. What must be done to stop Zimbabwe’s inflation? c. Zimbabwe’s government frequently responded to its inflation by changing its currency to “knock off” zeros on the currency. At one point it was proposed to knock off ten zeros from the currency (so that an old 10,000,000,000 denomination bill would become a new 1 domination bill). Why will knocking ten zeroes off all prices not stop Zimbabwe’s inflation?

Solutions to Additional Problems 1.

The required reserve ratios in China are much higher than those set by the Federal Reserve. The required reserve ratio is 17.5 percent in China. In the United States, the required reserve ratio is 3 percent of checking deposits between $10.3 million and $44.4 million and 10 percent of these deposits in excess of $44.4 million. The required reserve ratio on other types of deposits is zero. Figure 8.1 shows the effect of the boost in the required reserve ratio. The increase in the required reserve ratio decreases the quantity of money supplied and the money supply curve shifts leftward from MS0 to MS1. As a result, the interest rate rises, in the figure from 4 percent to 6 percent.

We know that the reported inflation rate is too low because the velocity of circulation calculated with it fell. The (true) velocity of circulation rises during hyperinflations as people strive to spend money as rapidly as possible. If the true velocity of circulation rose, then the true inflation rate is higher (probably much higher) than the reported inflation rate.

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b. c.

To stop Zimbabwe’s inflation, the central bank must stop or drastically lower the growth rate of the quantity of money. Knocking ten zeros off of all prices will not stop Zimbabwe's inflation because it just changes the units in which prices are measured. Prices will continue to grow as long as the quantity of money grows.

Additional Discussion Questions 11. Why is the use of money in the exchange of goods and services less costly than using barter? Barter requires a “double coincidence of wants.” For instance, suppose the first person has good A and wants good B. The person must find a second person with good B and who wants good A. Barter requires that the first person must undertake costly search for his or her trade partner. Use of money, on the other hand, breaks the necessity for the double coincidence of wants. The first person who has good A and wants good B can trade with anyone who wants good A and has money. After exchanging good A for money, the first person can now search for anyone who has good B and wants something else. That person will be willing to accept money in exchange for his or her good B because that person knows that the money can then be exchanged for whatever he or she wants. Therefore money has eliminated the need for the time-consuming and costly search needed with barter. 12. “Everyone knows that true money is issued by the government; that is, the only real form of money is the nation’s currency.” Comment on this assertion. This assertion is false. Money is anything that can be used as a medium of exchange. Funds in checking accounts clearly qualify because they can be used as a medium of exchange. Therefore funds in checking accounts are definitely money. Other sources of funds, such as funds in savings accounts, also come close to be money because they can be used with only slight difficulty as a medium of exchange. Therefore money includes many assets beyond government-issued currency. 13. Define the monetary base. The monetary base is equal to the sum of coins, Federal Reserve notes, and depository institutions’ deposits at the Federal Reserve. Except for coins, which are a small part of the monetary base, the monetary base is made up of liabilities of the Federal Reserve. 14. “Ask anyone if he or she has enough money. No one ever has enough money, that is, everyone demands more money. Thus theorizing about the demand for money makes no sense because this demand obviously is infinite.” Correct and comment on the error in this assertion. This assertion makes a fundamental error by confusing money with income. Money is M1. The demand for money is the amount of M1 people want to hold. People have a finite amount of M1 that they want to hold; that is, no one wants to hold an infinite amount of M1. Income, however, is a different story: people would like to receive infinite income because that means that they could have infinite consumption. But infinite income is not the same as holding an infinite quantity of M1! 15. If the price level was already doubling every month and inflation accelerating, what would you expect to happen to the velocity of circulation and why? How close would you expect the relation between the quantity of money and the price level to be? The velocity of circulation would increase. People would try to spend the money they receive as rapidly as possible in order to avoid suffering the loss that comes from higher prices. In this case, which occurs in hyperinflations, the inflation rate exceeds the growth rate of the quantity of money. In a hyperinflation with accelerating inflation, the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity. 16. How does a currency drain affect the money multiplier? [Requires Mathematical Note] A currency drain decreases the magnitude of the money multiplier. The money multiplier exists because some of the proceeds of the loans that one bank makes are deposited in other banks where it can be loaned once again. The more of the proceeds that are deposited in banks, the larger will be the next round of loans and hence the larger will be the money multiplier. A

MONEY, THE PRICE LEVEL, AND INFLATION

currency drain decreases the amount of the loans that is deposited back in banks. Because the faction of the loans that is deposited is less, the ultimate increase in the quantity of money—and hence the money multiplier—is smaller.

C h a p t e r

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

The Big Picture Where we have been: Chapter 9 is the last of four that examine the long-run trends of the economy. It uses the quantity theory result from Chapter 8 that in the long run, the price level is determined by the quantity of money. This result is used to show that in the long run, the nominal exchange rate is determined by the quantities of money in the two countries. Chapter 9 also uses the national income accounting identities introduced in Chapter 4 when explaining the balance of payments and, quite importantly, the demand and supply model of Chapter 3 when explaining short-run fluctuations in the exchange rate. Where we are going: Chapter 9 is the last of the “long-run chapters.” The next section looks at short-run fluctuations. Chapter 10, with its introduction of the aggregate supply/aggregate demand model, is key to understanding short run business cycle fluctuations. The material in this chapter is not prominently featured in future chapters, though it makes a slight recurrence in Chapter 14 when monetary policy is covered. Chapter 15, on International Trade, does not use the material in this chapter directly. However, the global loanable funds market can be used to motivate the models for the global market in goods and services.

N e w i n t h e Tw e l f t h E d i t i o n This chapter has some sections that have been modified, especially the section on exchange rate expectations. It is mostly a modest reorganization of content, so there are no new items to call to your attention. However, there is now a section on the Global Loanable Funds Market that was moved from chapter 7. Data in tables and graphs have been updated to 2014. The Economics In The News feature has a 2014 article on the rising value of the dollar. The Worked Problem presents a scenario in which the Fed and Bank of Japan announce their interest rate policies. The students are asked to analyze the announcements using the foreign exchange market and the supply and demand for U.S. dollars. To include the new Worked Problem without lengthening the chapter, some problems have *

* This is Chapter 26 in Economics.

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been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

Lecture Notes

The Exchange Rate and the Balance of Payments • • •

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market. The exchange rates for currencies are determined by supply and demand in the foreign exchange market. When a nation trades with other nations, the country’s balance of payments records the transactions.

The Foreign Exchange Market

Trading Currencies •

International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.

Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollars (84 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollars, stick to the “84 yen per dollar” format in your lectures. This also makes it easier for graphing and for the discussion about appreciation or depreciation. A change from 84 to 94 yen per dollar is dollar appreciation and shown by an increase along the vertical axis. •

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency. • A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.

Demand in the Foreign Exchange Market The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate. •

•

The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market. There are two reasons for the law of demand: • Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports. • Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market. The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

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Supply in the Foreign Exchange Market The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate. •

•

The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market. There are two reasons for the law of supply: • Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports. • Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market. The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.

Market Equilibrium •

Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect. • If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down. • If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up. • The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

Changes in the Demand for U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the demand for dollars and shifts the demand curve for dollars. • World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward. • Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward.

Changes in the Supply of U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars. • U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward. • U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

•

Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward.

Emphasize that the quantity of dollars measured on the horizontal axis are only dollars that are being offered for foreign exchange, not the entire quantity of money as we learned in Chapter 8.

Changes in the Exchange Rate The exchange rate changes when the demand for and/or the supply of foreign exchange change. •

When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, in the figure from 77 yen per dollar to 102 yen per dollar, and quantity traded does not change by much, indeed in the figure it does not change at all. Such changes took place between 2012 and 2014 when traders started to expect that the Federal Reserve would raise the interest rate in the United States while the Japanese interest rate would not change.

II. Arbitrage, Speculation, and Market Fundamentals Exchange rate expectations depend on deeper economic forces that influence the value of money. •

Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market. Arbitrage in the foreign exchange market and international loans markets and goods markets achieves four outcomes: • The law of one price: If an item is traded in more than one place, the price will be the same in all locations. An example of this law is that the exchange rate between the U.S. dollar and the U.K. pound is the same in New York as it is in London. • No round-trip profit: A round trip is using currency A to buy currency B, and then using B to buy A. A round trip might involve more stages, using B to buy C and then using C to buy A. Regardless, arbitrage removes the profit made from a round trip. • Interest rate parity: Borrowers and lenders must choose the currency in which to denominate their assets and debts. Interest rate parity, which means equal rates of return across currencies, means that for risk-free transactions, there is no gain from choosing one currency over another. • Purchasing power parity: Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.

Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.

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If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity goods and services in the United States as 1.33 Canadian dollars buys in Canada. • If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate. • Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate. The Economics in Action detail discusses the “Big Mac Index.” The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions.

Speculation Speculation is trading on the expectation of making a profit. Speculation contrasts with arbitrage, which is trading on the certainty of making a profit. Most foreign exchange transactions are based on speculation, which explains why the expected future exchange rate plays such a central role in the foreign exchange market. Changes in the expected future exchange rate instantly change the current exchange rate.

Market Fundamentals The fundamentals underlying the exchange rate are the demand for U.S. dollars, which depends on world demand for U.S. exports, and the supply of U.S. dollars, which depends on U.S. demand for imports. Both demand and supply depend on the U.S. interest rate differential.

The Real Exchange Rate •

The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E  P)/P* •

where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level. Price Levels and Money: Nominal and real exchange rates are linked by the equation RER = E  (P/P*). This relationship can be used in the short run and long run: • Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate. • Long Run: In the long run, rewrite the equation as E = RER  (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate. This result means that in the long run, the nominal exchange rate is a monetary phenomenon. Chapter 8 showed that in the long run, the quantity of money determines a nation’s price level, so the nominal exchange rate is determined by the quantities of money in the two countries.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

III. Exchange Rate Policy Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

Flexible Exchange Rate •

A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions. For instance, if the Fed raises the U.S. interest rate, the U.S. interest rate differential increases, which appreciates the U.S. exchange rate. Most countries, including the United States, have flexible exchange rates.

Fixed Exchange Rate •

A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank. • If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars. • In the figure the demand for dollars has decreased from D0 to D1. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day). To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange rate at 100 yen per dollar. • If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars.

Crawling Peg •

A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

The People’s Bank of China in the Foreign Exchange Market (Economics In Action Detail) •

•

From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. China accumulated foreign currency reserves of almost $1 trillion by mid-2006, and by the end of 2007 was fast approaching $2 trillion. Since 2005, the People’s Bank has allowed the yuan to crawl upward. Even so the yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S. dollars to hold the yuan/dollar exchange rate down.

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•

China most likely fixed its exchange rate to anchor its inflation rate so that it does not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from the U.S. inflation rate by an amount determined by the speed of the crawl.

IV. Financing International Trade Balance of Payments Accounts •

•

A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: • The current account records payments for imports of goods and services from abroad, receipts for exports of goods and services sold abroad, net interest income paid abroad, and net transfers (such as foreign aid payment). The current account balance equals exports plus net interest income plus net transfers minus imports. • The capital account records foreign investment in the United States minus U.S. investment abroad. Any statistical discrepancy is included in this account. • The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. An increase in foreign reserves corresponds to a negative official settlements account balance. This occurs because holding foreign currency is like (but not the same as) investing abroad, which is a negative entry in the capital account. The sum of the balances always equals zero:

current account + capital account + official settlements account = 0.

•

In 2013, the U.S. current account balance was negative and almost entirely offset by a positive capital account balance. Over time, the current account balance tends to mirror the capital account balance because the official settlements account balance is small.

Borrowers and Lenders Because of current account deficits and surpluses, countries, like individuals, can be borrowers or lenders. •

A country that is borrowing more from the rest of the world than it is lending to it is a net borrower. A net lender is a country that is lending more to the rest of the world than it is borrowing from the rest of the world. The United States currently is net borrower. Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

The Global Loanable Funds Market Demand and Supply in Global and National Markets • •

Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate. A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 6 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this lower real interest rate, the quantity of loanable funds supplied decreases to $1.4 trillion and the quantity of loanable funds demanded increases to $1.8 trillion. The difference, $0.4 trillion, is borrowed from abroad. The country has negative net exports, with X < M.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

•

A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation. • In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 4 percent and the equilibrium quantity of loanable funds would be $1.6 trillion. • With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this higher real interest rate, the quantity of loanable funds supplied increases to $1.8 trillion and the quantity of loanable funds demanded decreases to $1.4 trillion. The difference, $0.4 trillion, is loaned abroad. The country has positive net exports, with X > M. In a small country, changes in the national demand and supply of loanable funds change the country’s international loaning or borrowing and will change the country’s net exports.

Debtors and Creditors •

A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. A creditor nation is a country that during its entire history has invested more in the rest of the world than other countries have invested in it. The United States currently is debtor nation. • The net borrower/net lender difference refers to the current flow of borrowing or lending over a period of time. The debtor nation/creditor nation refers to the stock of debt or foreign assets that exists at a moment in time.

