SOLUTIONS MANUAL For Foundations of Economics, 9e (Global Edition) By Robin Bade, Michael Parkin by welldoneassistant

Foundations of Economics, 9e (Global Edition) By Robin Bade, Michael Parkin (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) All Chapters Solutions Manual Supplement files download link at the end of this file.

Getting Started

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

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Globalization has reduced African poverty. This entry is a macroeconomic topic because globalization is the result of choices made by billions of people rather than an individual or business.

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The government must cut its budget deficit. This entry is a macroeconomic topic because neither an individual nor a business makes decision to cut expenditures.

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

Part 1 . INTRODUCTION

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

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

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

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

Chapter 1 . Getting Started

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

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

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

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

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

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

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

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Part 1 . INTRODUCTION

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

Chapter 1 . Getting Started

 Additional Problems and Applications 1.

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

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

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

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

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

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

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

Part 1 . INTRODUCTION

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

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

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

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

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

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

Chapter 1 . Getting Started

(a)

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

(b)

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

(c)

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

(d)

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

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

Part 1 . INTRODUCTION

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

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

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

Chapter 1 . Getting Started

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

Part 1 . INTRODUCTION

 Multiple Choice Quiz 1.

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

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

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

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

Chapter 1 . Getting Started

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

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

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

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

1 1

Chapter

Appendix: Making and Using Graphs

ANSWERS TO APPENDIX CHECKPOINT

 Problems and Applications 1.

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

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

Part 1 . INTRODUCTION

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

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

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

Appendix 1 . Making and Using Graphs

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

Balloon rides (number per day) 50F

70F

90F

32 27 18 10

50 40 32 27

40 32 27 18

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

Part 1 . INTRODUCTION

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

2007

500

2009

297

2011

241

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

2013

174

2015

117

2017

125

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Appendix 1 . Making and Using Graphs

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

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

5 16

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

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

Part 1 . INTRODUCTION

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

Hot chocolate (cups per week) 50F

70F

90F

40 30 20 10

30 20 10 0

20 10 0 0

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

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

 Problems and Applications

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

Chapter

Part 1 . INTRODUCTION

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

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

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

Chapter 2 . The U.S. and Global Economies

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

Part 1 . INTRODUCTION

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

Chapter 2 . The U.S. and Global Economies

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

Part 1 . INTRODUCTION

 Additional Problems and Applications 1.

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

Chapter 2 . The U.S. and Global Economies

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

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

Part 1 . INTRODUCTION

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

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

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

Chapter 2 . The U.S. and Global Economies

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

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

Part 1 . INTRODUCTION

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

Chapter 2 . The U.S. and Global Economies

 Multiple Choice Quiz 1.

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

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

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

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

Part 1 . INTRODUCTION

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

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

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

The Economic Problem

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Labor

Pizzas

0 10 20 30 40

0 30 50 60 65

Bread (loaves) or or or or or

0 10 20 30 40

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

500 400 200 0

and and and and

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

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

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

0 300 500 550

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

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

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

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

 Multiple Choice Quiz 1.

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

Berries (pounds) and and and and and and

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

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

40 36 30 22 12 0

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

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

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

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

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

Chapter

Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

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

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

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

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

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

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

 Additional Problems and Applications 1.

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

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

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

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

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

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

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Answer: A

Chapter

Elasticities of Demand and Supply ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

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

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

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

tickets demanded equals

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

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



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

equals 

$9 a ticket - $7 a ticket

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

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

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

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

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

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

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

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

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

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

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

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

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

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

Efficiency and Fairness of Markets ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications

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

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

Chapter

Chapter 6 . Efficiency and Fairness of Markets

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

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

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

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

Chapter 6 . Efficiency and Fairness of Markets

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

Part 2 . A CLOSER LOOK AT MARKETS

 Additional Problems and Applications 1.

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

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

Part 2 . A CLOSER LOOK AT MARKETS

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

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

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

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

Chapter 6 . Efficiency and Fairness of Markets

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

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

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

Government Actions in Markets

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

Chapter 7 . Government Actions in Markets

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

Chapter 7 . Government Actions in Markets

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

 Additional Problems and Applications 1.