The analogy of a country being like an individual in terms of being a borrower or lender is revealing. However, you may want to point out a big difference in lifespan. Long periods of deficit seem bad for an individual, but are short when you are expected to live forever. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The key is what the debt is being spent on. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.

Current Account Balance and Net Exports •

The current account balance (CAB) is:

•

The main item in the current account balance is net exports (X − M). The other two items are much smaller and don’t fluctuate much. The national accounts show that Y = C + I + G + X − M and also that Y = C + S + T. These two relationships can be equated and rearranged to give (X − M) = (S − I) + (T − G). In this formula, • (X − M) is net exports, exports of goods and services minus imports of goods and services. • (S − I) is the private sector balance, saving minus investment. • (T − G) is the government sector balance, net taxes minus government expenditures on goods and services. The formula shows that net exports equal the sum of the private sector balance and the government sector balance. There is a strong tendency for the private sector balance and the government sector balance to move in opposite directions, which means that the relationship between net exports and the other two sectors taken individually is not a strong one.

CAB = X − M + Net interest income + Net transfers •

•

Where Is the Exchange Rate? In the short run, a change in the nominal exchange rate changes the real exchange rate and affects the U.S. current account balance. In the long run, a change in the nominal exchange rate leaves the real exchange rate unaffected and so in the long the nominal exchange rate plays no role in determining the current account balance.

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Additional Problems 1.

The Dollar’s Short-Lived Comeback The dollar fell to record lows against the euro in April. Over the next month the exchange rate rose because traders began to expect that the Federal Reserve was not going to cut U.S. interest rates any further. CNN, May 16, 2008 Explain how expectations that the Federal Reserve will not cut the interest rate can make the dollar appreciate.

Suppose that traders in the foreign exchange market come to believe that the U.S. exchange rate will rise over the next few months. How does this belief affect the demand for U.S. dollars and the supply of U.S. dollars? What is the impact of this belief on the current exchange rate? Draw a graph of the foreign exchange market to illustrate your answer.

A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say (and why) about: a. The exchange rate? b. The current account balance? c. The expected exchange rate? d. The interest rate differential? e. Interest rate parity? f. Purchasing power parity?

Solutions to Additional Problems 1.

If traders come to believe that the Federal Reserve will not cut interest rates, the interest rate in the future will be higher than previously expected. With the higher future U.S. interest rate, the future U.S. interest rate differential will also be higher. In turn, the higher future U.S. interest rate differential will raise the future U.S. exchange rate. Finally, the expected higher future U.S. exchange rate increases the current demand for U.S. dollars and decreases the current supply, thereby raising the current exchange rate and appreciating the dollar.

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS

The rise in the expected future exchange rate increases the expected profit from holding dollars. The increase in expected profit increases the current demand for U.S. dollars and decreases the current supply of U.S. dollars. The current exchange rate rises. Figure 9.1 shows the effect on the foreign exchange market of the change in traders’ beliefs. The demand increases so the demand curve for dollars shifts rightward from D0 to D1. The supply curve of dollars shifts leftward from S0 to S1. The dollar immediately appreciates, rising in the figure from 110 yen per dollar to 120 yen per dollar.

a. b.

c. d. e. f.

The exchange rate most likely rises—the currency appreciates. The reason is that to preserve purchasing power parity, the lower inflation rate means that the currency must appreciate. The current account balance depends on domestic investment relative to national saving. The balance could be positive or negative. Possibly with more rapid growth, investment in the country is high and so the current account might be in deficit. The exchange rate will be expected to appreciate so the expected future exchange rate is higher than the current exchange rate. The interest rate differential is negative. The interest rates in other countries exceed the domestic interest rate by an amount equal to the expected exchange rate appreciation. Interest rate parity holds every day. If it did not, large above-average profits would be available. Such profit opportunities do not go unexploited. Purchasing power parity probably doesn’t hold every day, but does hold on the average in the long run.

Additional Discussion Questions 1.

In 2007−2008, the nominal exchange rate of U.S. dollars declined relative to both the Japanese yen and the European euro. What would you need to know about the U.S. economy to determine whether this would be a benefit or a problem for the U.S. economy? Point out that the United States was just starting to enter a recession in 2008, as potentially was Japan and most of Europe. The Federal Reserve was ahead of other central banks in responding to the recession by lowering the interest rate before the other central banks took action. By lowering the U.S. interest rate, the U.S. interest rate differential decreased, which decreased the demand for U.S. dollars, increased the supply of U.S. dollars, and forced the exchange rate lower. By lowering the U.S. exchange rate, U.S. exports increased, which helped keep the U.S. economy stronger than otherwise would have been the case.

When the Federal Reserve Chairman Ben Bernanke repeatedly decreased the interest rate during late 2008, he was attempting to stimulate the U.S. economy by lowering the interest rates in the U.S. financial markets and lowering the cost of employing productive capital. What impact did this policy have on the exchange rates in the foreign exchange markets, all else equal? The fall in U.S. interest rates means that the U.S. interest rate differential falls. The fall in the interest rate differential increases the supply of dollars to the foreign currency exchange market, shifting the supply curve of dollars rightward. It also decreases the demand for dollars, shifting the demand curve for dollars leftward. With no other changes, the equilibrium exchange rate for dollars falls. As it happened, however, other factors were not equal. In late 2008 other

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central banks also lowered their interest rates. And apparently investors believed that the United States had less default risk than other countries. So on net the demand for dollars actually increased and the supply decreased so that the U.S. exchange rate rose. But the increase would have been significantly greater had it not been for the actions of the Federal Reserve. 3.

In part due to the recession of 2008, the U.S. government budget changed from a smaller deficits to larger deficits. What impact would this have on the net exports and private sector balances, all else equal? The three balances are related: Net exports equal the sum of government and private sector balances. If the private sector balance does not change, the net export deficit will increase. However if the public sector surplus were to increase substantially, the net export deficit might decrease.

C h a p t e r

AGGREGATE SUPPLY AND AGGREGATE DEMAND**

The Big Picture Where we have been: This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues. The chapter uses the fact established in Chapter 4, that expenditure equals C + I + G + (X – M), to explain the forces that determine aggregate demand. It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves. Where we are going: This chapter provides a description of the AS-AD model. The treatment parallels that of the demand and supply model in Chapter 3. That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained. But the curves are not formally derived. The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve. It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium. Then Chapters 12, 13, and 14 make use of the aggregate supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy.

N e w i n t h e Tw e l f t h E d i t i o n All the data are updated through 2014 and a discussion of the World Economy Headwinds in Economics in Action has been added. The Economics In The News feature has a 2014 article about stronger than expected rebound in the U.S. economy, which applies the AD-AS model. The Worked Problem presents aggregate demand and short-run aggregate supply schedules and then asks the shortrun equilibrium real GDP and price level. It also asks the effect of an increase in aggregate demand. The solutions to the problems use both the aggregate demand and short-run aggregate supply schedules and an AD-SAS figure. To include the new Worked Problem without lengthening the chapter, some *

* This is Chapter 27 in Economics.

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problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

Lecture Notes

Aggregate Supply and Aggregate Demand • •

The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined. The model also helps explains the factors that determine inflation and the business cycle.

Tell students that there is heated debate among economists on the most important influences in the macro economy and how to model those influences. Economists as a group are ambivalent about the aggregate supplyaggregate demand (AS-AD) model. Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent. Technological change shifts both the AS and AD curves simultaneously and in complicated ways. New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis. Despite the controversy, the AS-AD model is the key macroeconomic model for most economists. The model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics. The author does a good job of using the AS-AD model to explain various schools of thought. The AS-AD model is the best model currently available for introducing students to macroeconomics. It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance. Devoting at least a week of lecture time to the AS-AD model is worthwhile. Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features.

Aggregate Supply The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period. This amount depends on the quantity of labor employed, the capital stock, and the state of technology. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP.

Long-Run Aggregate Supply •

•

The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($13 trillion in the figure), showing that potential GDP does not depend on the specific price level. In the long run, the wage rate and other resource prices change in proportion to the price level. So moving along the LAS curve both the price level and the money wage rate change by the same percentage.

Short-Run Aggregate Supply • •

The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant. As illustrated in the figure, the SAS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce.

100

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Difference between LAS and SAS: The distinction between the LAS and the SAS comes about by assuming that resource and output prices adjust at different rates. Ask the class, “When there is an increase in demand, what do you think adjusts first, prices of goods on the shelves at Wal-Mart or wages of employees at Wal-Mart?” By discussing out the potential lag times in resource price adjustment, you have opened up a hotly contested item among economists. How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different assumptions yield different answers.

Movements Along the LAS and SAS Curves and Changes in Aggregate Supply Movements Along the Curves • When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve. • When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve. Shifts in the Curves • When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward. Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances. • Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward. The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest controversies in macroeconomics, you can do so at this early stage of the course by using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. Along the SAS curve: You cannot repeat yourself too many times about this topic: Moving along the SAS curve, resource prices are fixed. Point out that this is the same assumption for the “micro” supply curve. In particular, if there is an increase in the money wage rate at the Pepsi plant, the supply curve for Pepsi shifts leftward. That same principle gets applied to all goods and services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward. Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a positive slope but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified. Though you do not “need” to emphasize this point, what the LAS curve illustrates is that the real economy is independent of money prices!

II. Aggregate Demand • •

The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I), government expenditure (G), and net exports (X − M), or Y = C + I + G + (X − M). Buying plans depend on many factors including: • The price level • Expectations • Fiscal policy and monetary policy • The world economy

AGGREGATE SUPPLY AND AGGREGATE DEMAND

The Aggregate Demand Curve •

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping. • The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded).

Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the aggregate demand story, we also want to avoid being misleading. The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand. A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the students don’t totally appreciate the ceteris paribus condition. We must provide intuition with stories such as the Maria stories in the textbook. Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model in the next chapter before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better than confusion. You can pull this rabbit out of the hat when you get to the next chapter if you’re covering the material in the order presented in the textbook.

Changes in Aggregate Demand •

Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are: • Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward. • Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.

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•

The world economy: Exchange rates and foreign income affect net exports (X − M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

III. Explaining Macroeconomic Trends and Fluctuations Short-Run and Long-Run Macroeconomic Equilibrium •

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect. • If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices. • If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out in the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. •

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve. The figure shows the long-run macroeconomic equilibrium at a real GDP of $16 trillion and a price level of 110.

From the short run to the long run. Explain that market forces move the money wage rate to the long-run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment decreases. At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level.

Economic Growth and Inflation • •

Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward. Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve. In the long run, only growth in the quantity of money makes the AD curve continually shift rightward.

The Business Cycle The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP. • A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a below-full employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

•

• •

An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve. A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP. The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

Point out to the students that to simplify analysis of the business cycle, economists typically abstract from the long-term persisting increases in the LAS curve and AD curve that generate economic growth and inflation, respectively. So, by fixing the LAS curve when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run equilibrium level of output. Explain to the students that one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that short-term movements around the LAS are driven by different economic forces than the persisting long-run shifts in the LAS curve. So abstracting from long-term growth in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details. An Economics in Action feature discusses the “World Economy Headwinds”—slowing real GDP growth—that threaten to decrease U.S. exports and thereby leave a recessionary gap in the United States.

Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1. In the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase. In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $16 trillion and a price level of 100 to point b with real GDP of $17 trillion and a price level of 105. But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1. The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the

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economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c. In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $16 trillion in the figure--and only results in a higher price level—which has risen from 100 to 110 in the figure. Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward. Avoid confusing students by using “up” to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward. In the figure above, instead of using identifying the short-run aggregate supply curve with SAS0you might use SASW=$10 with the explanation that along this SAS curve the money wage rate, W, is fixed at $10/hour. Then, rather than label the new short-run aggregate supply curve SAS1, can identify it as SASW=$11. You can now show your students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent increase in the money wage rate.

Fluctuations in Aggregate Supply Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An increase in energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks.

IV. Macroeconomic Schools of Thought There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle. The importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is difficult for most people to evaluate whether the speaker is truly knowledgeable or a charlatan. Mainstream economic theories are completely thought out and fully articulated. Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.”

The Classical View •

• •

A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. A new classical view is that business cycle fluctuations are the efficient responses of a wellfunctioning market economy that is bombarded by shocks that arise from the uneven pace of technological change. The uneven pace of technological advancement are the main source of business cycle fluctuations. There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP. Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low.

The Keynesian View • •

A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required. Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky

AGGREGATE SUPPLY AND AGGREGATE DEMAND

• •

(slow to adjust), especially in the downward direction, the economy can remain mired in a recession. A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky. Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment.

Although Keynes agreed that the economy would return to its potential in the long run, he stated, “In the long run, we are all dead”. Keynes believed that because of the interaction between financial markets, the price level, and the labor market, there was no inherent tendency of the market system to return quick enough to potential GDP following an aggregate demand shock. The role of the government, in Keynes’ view, was not to replace markets with central planning, but to use stabilization policies to help the macroeconomy find equilibrium at potential GDP. Keynes’ analogy was that market capitalism in the Great Depression was like a car with a broken alternator. Fiscal policy would give the economy a jump-start when aggregate demand was inadequate. Keynes worried that without active aggregate demand management, high unemployment would lead to a breakdown of capitalism, with revolution leading to totalitarianism in the form of communism or fascism.

The Monetarist View • • • •

A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady. Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations. There is a short-run aggregate supply curve because money wages are sticky. The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy.

The Economics in the News detail discusses real GDP growth in the second quarter of 2014. This growth was more rapid than expected, which is analyzed in terms using the AD-AS model.

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Additional Problems 1.

Explain and draw a graph to illustrate how a depreciation of the dollar changes the short-run equilibrium real GDP and price level.

Suppose the government creates a fiscal stimulus by sending people checks representing temporary tax cuts. a. Explain and draw a graph to illustrate the effect of this fiscal stimulus payments on real GDP and the price level in the short run. b. At which type of short-run equilibrium would the government want to use this policy? c. Which macroeconomic school of thought would justify this policy? d. If the government used this policy when the economy was at full employment, explain what would happen in the long run. e. Draw a graph to illustrate your answer to d.

What is stagflation? Explain how the increase in the price of oil can cause stagflation and draw a graph to illustrate this outcome.

Solutions to Additional Problems 1.

The depreciation of the dollar increases U.S. net exports, which increases U.S. aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. These changes are illustrated in Figure 10.1. In this figure the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, from $16.0 trillion to $16.2 trillion, and the price level rises, from 119 to 121.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

c. d.

The fiscal stimulus check increased households’ consumer expenditure. The increase in consumption expenditure boosted aggregate demand so the aggregate demand curve shifted rightward. Figure 10.2 shows the effect of this change. The aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $16 trillion to $16.1 trillion, and the price level rises, in the figure from 119 to 121. The government wants to use this type of policy when the economy is in a below full-employment equilibrium with a recessionary gap. Keynesian economists would support this policy. If this stimulus policy was used when the economy was at full employment, in the short run the price rises and real GDP increases. But in the long run the money wage rate rises to reflect the higher price level. The rise in the money wage rate decreases short-run aggregate supply. Ultimately in the long run real GDP returns to potential GDP so there is no long-run change in real GDP. The price level, however, rises as short-run aggregate supply decreases. So the price level in the long-run is higher than in the short run. Figure 10.3 shows the long-run changes described in the previous answer. After the initial shift in the aggregate demand curve from AD0 to AD1, the price level has risen. As a result the money wage rate rises so that the short-run aggregate supply curve shifts leftward, in the figure from SAS0 to SAS1. In turn the price level rises still more, in the figure ultimately to 122. Real GDP, however, decreases and eventually returns to its initial level, which is potential GDP and in the figure is $16.0 trillion.

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Stagflation is the combination of recession and inflation. Increases in the price of oil can decrease aggregate supply. The decrease in aggregate supply raises the price level—so there is inflation—and decreases real GDP—so there is a recession. Figure 10.4 illustrates these results. In this figure the aggregate supply curve shifts leftward from AS0 to AS1. As a result real GDP decreases from $16.0 trillion to $15.8 trillion and the price level rises, from 118 to 120.

Additional Discussion Questions 11. “The demand curves for all products have negative slopes. For instance, the demand curves for milk, automobiles, personal computers, and shirts all have negative slopes. Therefore, because the aggregate demand curve shows the demand for all products, it too must have a negative slope.” Comment on this assertion. The assertion is incorrect. Demand curves for goods and services such as milk and so forth have negative slopes because the price measured along the vertical axis is a relative price; that is, it is the price of the good or service relative to the price of another good or service. As a result, the demand curve for these goods or services captures the possibility of substitution: A higher price for a gallon of milk causes consumers to substitute away from milk and toward other beverages, such as water or soda, whose price has not risen. The price level, which is the variable along the vertical axis for the aggregate demand curve, is not a relative price. It is the average of all prices. When the price level rises, all domestic prices have risen so the only substitution possibility is toward imported goods and over time (the intertemporal substitution effect). These substitutions offer reasons why the aggregate demand curve has a negative slope. Another, possibly more important reason for the negative slope is the wealth effect: When the price level rises and nothing else changes, people’s real wealth decreases. When real wealth decreases, people’s consumption expenditure decreases so that the aggregate quantity of goods and services demanded decreases. 12. Explain why the SAS curve slopes upward and the LAS curve is vertical. The SAS curve applies in the short run; the LAS curve applies in the long run. When the price level rises, firms find that the prices of the goods and services they produce have risen. In the short run the money wage rate (and other costs) do not change. With higher prices and unchanged costs, firms find it profitable to increase their production. Hence in the short run the quantity of real GDP produced increases, which means that along the SAS curve a higher price level leads to an increase in the quantity of real GDP supplied. However in the long run money wage rates adjust to reflect the higher price level. In the long run the money wage rate and price level rise in the same proportion. In the long run, with both higher prices and higher costs, firms return to their initial level of production. Hence in the long run the quantity of real GDP produced does not change, which means that along the LAS curve a higher price level leads to no change in (potential) GDP.

AGGREGATE SUPPLY AND AGGREGATE DEMAND

13. When the equilibrium real GDP is below potential GDP, how does the unemployment rate compare with the natural rate? What is the result of this state of affairs that restores the long-run equilibrium? When real GDP is less than potential GDP, the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate no longer falls so that all adjustments cease. 14. Explain how an increase in money wages affects the SAS curve. Why does a change in money wages affect only the SAS curve and not the LAS curve? An increase in the money wage rate means that firms’ costs have risen. At a given price level, the increase in their costs causes firms to decrease the quantity of goods and services they produce. The quantity of real GDP produced decreases and the SAS curve shifts leftward. The change in the money wage rate does not affect the quantity of production along the LAS curve because along that curve both the money wage rate and price level change in the same proportion. In other words, it is not possible to assume a given price level to investigate the effect of an increase in the money wage rate along the LAS curve because along that curve both variables change. And when both the price level and money wage rate change by the same proportion, firms will not change the quantity of real GDP they produce. 15. If the government spends more money by buying more goods and services, is this change an example of fiscal policy or monetary policy? When the government increases its expenditure by purchasing more goods and services, the government is engaging in fiscal policy. 16. What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap? A recessionary gap occurs when actual real GDP is less than potential GDP. With a recessionary gap the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate stops falling so that short-run aggregate supply stops increasing.

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EXPENDITURE MULTIPLIERS**

The Big Picture Where we have been: Chapter 11 uses the background provided in Chapters 4 and 10 to focus on aggregate expenditure and aggregate demand. It builds on the division of GDP into C + I + G + (X – M) explained in Chapter 4 and then derives the aggregate demand curve previously used in Chapter 10. Where we are going: Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve. The AD curve is important in all the core short-run macroeconomic chapters. The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy.

N e w i n t h e Tw e l f t h E d i t i o n The data in this chapter have been updated to reflect 2014 information. The Economics In The News feature reports the BEA statistics for 2014 with economic analysis using the Aggregate Expenditure model. The Mathematical Note now includes a short exercise at the end. Using data on disposable income and consumption expenditure, the Worked Problem shows the calculation and effect of the multiplier. It also asks the students to use the multiplier to determine the effect an increase in autonomous expenditure has on real GDP. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

* This is Chapter 28 in Economics.

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Lecture Notes

Expenditure Multipliers • • •

The Keynesian model focuses on the short run. In the Keynesian model, business cycle fluctuations are driven by changes in the components of aggregate expenditure, especially investment. The multiplier effect describes the amplified effect on real GDP from changes in expenditure.

Historical background. If you want to talk about Keynes and his contribution to economics, this is probably the best place to do it. The model, now generally called the aggregate expenditure model, presented in this section is the essence of Keynes General Theory. According to Don Patinkin, a leading historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable. This version of the model cannot be found in the General Theory, mainly because Keynes was writing before the national income accounting system had been developed. So he made up his own aggregates, based on employment and a money wage measure of the price level. But the words and equations of the General Theory can be translated readily into the textbook version of the model. This version of the model first appeared in The Elements of Economics, a textbook authored by Lorie Tarshis published in 1947. It was popularized by Paul Samuelson in the first edition of his celebrated text published in 1948. The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon. In contrast, today, we see the model as part of the aggregate demand story. The value of the model today—and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant—is that it explains the multiplier that translates a change in autonomous expenditure into a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve. (When an unintended change in inventories occurs, the economy is off the AD curve but moving toward it.)

Fixed Prices and Expenditure Plans

The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result, the price level is fixed and so aggregate demand determines real GDP.

Expenditure Plans • •

Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. In the very short term, planned investment, planned government expenditure, and planned exports are fixed. Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income. An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP.

Consumption Function and Saving Function •

Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income. Disposable income is aggregate income minus taxes plus transfer payments. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. The relationship between saving and disposable income, other things remaining the same, is called the saving function.

EXPENDITURE MULTIPLIERS

•

The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving. The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption. Consumption expenditure in excess of this amount is induced consumption.

The 45° line. Don’t assume that your students immediately understand the 45° line! Spend a bit of time explaining how to “read” it. Fundamentally, it shows all points where x = y. This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same. Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line. So at all points along the 45° line, x = y. If you wish, you can go on to show the students how the x = y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant. Emphasize that x and y can be anything. In the figure above, x is disposable income and y is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned expenditure.

Marginal Propensities to Consume and Save • • •

The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, C/YD. The MPC is the slope of the consumption function, which is 0.67 in the figure. The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, S/YD. The MPS is the slope of the saving function. The sum of the MPC plus the MPS equals 1.0.

Marginal propensities. The text defines the MPC and MPS, and shows that they sum to one because disposable income can only be consumed or saved. Students generally relate to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes.

Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function. An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward. •

The U.S. MPC is about 0.9. Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward.

Consumption as a Function of Real GDP and the Import Function • •

For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP. We use this observation when we derive the aggregate expenditure function. Just as consumption of domestically produced goods and services depends on real GDP, so do imports. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.

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II. Real GDP with a Fixed Price Level Real GDP (Y)

Consumption expenditure (C)

Investment (I)

Government expenditure (G)

Exports (X)

Imports (M)

Aggregate planned expenditure (AE=C+I+G+X−M)

(trillions of 2009 dollars) 14.0

10.2

2.0

1.0

0.8

14.4

15.0

11.1

2.0

1.0

0.9

15.2

16.0

12.0

2.0

1.0

16.0

17.0

12.9

2.0

1.0

1.1

17.8

Aggregate Planned Expenditure and Real GDP •

•

Aggregate planned expenditure, AE, is the sum of planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. The above table shows the calculation of an aggregate planned expenditure schedule. The figure shows the resulting AE curve. Consumption expenditure minus imports vary with real GDP and are induced expenditure. The sum of investment, government expenditures, and exports do not vary with real GDP and are autonomous expenditure. Consumption expenditure and imports also have an autonomous component. Actual expenditure can differ from planned expenditure because firms do not always sell what they plan to, in which case they have unplanned inventory investment. For instance, a car that is manufactured but not immediately sold is part of that firm’s actual inventory investment regardless of whether the firm planned to add it to inventory or not.

Equilibrium Expenditure and Convergence to the Equilibrium • •

Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. In the figure, equilibrium expenditure is $12 trillion. If aggregate expenditure does not equal its equilibrium, forces lead to convergence. For example, if real GDP exceeds aggregate planned expenditure, firms find their inventories are increasing more than planned. The unplanned inventory accumulation leads firms to cut production so that real GDP decreases, which decreases aggregate planned expenditures. Real GDP still exceeds aggregate planned expenditure, but by less than before. The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation.

III. The Multiplier • •

•

The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. When there is an autonomous change in a component of expenditure such as investment, additional changes in aggregate expenditure are set in motion. Because of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure. The multiplier effect operates for a decrease as well as an increase in autonomous expenditure.

EXPENDITURE MULTIPLIERS

Work through an example of a change in government spending. Suppose there are no taxes, no imports, no exports and the MPC is 0.9. If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its employees, subcontractors and material suppliers among other costs. These costs to Nuc’s turn into income (Y) for others (remind your students of the circular flow). These other people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney. Now JCPenney must pay its costs, which again turns into other people’s income, of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on… Explain to the students that we have a short-cut to explain this iterative process and capture the total change in income (Y) from the change in government spending (G). That short-cut is the multiplier, which shows that the change in GDP is given by GDP = 1/(1 − MPC) × G

Why is the Multiplier Greater Than 1? An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in consumption expenditure). Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure. The process converges because the increase in aggregate expenditure is smaller at each step of the process.