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

Chapter 7 . Government Actions in Markets

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

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

Chapter 7 . Government Actions in Markets

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

 Multiple Choice Quiz 1.

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

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

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

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

Chapter 7 . Government Actions in Markets

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

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

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

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

Chapter

Taxes

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

Price (dollars per month)

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

0 10 20 30 40 50 60

Quantity Quantity demanded supplied (units per week)

30 25 20 15 10 5 0

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

0 10 20 30 40 50 60

Chapter 8 . Taxes

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

Chapter 8 . Taxes

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

figure 1 8 7

6 5

e b

4 3 2 1

-1

Supply+tax

supply

-2 demand

QUALITY(MILLION PACKS PER MONTH)

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

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Chapter 8 . Taxes

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

Chapter 8 . Taxes

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

Chapter 8 . Taxes

 Multiple Choice Quiz 1.

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

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

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

Global Markets in Action ANSWERS TO CHAPTER CHECKPOINTS

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

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

Chapter

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

Chapter 9 . Global Markets in Action

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

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

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

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

Part 3 . HOW GOVERNMENTS INFLUENCE THE ECONOMY

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

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

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

Chapter 9 . Global Markets in Action

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

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

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

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

Chapter 9 . Global Markets in Action

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

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

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

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

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

Chapter 9 . Global Markets in Action

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

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

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

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

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

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

Chapter 9 . Global Markets in Action

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Chapter

Externalities ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

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

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

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

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

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

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

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

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

Chapter 10 . Externalities

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

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

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 Additional Problems and Applications 1.

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

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

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

Chapter 10 . Externalities

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

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

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

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

Chapter 10 . Externalities

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

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

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 Multiple Choice Quiz 1.

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

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

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

Chapter 10 . Externalities

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

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

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

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

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

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

Chapter 11 . Public Goods and Common Resources

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

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

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

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

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

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

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

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

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

Chapter 11 . Public Goods and Common Resources

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

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

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

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Price

MSC

P’ P

MSB Quantity

Q’ Q Tourism Market in Malaysia

Chapter 11 . Public Goods and Common Resources

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

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

Markets with Private Information ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

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

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

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

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

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

Chapter 12 . Markets with Private Information

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

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

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 Additional Problems and Applications 1.

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

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

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

Chapter 12 . Markets with Private Information

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

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

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

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

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

Chapter 12 . Markets with Private Information

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

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

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

Chapter 12 . Markets with Private Information

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Answer: B

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

Consumer Choice and Demand ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

Orange juice (cartons per day) 0

Total utility

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

7 5

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

Margina lutility

B 2 D

Chapter 13 . Consumer Choice and Demand

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

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

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

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

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

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

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

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

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

Q (Vive)

B (before) 0

B (after) Q (Oculus)

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

Chapter 13 . Consumer Choice and Demand

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

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

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

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

Chapter 13 . Consumer Choice and Demand

 Additional Problems and Applications 1.

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

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

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

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

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

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

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

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

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

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

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

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

Chapter 13 . Consumer Choice and Demand

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

(per day) 1 2 3 4 5 6

Marginal utility from smoothies 7 6 5 4 3 2

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

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

movies 30 24 18 12 6 0

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

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

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

Chapter 13 . Consumer Choice and Demand

 Multiple Choice Quiz 1.

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

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

Jane’s budget line

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

Total utility sumed.

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

as more of a good is con-

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

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

Answer: D

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

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

Answer: C

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

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

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

The paradox of value arises when people

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

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

Chapter

Production and Cost ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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After the second worker is hired, marginal returns decrease.

Labor 0

Total product 0

Average product xx

Marginal product 20 24 16 12

Chapter 14 . Production and Cost

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

Labor (workers)

Total Product (cameras produced per month)

1,000

6,750

800

6,500

600

6,000

400

3,500

200

2,000

Table 2 shows Nikon’s expected production and costs.