The Multiplier and the Marginal Propensities to Consume and Save •

The change in real GDP can be divided into the change in induced expenditure plus the change in autonomous expenditure, Y = N + A, where Y is real GDP, N is induced expenditures, and A is autonomous expenditure. The slope of the AE curve = N÷Y, so N = (slope of AE curve) Y. Using this equality in the previous formula shows Y = (slope of AE curve) Y + A. Solving for the change in

1  A. This last result shows that the multiplier 1 - slope of the AE curve 1 equals . In the previous figure, the slope of the AE curve is 0.8, so the 1 - slope of the AE curve GDP, Y, gives Y =

•

multiplier is 5.0. If there are no imports or income taxes, the slope of AE curve equals the MPC so the multiplier equals

1 1 or, equivalently, . 1 - MPC MPS

The size of the multiplier depends on the MPC and the MPS. The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier.

The basic idea and practice. Students need quite a lot of practice using multipliers. One good problem involves working out the effects on consumption as well as on GDP of a change in investment (when the price level is fixed). The best way to present this problem to the students seems to be sequentially. Begin by giving them the data necessary to deduce how real GDP changes from an increase in investment. Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes. Tell them that the marginal propensity to consume is b (pick any valid number you like), and that investment has changed by I (pick any valid number you like). Then, after the students have computed the change in GDP, ask them what the change in consumption expenditure is. Review their attempts to answer this question as follows: The change in GDP, Y, is given by the equation: Y = C + I. Given I from the initial statement of the problem and Y from the first set of calculations, the students can readily calculate C. Focusing the students’ attention on the change in consumption is important because it reinforces the point that a change in autonomous expenditure (investment in this example) leads to an induced change in consumption expenditure and that this increase in consumption expenditure is the source of the multiplier. An Economics in Action detail analyzes the multiplier in the Great Depression. The analysis concludes that the multiplier during that episode in history equaled 1.6.

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The Effect of Imports and Income Taxes on the Multiplier; Business Cycle Turning Points • • •

Imports and income taxes both mean that the increase in expenditure on domestic production will be smaller at each step of the multiplier process and so the multiplier is smaller. An unexpected decrease in autonomous expenditure is signaled by a buildup of unplanned inventories. The buildup in inventories sets the multiplier process in motion that decreases aggregate expenditure and real GDP so that a recession follows. An unexpected increase in autonomous expenditure is signaled by an unwanted depletion of inventories. The depletion in inventories sets the multiplier process in motion and an expansion follows.

The idea that prices are fixed, even in the very short run, is controversial in economics. However, the fact that changes in inventories have long been a good leading indicator of business cycles is less controversial.

IV. The Multiplier and the Price Level In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve.

The Aggregate Expenditure Curve and the Aggregate Demand Curve •

•

The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same. The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level. When the price level changes, the AE curve shifts and there is a movement along the AD curve. A change in the price level has two effects on consumption expenditure: • Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures. • Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect).

The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes. It is through the multiplier process that expenditure and GDP respond to unplanned changes in inventories. I like to draw out the model with AE curve on top and the AD and AS curves on the bottom. Then: ‡ Shift AE curve upward by change in G. ‡ Show the larger change in Y due to multiplier. ‡ Shift the AD curve rightward by an amount equal to the change in Y holding the price level constant. Ask the students, “Will the economy get the full change in Y?” They will see that in that the upward sloping SAS curve means that there is an increase in the price level, lowering the multiplier effect. ‡ Next, show them the price level effect in the AE graph (a smaller downward shift in the AE curve). Now ask them, “How big is the multiplier in the long run?” You should be able to get a few to mumble “Zero”. So, tell them the conclusion: There is no multiplier in the long run! If the long run is not so long, then it is questionable to increase G in order to increase Y. Students appreciate learning about the tension in economics surrounding this issue since it relates well with politics too. The mechanics of the relationship between the AE and AD curves. Students need a lot of help and clear explanation of the mechanics of the link between these two curves. Here’s what to stress: 1. The AE curve shows how aggregate planned expenditure depends on real GDP (through the effects of disposable income), other things remaining the same. 2. The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same. The next two points are really hard for students: 3. A change in the price level changes autonomous expenditure, which shifts the AE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve. 4. A change in autonomous expenditure at a given price level shifts the AE curve, generates a new level of

EXPENDITURE MULTIPLIERS

equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier. •

•

The wealth effect and the substitution effects show that a rise in the price level decreases consumption expenditure. So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE1. In the figure, equilibrium expenditure decreases to $14 trillion. The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b. The aggregate quantity of real GDP demanded decreases from $16 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $14 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left).

If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts. For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount. In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure. In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward. The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1.

Equilibrium Real GDP and the Price Level • •

Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP. In the short run: • An increase in aggregate demand raises the price level and increases real GDP. In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion. • The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward.

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•

Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run. In the long run: • Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases. • In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion. • The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level. As a result, the long-run multiplier is equal to zero.

It is important to emphasize that the aggregate expenditure model is not without connection to the AS-AD model. Point out to the students that the AE model provides the underpinnings for the AD curve in the AS-AD model used throughout macroeconomics. That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve. It may be a good time to remind students that, just as the Keynesian AE model provides underpinnings for the AD curve, the labor market/aggregate production function model discussed in Chapter 6 provides underpinnings for the long-run aggregate supply curve. Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics. The Economics in the News section studies expenditure changes in the 2014 expansion. It analyzes the growth during the second quarter in terms of the aggregate expenditure model. It focuses on which changes in autonomous expenditure were responsible for increasing aggregate expenditure and hence real GDP.

EXPENDITURE MULTIPLIERS

Additional Problems 1. a. How is it possible for households to have a negative savings rate? What has caused this negative household savings rate? b. Is this negative household savings rate sustainable in the long-run? 2.

Why is the multiplier only a short-run influence on GDP?

When the economy is in a recession and the government enacts a stimulus package, why might a low MPS be good in the short-run in this situation, but not in the long-run?

Solutions to Additional Problems 1.

Households can have a negative saving rate by borrowing. Households increase their borrowing if their wealth rises, if the real interest rate falls, or if their expected future income rises. Any or all of these factors could lead to a negative saving rate. A negative saving rate is not sustainable in the long run. In the long run the saving rate must be positive, if for no other reason than to repay the borrowing.

The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes. The change in the money wage rate affects short-run aggregate supply and lowers the price level. The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium. The long-run change in aggregate expenditure offsets the initial multiplier effect on real GDP.

In the short run, the fear is that a stimulus package while not have enough force to move the economy back to potential GDP. In this situation a small MPS is desirable because it means more spending from any increase in disposable income. However in the long run the economy needs saving to help it grow. Saving in the United States is quite low so in the long run a small value for the MPS is not helpful.

Additional Discussion Questions 11. Why is there a “two-way” link between consumption and GDP? Consumption is part of aggregate expenditure so an increase in consumption increases aggregate expenditure and hence increases GDP. Simultaneously GDP is equal to aggregate income so an increase in GDP increases disposable income and hence increases consumption. 12. How does an increase in disposable income affect the consumption function? An increase in expected future income? An increase in disposable income leads to a movement upward along the consumption function. An increase in expected future income shifts the consumption function upward. 13. If the consumption function shifts upward, what happens to the saving function? Why? If the consumption function shifts upward, the saving function shifts downward. The upward shift in the consumption function means that for each level of disposable income consumption increases. If consumption increases at each level of disposable income, saving necessarily must decrease. The decrease in saving at each level of disposable income means that the saving function shifts downward. 14. When is actual aggregate expenditure different from planned aggregate expenditure? What happens to bring the two back to equality? Actual aggregate expenditure differs from planned aggregate expenditure whenever the economy is not at its equilibrium. These amounts differ as a result of unplanned inventory changes. Take, for instance, the situation when actual aggregate expenditure exceeds equilibrium expenditure. In this case the 45° line, which shows actual aggregate expenditure, lies above the aggregate planned expenditure curve, which shows planned aggregate expenditure. Hence actual aggregate expenditure exceeds planned aggregate

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expenditure. In this situation actual inventory change—which is the measure of inventory change that is included in actual aggregate expenditure—exceeds planned inventory change—which is the measure of inventory change that is included in planned aggregate expenditure. Because actual inventory change exceeds the planned inventory change, firms are finding that their inventories are accumulating in an undesired fashion. They respond to this state of affairs by decreasing their production. As production decreases, real GDP and hence aggregate expenditure decrease until aggregate expenditure eventually equals equilibrium expenditure. 15. Explain why income taxes reduce the size of the expenditure multiplier. The expenditure multiplier results because an increase in autonomous expenditure increases disposable income and induces additional consumption expenditure. In turn the additional consumption expenditure increases disposable income once again, which then induces still additional consumption expenditure. The result that expenditure increases because of the initial increase in autonomous expenditure and then also because of the induced increase in consumption expenditure is why the expenditure multiplier exists. Income taxes decrease the size of the increase in disposable income that results from an increase in expenditure. Therefore the resulting (induced) increase in consumption expenditure is smaller so that the overall expenditure multiplier is smaller. 16. Explain the difference between the aggregate expenditure curve and the aggregate demand curve. The aggregate expenditure curve shows how aggregate expenditure changes when GDP changes. The aggregate demand curve shows how (equilibrium) expenditure and GDP change when the price level changes. 17. Suppose that exports (autonomously) increase. What happens to the aggregate expenditure curve? The equilibrium level of aggregate expenditure? The aggregate demand curve? The aggregate expenditure curve shifts upward. Through the multiplier process the equilibrium level of aggregate expenditure increases. The aggregate demand curve shifts rightward by an amount equal to the increase in equilibrium expenditure.

C h a p t e r

THE BUSINESS CYCLE, INFLATION AND DEFLATION**

The Big Picture Where we have been: Chapter 12 uses the AS-AD model developed in Chapter 10 to explore business cycles, inflation, and deflation. The distinction between the short-run and long-run aggregate supply curves is useful for appreciating the difference between the short-run and long-run Phillips curves. Chapter 12 also draws on the definition of inflation in Chapter 5. Where we are going: Chapter 12 is the last of three chapters dealing with macroeconomic fluctuations. The explanation of the business cycle through the lens of the aggregate supply-aggregate demand model lays the foundation for the next two chapters, on fiscal policy and monetary policy respectively.

N e w i n t h e Tw e l f t h E d i t i o n Along with the new title for the chapter, there is now a new section on deflation. None of the other content was removed, but some sections were written more concisely and the chapter was reorganized to move the business cycle section to the beginning. The Economics In Action about the United States Phillips Curve was shortened by including only data for the 2000’s. The end of chapter Economics In The News feature has a 2014 article about the ECB’s attempts to fight stagnation in the Eurozone. The Worked Problem covers demand-pull and cost-push inflation issues. The Worked Problem gives aggregate demand and short-run aggregate supply schedules and then asks the effect of changes in aggregate demand and aggregate supply. It also asks what type of output gap is created. The answers use both the data in the aggregate demand and short-run aggregate supply functions as well as an aggregate supply/aggregate supply figure. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are still in the MyEconLab and are called Extra Problems.

* This is Chapter 29 in Economics.

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Lecture Notes

The Business Cycle, Inflation and Deflation • • • •

Explain how aggregate demand shocks and aggregate supply shocks create the business cycle Explain how demand-pull and cost-push forces bring cycles in inflation and output Explain the causes and consequences of deflation Explain the short-run and long-run tradeoff between inflation and unemployment

The Business Cycle

Business Cycles. Most principles of economics textbooks have a chapter that is similar to this one. However, many of them contain an extended discussion to the effect that, “This school of thought thinks this, but this other school of thought disagrees, and, by the way, here’s a third school of thought that thinks the first school is partially correct but partially wrong ...” This material is (appropriately enough!) found to be exceptionally tedious by the students. Fortunately, Parkin’s chapter is not at all like these other weak attempts. Parkin shows the students how the schools relate to each other and presents an incredibly exciting chapter. You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it “hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic. You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics.

Mainstream Business Cycle Theory The mainstream business cycle theory regardless fluctuations in aggregate demand around a growing potential GDP (and hence constantly rightward shifting LAS and SAS curves) as the cause of the business cycle. Real GDP differs from potential GDP when money wage rates do not offset changes in the price level. • • •

•

Keynesian Cycle Theory: The Keynesian cycle theory asserts that fluctuations in investment driven by fluctuations in business confidence—summarized by the phrase “animal spirits”—are the main source of fluctuations in aggregate demand. Money wage rates are assumed rigid. Monetarist Cycle Theory: The monetarist cycle theory asserts that fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations in aggregate demand. Money wage rates are assumed rigid. New Classical Cycle Theory: The new classical cycle theory asserts that the money wage rate and hence the position of the SAS curve are determined by the rational expectation of the price level, which depends on potential GDP and expected aggregate demand. Because the money wage rate changes with expected changes in aggregate demand, only unexpected fluctuations in aggregate demand lead to business cycle fluctuations. New Keynesian Cycle Theory: The new Keynesian cycle theory asserts that today’s money wage rates were negotiated at many past dates, which mean that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. Because the money wage rate does not change with newly expected changes in aggregate demand, both expected and unexpected fluctuations in aggregate demand lead to business cycle fluctuations.

Real Business Cycle Theory The real business cycle theory (or RBC theory) regards random fluctuations in productivity as the main source of economic fluctuations.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

• •

•

RBC Impulse: changes in the growth rate of productivity that results from technological change. A decrease in productivity growth brings a recession and an increase brings an expansion. Productivity shocks are measured using growth accounting The RBC Mechanism: A change in productivity changes investment demand and the demand for labor. • If productivity falls, investment demand and hence the demand for loanabe fund decreases. In addition, the demand for labor decreases. The decrease in the demand for loanable funds means the real interest rate falls. According to RBC theory, the fall in the real interest rate decreases the supply of labor because of intertemporal substitution. Because both the supply of labor and the demand for labor decrease, employment decreases and the change in the real wage rate is small. Real GDP decreases. Money plays no role in generating business cycles in the RBC theory; it affects only the price level.

I like to motivate RBC theory by suggesting that economists, such as Lucas and Prescott, challenged our previous portrayal of the LAS curve as being a stable curve that the short run fluctuations revolve around. You can use your arm to suggest that the LAS curve itself might shift leftward and rightward because of technology continuously impacting productivity in unstable ways.

Criticisms and Defenses of Real Business Cycle Theory • •

Critics assert that money wages are sticky and that intertemporal substitution is too weak to account for large fluctuations in the supply of labor, which are necessary for RBC theory to explain the empirical fact that there are large fluctuations in employment with only small fluctuations in the real wage rate. A second criticism of RBC theory has to do with the direction of causality between productivity and business cycle fluctuations. RBC theory assumes changes in productivity cause business cycle fluctuations. Traditional aggregate demand theories suggest that measures of productivity change as a result of business cycle fluctuations. For instance, they assert that in expansions, capital and labor are used more intensely so that measured productivity increases, even with no change in technology.

What does it mean to use capital and labor more intensely? It is easy to see with labor hours. A firm could record the same number of labor hours in an expansion as in a recession. But, if the firm is trying to increase production to meet high demand in the expansion, workers will work harder and, therefore, be more productive in the expansion. This change in productivity is not related to technology but growth accounting likely will (erroneously) attribute the increase in productivity to a technological advance. •

RBC theory defenders point out that the theory is consistent with microeconomic evidence about labor supply decisions and labor demand and investment demand decisions.

II. Inflation Cycles Inflation is a process in which the price level is rising and money is losing value. Inflation is not a rise in one price— it is a broad increase in the price level. Inflation also is not a one-time jump in the price level. It is an ongoing process. There are many examples of one-time jumps in the price level that are not the same as inflation. In Canada, when the federal sales tax was changed in the early 1990s, there was a one-time increase in the CPI. Likewise, when the euro was introduced in 2001, there were one-time increases in many prices in some countries. Neither of these events led to a persistent rise in the rate at which the price level increased and measured inflation using the CPI fell to previous levels soon after the one-time events.

Demand-Pull Inflation An inflation that results from an initial increase in aggregate demand is called demand-pull inflation. Any factor that increases aggregate demand, such as an increase in the quantity of money, an increase in government expenditure, or an increase in exports, can start a demand-pull inflation.

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•

In the short run, an increase in aggregate demand raises the price level and increases real GDP. In the figure the aggregate demand curve shifts from AD0 to AD1 so that the economy moves from point a to point b and the price level rises from 100 to 110. Real GDP exceeds potential GDP and so in the tight labor market the money wage rate rises. The rise in the money wage rate decreases short-run aggregate supply. In the figure, the SAS curve shifts from SAS0 to SAS1. As a result, the economy moves from point b to point c and the price level rises even more, in the figure to 120. Real GDP returns to potential GDP. Inflation occurs only if aggregate demand continues to increase. And aggregate demand continues to increase only if the quantity of money persistently increases.

Demand-Pull Inflation. The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift to the right, for example because of persistent government budget deficits. (However immediately tell the students that if the budget deficit does not constantly increase in size relative to GDP, it will not lead to a constant increase in aggregate demand.) What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate the budget deficit with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central bank is less independent than in the United States, it has been more common for the central bank to consistently monetize budget deficits.

Cost-Push Inflation An inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are an increase in money wage rates or an increase in the money prices of raw materials. •

•

The cost hike decreases short-run aggregate supply, which raises the price level and decreases real GDP. In the figure the short-run aggregate supply curve shifts from SAS0 to SAS1 so that the economy moves from point a to point b and the price level rises from 100 to 110. The combination of a rise in the price level and a fall in real GDP is called stagflation. One possible response to the decrease in real GDP is for the Fed to use monetary policy to increase aggregate demand. If the Fed increases aggregate demand, real GDP increases and the price level rises still higher. In the figure, this Fed policy shifts the aggregate demand curve from AD0 to AD1 and the price level rises to 120. Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand.

Cost-Push Inflation. The text gives a good description of the first oil price increase in the 1970s as a cost-push inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979. An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is the result of monetary growth. To explain inflation, economists are looking for an explanation that fits all cases not an explanation that focuses on specific prices of specific goods that differ from one inflation to another.

Expected Inflation •

•

When inflation is anticipated, the money wage rate changes to keep up with the anticipated inflation. So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SAS curve shifts leftward. If the increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant. There are no deviations from full employment. The magnitude of the shift in A D equals that in SAS so that GDP remains equal to potential GDP and the economy moves up along the LAS curve, from point a to point c in the figures above. If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level. Some of the inflation is unanticipated, so as a result the real wage rate changes and there are deviations from full employment. If aggregate demand grows faster than anticipated, real GDP exceeds potential GDP and the economy behaves as if it were in a demand-pull inflation. If aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation. Because of the costs of unanticipated inflation, there are benefits to forming accurate forecasts of inflation. The best available forecast is the one that is based on all relevant information and is called a rational expectation.

III. Deflation An economy experiences deflation when it has a persistently falling price level.

What Causes Deflation? •

The starting point for understanding the cause of deflation is to distinguish between a one-time fall in the price level and a persistently falling price level. A onetime fall in the price level is not deflation. Deflation is a persistent and ongoing falling price level. The Quantity Theory and Deflation • The quantity theory of money explains the trends in inflation by focusing on the trend influences on aggregate supply and aggregate demand. The foundation of the quantity theory is the equation of exchange, which in its growth rate version and solved for the inflation rate states: Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate •

•

The quantity theory adds to the equation of exchange two propositions. • First, the trend rate of change in the velocity of circulation does not depend on the money growth rate and is determined by decisions about the quantity of money to hold and to spend. • Second, the trend growth rate of real GDP equals the growth rate of potential GDP and, again, is independent of the money growth rate. With these two assumptions, the equation of exchange becomes the quantity theory of money and predicts that a change in the money growth rate brings an equal change in the inflation rate.

What are the Consequences of Deflation? The effects of deflation (like those of inflation) depend on whether it is anticipated or unanticipated. But because inflation is normal and deflation is rare, when deflation occurs, it is usually unanticipated. •

Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and diverts resources from production. • Workers with long-term wage contracts find their real wages rising. But employers respond to a higher and rising real wage by hiring fewer workers, so employment and output decrease. • With lower output and profits, firms re-evaluate their investment plans and cut back on projects that they now see as unprofitable. This fall in investment slows the pace of capital accumulation and slows the growth rate of potential GDP.

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An Economics in Action explores the “Fifteen Years of Deflation in Japan.” The Economics in Action feature describes how the deflation was unexpected, which decreased Japan’s economic growth rate, and was the result of monetary growth that was kept too low. How Can Deflation be Ended? • Deflation can be ended by removing its cause: The quantity of money is growing too slowly. If the central bank ensures that the quantity of money grows at the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation, then, on average, Money Growth, Not the Quantity of Money • It takes an increase in the growth rate of the money stock, not a one-time increase in the quantity of money, to end deflation. • Central banks sometimes increase the quantity of money and fail to increase its growth rate.

IV. Inflation and Unemployment: The Phillips Curve A Phillips curve shows the relationship between inflation and unemployment. There are two time frames for a Phillips curve: the short run and the long run. HISTORY NOTE: The Phillips Curve. As a description of how economics advances, I like to give the students a stylized history of the Phillips curve. The story I tell starts in 1958 when A. W. Phillips published his empirical work. At that time the mainstream economic model was quite different from the AS-AD model derived in the text. Essentially, it was similar to the simple aggregate expenditure model presented in Chapter 11. He had British data that covered a long period of time and so his results appeared to be a long run phenomenon. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, however, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure. This type of analysis reached its peak of popularity during the early and middle 1960s. By 1967, however, it was under attack. On a theoretical level, economist Milton Friedman—among others—pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the simple, fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve. At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that shortrun Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today. This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

The Short-Run Phillips Curve •

•

The short-run Phillips curve (SRPC) shows the relationship between the inflation rate and the unemployment rate holding constant the expected inflation rate and the natural unemployment rate. The figure shows a short-run Phillips curve. Inflation and unemployment have a negative relationship in the short run, so moving along a short-run Phillips curve, a higher inflation rate (holding constant the expected inflation rate) leads to lower a unemployment rate. The downward sloping short-run Phillips curve is equivalent to the upward sloping short-run aggregate supply curve. When aggregate demand unexpectedly increases so that real GDP and the price level both unexpectedly rise, the increase in real GDP lowers the unemployment rate and the unexpectedly higher price level means there is unexpectedly high inflation. The short-run Phillips curve captures the relationship between the lower unemployment rate and higher inflation rate.

Use the board to create a scatter plot of observations that allow you to later “statistically fit” a line through the points as the Phillips curve. As you make the points on the graph, you can call them out as different years from 1950-1969. Now discuss how policy-makers embraced this model as getting to choose where they want to be on the Phillips curve. You can motivate this by picking two points and asking the students which one they thought would be preferred, high inflation and low unemployment or vice versa. As government started to think it could “fine-tune the economy,” we began to observe data points that had high inflation and high unemployment. Was Phillips wrong? Ask the students what might have happened and you may get someone to say it shifted! This answer is, of course, correct. Economists started to explore the effect of expected inflation as a factor that shifts the Phillips curve. You can now discuss the distinction between the longrun and the sort-run Phillips curve. The Long-Run Phillips Curve • The long-run Phillips curve (LRPC) shows the relationship between the inflation rate and the unemployment rate when the actual inflation rate equals the expected inflation rate. As illustrated in the figure, the long-run Phillips curve is vertical at the natural unemployment rate. • The short-run Phillips curve intersects the long-run Phillips at the expected inflation rate. In the figure the expected inflation rate is equal to 4 percent. • In the long run, higher or lower inflation has no effect on the unemployment rate. This result is analogous to the conclusion from the AS-AD model that in long run, a higher or lower price level has no effect on real GDP, which equals potential GDP so that the economy is at full employment.

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The Phillips curve and the AS-AD model: Students can become confused about the tie between the Phillips curve and the aggregate supply/aggregate demand (AS-AD) model. Although this relationship is nicely developed in the text, some students will remain baffled. I do not think that a principles course is the appropriate place to derive the link between the two in much detail. But I do think that my lectures are an appropriate place to convey the idea of the relationship. Thus I point out that the vertical long-run aggregate supply curve is analogous to the vertical long-run Phillips curve. If you graph the two side by side, identify potential real GDP and the natural rate of unemployment on the two graphs at the intersection of the long run curves and the horizontal axis. The point that the long-run aggregate supply curve is vertical means that a higher price level has no effect on real GDP and hence no effect on the unemployment rate. Similarly, the fact that the long-run Phillips curve is vertical implies that a higher inflation rate has no effect on the unemployment rate and hence no effect on real GDP. The analogy also carries over to the short-run curves: the positively sloped short-run aggregate supply curve shows that in the short-run an unexpected higher price level raises real GDP and thus lowers unemployment. In the same way, the negatively sloped short-run Phillips curve demonstrates that in the short-run an unexpected higher inflation rate lowers unemployment, thereby raising real GDP. Students find that the two diagrams actually complement each other. I think that this approach is preferable to having the two diagrams compete with each other!

Shifts of the Phillips Curves • •

A change in the expected inflation rate shifts the SRPC vertically upward or downward by the amount of the change but has no effect on the LRPC. A change in the natural unemployment rate shifts both the SRPC and the LRPC. An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the increase; a decrease shifts the curves leftward by the amount of the decrease.

The U.S. Phillips Curves Because of changes in the expected inflation and the natural rate of unemployment, the short-run Phillips curve has shifted around a lot over time so that there is no single obvious negative relationship between inflation and unemployment. The Economics in the News section analyzes the EBC’s response to potential deflation in 2014.

THE BUSINESS CYCLE, INFLATION, AND DEFLATION

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Additional Problems 1. 2.

Has the U.S. economy experienced inflation or deflation during recent recessions? Explain. The spreadsheet provides information about the economy in Argentina. Column A is the year, Column B is real GDP in billions of 2000 pesos, and Column C is the price level. a. In which years did Argentina experience inflation? In which years did it experience deflation (a falling price level)? b. In which years did recessions occur? In which years did expansions occur? c. In which years do you expect the unemployment rate was highest? Why? d. Do these data show a relationship between unemployment and inflation in Argentina?

1 2 3 4 5 6 7 8 9 10 11 12

A 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

B 277 288 278 276 264 235 256 279 305 331 359 384

C 105.6 103.8 101.9 102.9 101.8 132.9 146.8 160.4 174.5 198.0 226.1 267.7

Solutions to Additional Problems 1,

The United States has experienced inflation during recent recessions, though there have been instances when the inflation rate fell during recessions. For instance in late 2008 the inflation rate fell as the economy moved into a recession. Inflation, however, generally continued because aggregate demand continued to increase during the recessions, though at a slower rate. a. Argentina experienced inflation in 2000 and from 2002 through 2008. Argentina experienced deflation in 1998, 1999, and 2001. b. Argentina had recessions in 1999, 2000, 2001, and 2002. Argentina had expansions in 1998 and 2003 through 2008. c. The unemployment rate was probably high in all of the recessionary years. It was probably the highest in 2000 and 2002 when the recessions were at their worst. d. There is not a strong relationship between unemployment and inflation in the data. The unemployment rate would likely have been higher in the recession years of 1999, 2000, 2001, and 2002. In 2000 Argentina experienced low inflation and 2002 Argentina experienced high inflation. In 1999 and 2001 Argentina experienced deflation. But Argentina also experienced deflation 1998. So there is no consistent relationship between either inflation and high unemployment or deflation and high unemployment. There also is a similar lack of relationship between inflation and low unemployment or deflation and low unemployment.

Additional Discussion Questions 11. Some economists claim that inflation is always a “monetary phenomenon.” What do they mean by this claim and are they correct? This claim points to the result that an on-going inflation requires the central bank to constantly increase the quantity of money. In the absence of continual monetary growth, the price level might rise but it would eventually stabilize. The price level will continue to rise, which means that on-going inflation will occur, only if the Federal Reserve constantly increases the quantity of money. Because inflation requires constant growth in the quantity of money, inflation can be thought of as a “monetary phenomenon.” 12. How can a higher price of oil create inflation? By itself a higher price of oil cannot create inflation. Taken by itself a higher price of oil can lead to a higher price level but after the adjustment is made to the higher price of oil, the price level stops rising—that is, inflation stops. A

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higher price of oil can lead to inflation only if the central bank “ratifies” it by increasing the quantity of money. If the central bank, the Federal Reserve in the United States, responds to the decrease in real GDP created by the higher price of oil by increasing the quantity of money, then inflation can result. The increase in the quantity of money will drive the price level still higher. In this situation oil producers might respond by again boosting the price of oil. If the Fed responds once again in turn, the process can continue indefinitely and a cost-push inflation results. 13. What is the relationship between the short-run aggregate supply curve and the short-run Phillips curve? Between the long-run aggregate supply curve and the long-run Phillips curve? The short-run aggregate supply curve and the short-run Phillips curve are closely related. If aggregate demand increases, the economy moves upward along its short-run aggregate supply curve so that the price level and real GDP both increase. The rise in the price level means that inflation rises and the increase in real GDP means that unemployment falls. The rise in the inflation rate combined with the fall in the unemployment rate correspond to a movement upward along the economy’s short-run Phillips curve. Similarly the long-run Phillips curve and long-run aggregate supply curve also are closely related. In the long run an increase in aggregate demand moves the economy upward along its long-run aggregate supply curve so that the price level rises and real GDP does not change—it remains equal to potential GDP. The rise in the price level means that the inflation rate rises and the result that real GDP remains equal to potential GDP means that the unemployment rate remains equal to its natural rate. The rise in the inflation rate combined with the unemployment rate remaining equal to its natural rate correspond to a movement upward along the economy’s long-run Phillips curve. 14. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent while the expected inflation rate remains at 7 percent, what happens to the unemployment rate? If the actual inflation rate falls and the expected inflation rate does not change, the economy moves downward along a short-run Phillips curve so that the unemployment rate increases. 15. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent and the expected inflation rate also falls to 5 percent, what happens to the unemployment rate? If the actual inflation rate and the expected inflation rate fall by the same amount, the economy moves downward along its long-run Phillips curve so that the unemployment rate does not change—it remains equal to the natural unemployment rate. 16. Suppose that the actual inflation rate is 7 percent and that the economy is at the natural unemployment rate. If the Fed announces that it is going to lower the inflation rate and people believe this announcement (so that the decline in the inflation rate is not a surprise), what happens to the unemployment rate? Suppose that people believe the Fed’s announcement and that the expected inflation rate falls, but then the Fed keeps the inflation rate at 7 percent. Now what happens to the unemployment rate? If the Fed follows through on its announcement, both the actual and expected inflation rate fall by the same amount so that the unemployment rate remains equal to its natural rate. However if the Fed actually does not lower the inflation rate, then the actual inflation rate exceeds the expected inflation rate. In this case the short-run Phillips curve shifts downward. The economy moves to a point on its new short-run Philips curve at the unchanged inflation rate and the unemployment rate falls. 17. How do you think recessions influence elections? Recessions have large impacts on elections. If an election occurs during (or near) a recession, the incumbent party suffers. This empirical result holds true for President Ford who lost his reelection bid in 1976; President Carter who lost his reelection bid in 1980; President Bush who lost his reelection bid in 1992; and Senator McCain who lost his election bid in 2008. All of these candidates were members of the incumbent party and all faced election either near or during a recession. President Obama’s re-election in 2012 was an unusual case in that the economy was in recovery but unemployment was still high near 8 percent.

C h a p t e r

FISCAL POLICY

The Big Picture Where we have been: This chapter extensively uses the aggregate supply-aggregate demand model introduced in Chapter 10. It also makes use of Chapter 11’s discussion of multipliers. The material on the labor market and potential GDP from Chapter 6 is important when discussing the supply-side effects of fiscal policy. Where we are going: Chapter 14 on monetary policy completes the material on macroeconomic stabilization policies.

N e w i n t h e Tw e l f t h E d i t i o n This chapter is rich with data, which has all been updated to 2014. The At Issue section has updated content while it continues to have President Obama and Paul Ryan’s contrasting policy suggestions. The Economics in the News feature at the end of the chapter discusses a 2014 article on Japan’s challenges with its debt and deficit. The Worked Problem explores the short-run and long-run consequences on economic growth and other variables of an increase in infrastructural expenditure and a decrease in taxes. The AD-SAS model is used to answer the questions. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are still in the MyEconLab and are called Extra Problems.

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Lecture Notes

Fiscal Policy • •

Fiscal policy refers to changes in government expenditure and taxes. Fiscal policy impacts both aggregate supply and aggregate demand.

The Federal Budget

The annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support those outlays and receipts make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy.

The Institutions and Laws •

•

The President submits a budget proposal to Congress. Congress debates, amends, and enacts the budget. The budget operates within the framework of the Employment Act of 1946, which states: “… it is the continuing policy and responsibility of the Federal Government to use all practicable means … to coordinate and utilize all its plans, functions, and resources … to promote maximum employment, production, and purchasing power.” The Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecasts of where it is heading.

Highlights of the 2015 Budget • • •

Receipts come from four sources: personal income taxes ($1,505 billion), social security taxes ($1,176 billion), corporate income taxes ($537 billion), and indirect taxes and other receipts ($296 billion). Outlays are classified in three categories: transfer payments ($2,649 billion), expenditure on goods and services ($1,030 billion), and debt interest ($479 billion). Budget balance = Receipts – Outlays • If receipts exceed outlays, the government has a budget surplus. • If outlays exceed receipts, the government has a budget deficit. • If receipts equal outlays, the government has a balanced budget.

The U.S. Budget in Historical Perspective and in Global Perspective • • •

Since 1990, except between 1998 to 2001, the U.S. government has had a budget deficit. Government debt is the total amount that the government has borrowed. A budget deficit adds to the government debt. In 2014, all of the world’s major economies except Germany had a budget deficit. The newly industrialized economies of Asia had the smallest deficits while Japan, the United States, the United Kingdom (in that order) had the largest deficits as a fraction of GDP. The U.S. deficit was about 5 percent of GDP.

The At Issue detail presents arguments about different budget plans. President Obama’s plan keeps the budget deficit constant at $500 billion through 2024, while Representative Paul Ryan’s plan would slash the deficit to $100 billion over the same time period. Deficit and debt. Many students need help with the distinction between the deficit and the debt (and with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance (the deficit or surplus) is just like a personal budget balance (the amount that a student borrows or pays back during a given year). The debt—the total amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job (usually) have a budget surplus and decreasing debt. An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last

FISCAL POLICY

one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $30 billion by 2015!)

II. Supply-Side Effects of Fiscal Policy The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects.

The Effects of Taxes on Full Employment and Potential GDP • •

• •

•

The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP. The equilibrium quantity of employment is determined in the labor market. The first figure shows the labor market. In the figure equilibrium employment is 250 billion hours per year. This amount of employment is full-employment. The second figure shows the production function. With employment of 250 billion hours, the production function shows that real GDP is $13 trillion. An income tax decreases the supply of labor and shifts the supply of labor curve leftward. In the top figure, the LS curve shifts leftward. Because of the tax wedge, the level of employment decreases. In the bottom figure the decrease in employment decreases potential GDP. An income tax drives a tax wedge between the before-tax wage rate that firms pay and the after-tax wage rate that workers receive. Other taxes, such as sales taxes, add to the tax wedge by effectively lowering the real wage rate.

Some Real World Tax Wedges … Does the Tax Wedge Matter? Tax wedges vary across countries, being much higher in France than in the United States. According to supply-side economists such as Ed Prescott, the tax wedge has a large impact on potential GDP. Potential GDP per person in France is 30 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges.

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Taxes and the Incentive to Save and Invest •

•

A tax on interest income decreases the supply of saving and shifts the supply of loanable funds curve leftward. The tax drives a wedge between the aftertax interest rate received by savers and the interest rate paid by firms. The tax does not change the demand for loanable funds. The figure shows the result: the real interest rate paid by borrowers rises (from 5 percent to 6 percent in the figure) and the equilibrium quantity of loanable funds and investment decrease. The decrease in investment lowers the growth rate of potential GDP.

Tax Revenues and the Laffer Curve •

•

The relationship between the tax rate and the amount of tax collected is called the Laffer curve. The Laffer curve shows that at a high enough tax rate, an increase in tax rates decreases tax revenues. Tax revenues decrease because individuals find ways to avoid the high taxes, including by working less. Most economists believe that taxes have an effect on the supply of labor, but that in the U.S. economy, the tax rate is low enough so that an increase in the tax rate increases tax revenues.

Laffer Curve and Napkins: Students get a kick out of the napkin roots of the Laffer Curve. The story that Laffer himself cannot deny nor confirm is that he first drew the Laffer curve on a napkin during one of his first attempts to persuade someone of his supply side theory. Draw the Laffer curve and ask what side of the curve are we on? Ask them what they think the highest tax rate was in the United States, they are usually shocked to learn that we had marginal rates in the 70% range as recently as the 1970. This a great discussion point on how high tax rates can deter work! Consumption Tax: Students enjoy exploring the controversial idea of abolishing the IRS in favor of a consumption tax. Whether you agree with it or not, the Fairtax plan (Google Fairtax plan to find the website) covers many issues from this chapter and is an awesome way to bring together many of the topics from the course. Students engage with the concept of a revenue neutral switch from our mixed tax system to 100% consumption tax. I assign a short paper for them to investigate one of the many sub-topics within the plan. The Economics in the News detail compares the U.S. corporate tax rate with those in other countries and explores how the tax wedge affects the U.S. loanable funds market.

III. Generational Effects of Fiscal Policy Generational accounting is an accounting system that measures the lifetime tax burden and benefits of government programs to each generation.

Generational Accounting and Present Value To compare the costs and benefits that occur at different points in the future, which is necessary in generational accounting, the concept of present value is used. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account. Because there is uncertainty about the proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values.

The Social Security Time Bomb •

Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2014, the fiscal imbalance was estimated to be $68 trillion and growing by about $2 trillion every year. The fiscal imbalance is high because of obligations under Social Security laws and Medicare.

FISCAL POLICY

•

There are four alternatives for redressing the fiscal imbalance: raise income taxes, raise Social Security taxes, cut Social Security benefits, or cut federal government discretionary spending. But the changes needed would be severe. It is estimated that income taxes would need to be raised by 69 percent; or Social Security taxes raised by 95 percent; or Social Security benefits cut by 56 percent.

Generational Imbalance Generational imbalance is the division of the fiscal imbalance between the current and future generations assuming that the current generation will enjoy the current levels of taxes and benefits. It is estimated that the current generation will pay 83 percent of the fiscal imbalance and the future generations will pay 17 percent.

IV. Fiscal Stimulus • •

A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy. A fiscal action that is triggered by the state of the economy is called automatic fiscal policy.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances •

• •

Tax revenues and needs-tested spending change with the business cycle. • The government sets tax rates. As incomes vary with the business cycle, the tax revenue collected changes. Tax revenue automatically falls in recessions and automatically rises in expansions. • Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending. Needs-tested spending automatically increases in a recession and automatically decreases in an expansion, helping to stabilize the economy. Induced taxes and needs-tested spending mean that the federal budget deficit is counter-cyclical, with the deficit increasing in a recession and decreasing in an expansion. The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit. • In 2014 the total U.S. budget deficit was $0.64 trillion. According to the Congressional Budget Office (CBO) the cyclical deficit was $0.18 trillion so the structural deficit was $0.46 trillion. • The structural deficit skyrocketed after 2008..

By their nature, automatic fiscal policy implies federal budget deficits in recessions as tax revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy. In the 2008 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle. •

Automatic fiscal policy helps stabilize the business cycle because it provides an automatic stimulus during a recession and an automatic contraction during an expansion.

Discretionary Fiscal Stimulus • •

The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. An increase in government expenditure increases aggregate expenditures setting in motion the multiplier process. The tax multiplier is the quantitative effect of a change in taxes on real GDP. A decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process. • The effect on aggregate demand from a tax cut is less than that from a similar sized increase in government expenditure. A $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC) of the $1 increase in disposable income is spent on consumption expenditure.

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Fiscal Stimulus •

•

Expansionary fiscal policy (an increase in government expenditure or a decrease in taxes) seeks to eliminate a recessionary gap. If timed correctly and of the correct magnitude, fiscal policy can be used to push the economy to potential GDP. The figure shows the effect of expansionary fiscal policy on aggregate demand. At the initial equilibrium, $15 trillion real GDP and price level of 110, there is a recessionary gap. The expansionary policy increases aggregate demand and the multiplied effect shifts the AD curve rightward from AD0 to AD1. The recessionary gap is eliminated and the economy moves to its new equilibrium, $16 trillion real GDP (which equals potential GDP) and price level of 115.

Fiscal Stimulus and Aggregate Supply The focus so far has been on only aggregate demand. But fiscal policy also impacts aggregate supply. • Government Expenditure: An increase in government expenditure increases the budget deficit. The demand for loanable funds increases, so the real interest rate rises and investment is crowded out. The decrease in investment offsets the expansionary effect from the increase in government expenditure. The crowding-out effect is strong enough so that the government expenditure is less than 1. • Tax Cut: A tax cut also has effects on aggregate supply. A tax cut increases the supply of labor and the supply of loanable funds, both of which increase aggregate supply. The supply-side effects make the tax multiplier larger than the government expenditure multiplier. There is quite a bit of controversy about the size of the multipliers and this controversy is nicely covered in an Economics in Action detail. Christina Romer, while working for the Obama administration, asserted that the government expenditure multiplier was 1.5. Robert Barro, of Harvard University, says his research shows the multiplier is 0.5. These differences are dramatic and students can appreciate their importance and real-world relevance. Highlight the Ricardo-Barro effect as a possible argument for smaller multipliers.

Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by three time lags: • • •

Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed. Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending. Impact Lag: The impact lag is the time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP.

Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditure shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the length of time it took the Congress to pass the 2002 “stimulus package” and the time it took in the Fall of 2008 to decide on a fiscal policy to be used after the initial “bailout package.” The law-making lag can be substantial and the outcomes questionable!

FISCAL POLICY

Additional Problems 1.

The government is proposing to lower the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions and describe what happens on the relevant graph. You are being asked about directions of change, not exact magnitudes. a. What will happen to the supply of labor and why? b. What will happen to the demand for labor and why? c. What will happen to the equilibrium level of employment and why? d. What will happen to the equilibrium before-tax wage rate? e. What will happen to the equilibrium after-tax wage rate? f. What will happen to potential GDP?

How Reagan Would Fix the Economy Many Republicans look at Reagan’s policies in the early 1980s and assert that tax cuts pay for themselves. That’s wrong—Reagan’s rate cuts for the rich paid for themselves, but the tax cuts for the poor, the middle class and corporations did not. The deficit increased. But there is a limit to the deficit. At some time the government debt grows so large that it starts to harm the economy through higher interest rates, bigger debt payments, a weaker currency, etc. Time, May 26, 2008 a. Explain why Reagan’s tax rate cuts for high income taxpayers may have paid for themselves, but cuts for lower-income and middle-income taxpayers did not. b. Explain the negative consequences of running persistently large budget deficits.

Explain why extending unemployment insurance benefits has both a supply-side and demand-side effect on real GDP and the price level.

Solutions to Additional Problems 1.

b. c.

d. e.

f. 2.

The supply of labor increases. The supply of labor curve shifts rightward. The supply of labor increases because at each real wage rate, the after-tax wage rate received by workers will be higher given a decrease in the tax rate on labor income. The demand for labor remains the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income. The equilibrium level of employment increases. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases. The equilibrium pre-tax wage rate decreases. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve. The equilibrium after-tax wage rate increases. The decrease in the tax rate on labor income decreases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate increases. Potential GDP increases. The equilibrium level of employment is the full employment quantity of labor. So as full employment increases, potential GDP increases along the production function. High-income taxpayers faced very high tax rates. For these taxpayers, the cut in tax rates probably lead to large increases in the quantity of labor they supplied so that the tax revenue from high-income taxpayers increased. But middle-income and lower-income taxpayers did not face such high rates. For these groups the tax cut increased the quantity of labor they supplied but by only a small amount so that the tax revenue from middle-income and low-income taxpayers decreased. Persistently running large budget deficits increases the government debt, which increases the interest the government must pay and contributes to larger budget deficits in the future. Budget deficits also crowd

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out investment, so persistently running budget deficits decreases investment and the capital stock is less than otherwise. Because the capital stock is smaller, U.S. potential GDP is lower. 3.

Extending unemployment insurance benefits increases the amount of time unemployed workers search for new jobs, which decreases employment. The decrease in employment decreases aggregate supply. Simultaneously extending unemployment insurance benefits increases the income received by unemployed workers. The increase in income increases consumption expenditure, which increases aggregate demand.

Additional Discussion Questions 11. What is the distinction between the government’s budget deficit and the government’s debt? The budget deficit is the amount the government is borrowing in any given year. The government debt is the total amount the government has borrowed over all the years. The budget deficit adds to the (total) government debt. 12. Suppose that the government increases its expenditures payments by $100 billion and pays for the increase by raising taxes by $100 billion. What is the effect on aggregate demand and real GDP of each change individually and of the two combined? The increase in government expenditure adds directly to aggregate demand so that aggregate demand and real GDP both increase. The increase in taxes indirectly decreases aggregate demand by decreasing consumption expenditure. The decrease in aggregate demand leads to a decrease in real GDP. The magnitude of the increase in aggregate demand from the increase in government expenditure exceeds the magnitude of the decrease from the increase in taxes. So when both effects are combined, on net aggregate demand increases so that real GDP increases. 13. Why does a change in income taxes have a different effect on aggregate supply than a change in government expenditures? A change in income taxes changes the tax wedge and affects people’s incentives to supply labor. The supply of labor changes, which affects employment and hence potential GDP. For example, if income taxes are boosted, the supply of labor decreases. With the decrease in the supply of labor, employment decreases so that potential GDP decreases. The decrease in potential GDP decreases aggregate supply. A change in government expenditures does not have this same incentive effect. Because it does not have this effect, it has no impact on aggregate supply. 14. Suppose because of a recession, most state governments experience reductions in tax revenues, and respond by reducing their expenditures and increasing their taxes to keep their state budgets in balance (a constitutional requirement in many U.S. states). Will this have any effect on the recession, and if so, what? This policy on the part of states deepens the recession. In a recession fiscal policy generally aims to increase aggregate demand because the increase in aggregate demand increases real GDP. Cutting state government spending and raising taxes decreases aggregate demand. A decrease in aggregate demand decreases real GDP and worsens the recession. 5. In 2012, the looming “Fiscal Cliff” meant that there would be an increase in taxes coupled with a decrease in government spending. Meanwhile the Federal Reserve was continuing “Quantitative Easing.” Discuss the combined effects of these events on the economy. The fiscal cliff is a combination of two contractionary fiscal policies which would decrease aggregate demand. Quantitative Easing is an expansionary monetary policy meant to increase aggregate demand. Chairman Bernanke stated during the fourth quarter of 2012 that the Fed was pursuing that policy in part to hedge against the negative effects of the fiscal cliff should it happen.

C h a p t e r

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The Big Picture Where we have been: Chapter 14 heavily uses material from Chapter 8, which was the first chapter dealing with money, and Chapter 10, which introduced the aggregate supply-aggregate demand model. The expenditure multiplier, covered in Chapter 11, plays a small role in this chapter. Playing a larger role is the loanable funds market, developed in Chapter 7. Where we are going: Chapter 14 is the last dealing with macroeconomics. The next chapter, on international trade, will not use the material from this chapter.

N e w i n t h e Tw e l f t h E d i t i o n This chapter is largely the same as the eleventh edition with a nice update to the At Issue section along with data updates throughout. The At Issue section now presents opposing opinions from Janet Yellen and other members of the Federal Reserve System. The Economics In The News feature has a 2014 story and analysis about the Fed’s continued promises to keep interest rates low in the near future. The Worked Problem discusses federal funds rate movement and its effect on other macroeconomic variables. It challenges the student to explain how and when a Fed policy to stimulate the economy works. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are still in the MyEconLab and are called Extra Problems.

* This is Chapter 31 in Economics.

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Lecture Notes

Monetary Policy • • •

The Fed can influence the federal funds interest rate and thereby affect economic activity. What are the transmission channels of monetary policy? What are alternative monetary policy strategies? The Fed (and other government agencies) has responded to the financial crisis of 2007-2008 with a variety of innovative policies designed to fight the crisis.

Monetary Policy Objectives and Framework

Monetary Policy Objectives The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” •

Goals: The goals in the mandate are “maximum employment, stable prices, and moderate long-term interest rates.” Achieving stable prices, keeping the inflation rate low, is the key. It is the source of maximum employment and moderate long-term interest rates. Low inflation rates mean that people make decisions without the confusion created by inflation. And, because the nominal interest rate equals the real interest plus the inflation rate, a low inflation rate means low long-term interest rates. • Operational “Stable Prices” Goal: The Fed pays close attention to the core PCE deflator, the PCE deflator excluding food and fuel. The core inflation rate is the rate of increase of the core PCE deflator. Price stability can mean either a core inflation rate “low and stable enough so that it does not enter materially into the decisions of households and firms” (Alan Greenspan) or a core inflation rate of “1 or 2 percent” (Ben Bernanke). •

Operational “Maximum Employment” Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP. The Fed tries to minimize the output gap.

Responsibility for Monetary Policy •

• •

The Role of the Fed The Federal Reserve Act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy. The Fed has ultimate responsibility for monetary policy. The FOMC makes monetary policy decisions at eight scheduled meetings a year. The Role of Congress Congress plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress. The Role of the President The formal role of the president of the United States is limited to appointing the members and the chairman of the Board of Governors.

II. The Conduct of Monetary Policy The Monetary Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target. • •

•

The Fed could fix the exchange rate as its policy instrument. But then it could not pursue an independent monetary policy, so for that reason the Fed does not fix the exchange rate. The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. Although the Fed can change the federal funds rate by any reasonable amount, it normally changes the federal funds rate one quarter of a percentage point at a time. The federal funds rate is determined in the market for reserves.

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•

The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. So the higher the federal funds rate, the smaller the quantity of reserves demanded. As shown in the figure, the demand curve for reserves is downward sloping. The Fed’s open market operations determine the supply of reserves. Because the Fed determines the quantity of reserves, the figure shows that the supply curve of reserves is vertical at this quantity. • An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves. The supply of reserves increases. • An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves. The supply of reserves decreases. The figure shows the market for reserves. In the figure the equilibrium federal funds rate is 5 percent. • If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The quantity of reserves increases and the federal funds rate falls. •

If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities. The quantity of reserves decreases and the federal funds rate rises.

Interest Rate Determination: The reason that an increase in the reserves lowers the interest rate can be easily developed by focusing on banks. Using an open market operation, the Fed increases excess reserves. Banks want to loan these new excess reserves, and thus the supply of loans and loanable funds increases. As a result, the interest rate on loans falls as they struggle to make more loans. This type of intuitive explanation often can be quite helpful in supplementing the formal analysis.

FOMC Decision Making and the Market for Reserves After assessing the current state of the economy using the Beige book (which is now online), the Fed turns to forecasting three key variables: the inflation rate, the unemployment rate, and the output gap. Based on those forecasts, The FOMC formulates its monetary policy and decides upon its target federal funds rate. The FOMC instructs the New York Fed to use open market operations—the purchase or sale of government securities in the open market—to hit its federal funds target rate. Interest on Reserves: You may want to mention that because of the 2008 financial crisis, the Fed accelerated its plan to implement paying interest on reserves. This change effectively created a lower bound for the federal funds rate and added another tool to the Fed’s toolbox. A relevant article on the subject can be found on the San Francisco Fed website entitled “Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay?”

III. Monetary Policy Transmission Ripple Effects of Changing the Interest Rate Suppose the Fed lowers the federal funds rate using an open market sale. As a result: • • •

Other interest rates: Other short-term interest rate falls. Long-term bond interest rates also fall, but by a lesser amount. Exchange rate: The fall in the U.S. interest rate lowers the U.S. interest rate differential. The demand for U.S. dollars decreases and the supply of U.S. dollars increases. The exchange rate falls (the dollar depreciates). Money and bank loans: Banks’ reserves have increased so they have excess reserves. Banks loan the excess reserves, so loans and the quantity of money increases.

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• • •

Long-term real interest rate: The real interest rate is determined in the loanable funds market. In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate. Expenditure plans: Consumption expenditure and investment increase as a result of the lower real interest rate. Net exports increase as a result of the fall in the exchange rate. Aggregate demand: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases.

Effects of Money on Real GDP and the Price Level: We bring in here the expenditure multiplier; it is important to ensure that students do not get confused between the multiplier impact of open market operations on the quantity of money, and the multiplier process that magnifies autonomous expenditure changes. Additionally, when using the AS-AD model to explain the impact of deflationary monetary policy, it is important to stress the text’s point that the model is a stationary simplification, whereas in reality output and the price level both tend to grow, so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow their growth.

The Fed Fights Recession If the Fed believes that real GDP is less than potential GDP (a negative output gap), the Fed will undertake expansionary monetary policy: it lowers the federal funds rate using an open market sale. The monetary policy is transmitted as outlined above and real GDP increases.

The Fed Fights Inflation If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem (a positive output gap), the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale. The effect of the monetary policy is transmitted as described, only the directions of the changes are reversed. Real GDP decreases. Tying it All Together: Students often think that macroeconomics is difficult because there are so many different concepts introduced. Among others, students must learn about aggregate demand curve and the short-run and long-run aggregate supply curves; the aggregate production function; ; the demand for labor, the supply of labor, and the labor market; the demand for reserves, the supply of reserves, how Fed policy affects the supply of reserves, and the market for reserves; the demand for money, the supply of money, the money multiplier, and the market for money; and, the demand for loanable funds, the supply of loanable funds, the market for loanable funds, and government impacts on this market. This chapter offers a great chance for you to use the book’s very clear presentation and very straightforward presentation of monetary policy transmission to help the student see how all the parts interact. Use the book’s “four quadrant diagrams” (Figures 14.6a, 14.6b, 14.6c, and 14.6d as well as 14.7a, 14.7b, 14.7c, and 14.7d) to show the students how everything they learned ties together to give a complete and coherent view of the otherwise exceedingly complex macroeconomy. Don’t hesitate to refer back to earlier chapters to remind the students what they learned in those chapters and how that is now being used to explain how our economy functions.

Loose Links and Long and Variable Lags •

In reality, the ripple effects of monetary policy are not as precise as outlined above. • The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate. And the response of expenditure plans to the real interest rate also is not tight. •

•

The transmission channels described above take time to operate and the time can vary from one episode to the next.

In the United States, when the federal funds rate rises relative to the long-term bond rate, a year later real GDP growth generally slows.

The Economics in the News section details how aggressive Fed policy since 2008 did not have an equally strong effect on GDP. The section notes that the Fed’s policy had a weak effect on long-term interest rates which, in turn, had a weak effect on aggregate expenditure.

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Effects of Money on Real GDP and the Price Level Revisited: You might want to remind the students that the effects of monetary policy on real GDP and the price level so clearly discussed in this chapter are short run effect. In the long run, the quantity theory covered in Chapter 8 rules the roost. You can point out to your students that in the long run, the impact on real GDP dissipates and the only long run effect is on the price level (or the inflation rate). In the late 1970s and early 1980s, several central banks targeted the quantity of money to successfully lower their inflation rates. However, central banks eventually abandoned this procedure as financial innovations made the demand for money (and velocity) mush less stable than in the past.

IV. Extraordinary Monetary Stimulus The Key Elements of the Crisis The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression. •

• •

Banks were put under stress from three sources: • A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity. • A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start. • A Run on the Bank: One bank in the United Kingdom, Northern Rock, experienced a bank run. In the United States, massive withdrawals of deposits from money market mutual funds occurred. Banks’ desired reserves increased so banks increased their reserves by calling in loans. • The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity. Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world. The drastic decrease in the supply of loanable funds started to affect the real economy.

The Policy Actions •

Policy actions responding to the crisis were slowly implemented until by November 2008 eight groups of policies were in place: • Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity. The federal funds rate was lowered, in December to between 0.00 and 0.25 percent. • Extension of Deposit Insurance: Deposit insurance was extended to other institutions, such as money market funds. This policy was aimed at preventing runs. • Term Auction Credit; Primary Dealer and Other Broker Credit; and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility: These are three separate policies but all have similar effects: The Fed accepted significantly riskier assets from a wider range of depository institutions than before in exchange for assets or reserves. These policies allowed depository institutions to swap risky assets for safer assets or reserves. • Troubled Asset Relief Program (TARP 1): The TARP is conducted by the U.S. Treasury not the Fed. The TARP was funded with $700 billion of government debt. As first envisioned, the plan was for the U.S. government to buy troubled assets from depository institutions and replace them with U.S. government securities. But this process was more difficult than thought and its overall value was questioned. • Troubled Asset Relief Program (TARP 2): Because of the difficulties of the TARP 1 and concern about its effectiveness, the TARP was modified to the TARP 2, in which the U.S. government took direct equity stakes in major depository institutions. This action directly increased these firms’ equity and reserves. In December of 2008 some of the TARP funds were used to assist major automakers. • Fair Value Accounting: The accounting standard that required depository institutions to value their assets at their current market value was relaxed and they were permitted, in rare occasions, to use a model to value the assets. The effect of this policy was to try to keep depository institutions’ (accounting measure of their) equity higher.

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Persistently Slow Recovery • •

Despite extraordinary efforts by monetary and fiscal policy, the U.S. economy at the end of 2010 still had slow growth and high unemployment, with the unemployment rate near 10 percent. Critics argue that the Fed did more harm than good by creating uncertainty with its policies. They argued that the Fed should create greater clarity about its monetary policy strategy.

The At Issue detail presents arguments within the Fed for and against keeping interest rates low for a “considerable time.” Janet Yellen, chair of the Fed presents arguments in favor of this policy and Richard Fisher, President of the Dallas Fed, argues against it.

Policy Strategies and Clarity Two alternative decision-making strategies have been proposed. Both strive to create greater openness and certainty about the Fed’s monetary policy.

Inflation Rate Targeting •

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target. Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low.

Taylor Rule •

The Taylor rule uses a formula to set the target federal funds rate. The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be 2 percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to: FFR = 2 + INF + 0.5(INF − 2) + 0.5GAP John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better.

Why Rules? •

Rules are important because rules enable households and firms to form more accurate inflation expectations. Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations.

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Additional Problems 1.

In Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 1, the short-run aggregate supply curve is SASA and a drought decreases potential GDP to $250 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

Figure 14.2 shows the economy of Freezone. The aggregate demand curve is AD, and the short-run aggregate supply curve is SASA. Potential GDP is $300 billion. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What do you predict will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

Suppose that in Freezone, shown in problem 3, the short-run aggregate supply curve is SASB and potential GDP increases to $350 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

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China Raises Reserve Requirements The People’s Bank of China, the country’s central bank, raised the reserve requirements of its top commercial banks to put a squeeze on the credit market following a spell of robust economic growth. Source: International Business Times, October 11, 2010 a. If the United States had the economic performance of China, what monetary policy actions would the Fed’s most likely take. b. How would you expect China’s monetary policy of squeezing the credit market to influence aggregate demand in China. Would you expect it to have a multiplier effect? Why or why not? c. What actions might the People’s Bank of China take to slow the economy?

Solutions to Additional Problems 1.

a. b. c.

b. c. 3.

a. b. c.

The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 110 and real GDP is $400 billion. Freezone has an inflation problem because its real GDP, $400 billion, is greater than its potential GDP, $300 billion. In this case if no action is taken Freezone will suffer from inflation. If the central bank takes no monetary policy action, the nominal wage rate and other resource costs will eventually rise so that short-run aggregate supply decreases. Ultimately in the long run the economy will reach equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will rise to 120. The central bank can take a contractionary monetary policy by raising the interest rate. This policy decreases aggregate demand, which decreases real GDP, lowers the price level, and decreases inflation. Decreasing real GDP, however, will increase the unemployment rate. Freezone’s price level is 130 and its real GDP is $200 billion. Freezone has an unemployment problem because its real GDP is less than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand will increase. The increase in aggregate demand will raise the price level and increase real GDP, helping solve Freezone’s unemployment problem. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, the price level falls and real GDP decreases, which worsens Freezone’s unemployment problem. Freezone should lower the interest rate and buy securities because this policy will help solve Freezone’s unemployment problem. The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 130 and real GDP is $200 billion. Freezone has an unemployment problem because its real GDP, $200 billion, is less than its potential GDP, $300 billion. If the central bank takes no action, the nominal wage rate and other resource costs eventually fall so that the short-run aggregate supply increases. Ultimately in the long run the economy will reach an equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will fall to 120. The central bank can take an expansionary monetary policy by lowering the interest rate. This policy increases aggregate demand, which raises the price level and increases real GDP. Unemployment decreases. Raising the price level, however, increases the inflation rate. Freezone’s price level is 110 and its real GDP is $400 billion. Freezone has an inflation problem because its real GDP is greater than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand increases. The increase in aggregate demand increases real GDP and further raises the price level, worsening Freezone’s inflation problem. If the central bank raises the federal funds rate and sells securities, aggregate demand decreases. As a result, real GDP decreases and the price level falls, which will decrease inflation and help solve Freezone’s inflation problem. Freezone should raise the federal funds rate and sell securities because this policy will help solve Freezone’s inflation problem.

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a. b.

The Fed most likely would undertake contractionary monetary policy, as did the People’s Bank of China. The Fed, however, would probably raise the federal funds rate rather than raise reserve requirements. China’s policy is designed to decrease the supply of loanable funds in China, thereby raising the real interest rate in China and decreasing investment and consumption expenditure. Aggregate demand decreases because both consumption expenditure and investment decrease. The overall impact of this policy might be smaller than expected because foreign loanable funds will flow into China to take advantage of the higher Chinese real interest rate. This increase in the supply of loanable funds will moderate the rise the interest rate. Even so, it is likely there will be a small multiplier effect if aggregate demand decreases because there will be some induced decrease in consumption expenditure. The People’s Bank of China could raise the Chinese interest rate or, as it has done, increase reserve requirements.

Additional Discussion Questions 1.

Suppose events in the rest of the world cause the exchange rate to fall when the U.S. economy is at full employment. How should the Fed react in order to maintain macroeconomic stability? Why? The fall in the foreign exchange rate increases U.S. aggregate demand and will, if left alone, create an inflationary gap. The Fed should conduct a contractionary monetary policy by raising the federal funds rate. The contractionary monetary policy decreases U.S. aggregate demand and offsets the incipient inflationary gap.

What limits the Fed’s ability to steer the economy to avoid both recession and inflation? The Fed can offset fluctuations in aggregate demand because its monetary policy affects aggregate demand. So, for instance, if aggregate demand decreases the Fed can undertake expansionary monetary policy to increase aggregate demand, thereby offsetting the original decrease. However the Fed cannot offset fluctuations in aggregate supply without either creating more inflation or more unemployment. For instance, if aggregate supply decreases, the price level rises and real GDP decreases. If the Fed combats the higher price level (and rise in inflation) by using contractionary monetary policy, real GDP decreases even more. And if the Fed combats the decrease in real GDP (and rise in unemployment) by using expansionary monetary policy, the price level rises still higher.

Why is there a difference between the short-run and long-run effects from an increase in the quantity of money? In the short run the price level rises and the money wage rate does not change, so the economy moves along its short-run aggregate supply curve and real GDP increases. Real GDP can be different from potential GDP. But in the long run the money wage rate rises to adjust to the rise in price level. Once this adjustment takes place, real GDP returns to potential GDP. When that occurs in the long run, the effect of the increase in the quantity of money has worn off.

What are the benefits of using rules to conduct monetary policy? Rules have one major benefit: People can understand them. The point is that members of the economy need to make decisions about what to supply and what to demand. On average these decisions will be better the less uncertainty faced. One source of uncertainty is monetary policy. If monetary policy is erratic and takes people by surprise they will often find that they have made sub-optimal decisions that they regret. If monetary policy follows rules—especially easily followed and easily understood rules—then this source of uncertainty is removed from people’s calculations. As a result, following rules will help members of the public make better economic decisions which means the economy will function better.

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