Labor

1,000 800 600 400 200

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

TVC

ATC

2,200,000

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

TVC

1000

6,750

1,950,000

2,200,000

800

6,500

1,780,000

2,030,000

600

6,000

1,560,000

1,810,000

400

3,500

940,000

1,190,000

200

2,000

520,000

770,000

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

change in the total cost change in the quantity produced

. Labor

ATC

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

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

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

MC 680 440 248 280 Labor

ATC

1000 800 600 400 200

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

325.93 312.31 301.67 340.00 385.00

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

MC ATC AVC

AFC Efficient output

output

Chapter 14 . Production and Cost

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

TP 0

TVC 0

TC 100

AFC

AVC

ATC

105

140

L 0

TP 0

TVC 0

TC 100

AFC xx

AVC xx

ATC xx

135

10.00

3.50

13.50

170

4.17

2.91

7.08

105

205

2.63

2.76

5.39

140

240

2.27

3.18

5.45

13.50 2.50 2.50 5.83

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

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

Chapter 14 . Production and Cost

 Additional Problems and Applications 1.

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

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

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

Labor

1 2 3 4 5 6

1 2 6 10 12 13

Marginal product/ton 0 1 4 4 2 1

Andy’s coffee farm Labor 1 2 3 4 5 6

TP 1 2 6 10 12 13

Average product/ton 1 1 2 2.5 2.4 2.17

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

Labor 1 2 3 4 5 6

TP 1 2 6 10 12 13

AVC 100 100 50 40 41.7 46.2

ATC 700 400 150 100 91.7 92.3

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

Labor 1

TP/$ 10

TVC/$ 200

ATC/$ D

400

900

800

1100

8.6

22.9

31.4

MC/$ E

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

20 40 40

Chapter 14 . Production and Cost

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

∆TC ∆TP

$400−$200 20−10

= $20.

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

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 Multiple Choice Quiz 1.

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

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

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

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

Chapter 14 . Production and Cost

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

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

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

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

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Perfect Competition ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

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

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

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

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

0 1 2 3 4 5 6

Quantity (batches per day)

AFC

AVC ATC (dollars per batch)

84.0

51.00

135

42.0

44.00

28.0

39.00

21.0

36.00

16.8

35.20

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

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

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Chapter 15 . Perfect Competition

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

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

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

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

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

Chapter 15 . Perfect Competition

Price (dollars per bottle)

ATC P P’

Bottle s pe r ye ar

Beverage market PepsiCo faces Price (dollars per bottle)

S’

Bottle s pe r ye ar

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

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

Chapter 15 . Perfect Competition

 Additional Problems and Applications 1.

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

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

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

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



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



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



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

 4.

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

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Part 6 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE

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

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

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

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

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

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

Chapter 15 . Perfect Competition

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

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

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

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

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

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

Chapter 15 . Perfect Competition

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

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 Multiple Choice Quiz 1.

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

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

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

Answer: C

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

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

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

At the shutdown point, the firm

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

Chapter 15 . Perfect Competition

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

Answer: D

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

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

if it produces the

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

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

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

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

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

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

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Monopoly ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

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

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

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

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

Chapter 16 . Monopoly

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

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

Deadweight $600

Economic profit

Demand

loss

ATC

MR Quantity/pack The market for EpiPen

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

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

Price/pack

Deadweight loss2 MC ATC

D1 MR1

MR2 Quantity/pack

The market for EpiPen

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

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

Chapter 16 . Monopoly

Price/set

Monopoly price

MC ATC

Price cap

Demand

MR The market for stents

Quantity/set

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

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

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

Chapter 16 . Monopoly

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

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

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

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

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

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

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

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

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

Chapter 16 . Monopoly

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

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

100

1800

200

3200

300

4200

400

4800

500

5000

600

4800

700

4200

800

3200

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

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

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

18 14 10 6 2 2 6 10

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

Chapter 16 . Monopoly

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Chapter

Monopolistic Competition ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

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

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

price and cost /$

Just Eat's delivery market

quantity of delivery/service per day

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

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

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

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

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

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

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

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

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

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

 Additional Problems and Applications 1.

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

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

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

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

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

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

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

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

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

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

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

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Chapter

Oligopoly ANSWERS TO CHAPTER CHECKPOINTS

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

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

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

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

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

Chapter 18 . Oligopoly

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

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

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

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

$10

$40

Chapter 18 . Oligopoly

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

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 Additional Problems and Applications 1.

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



Is the equilibrium practical? Why?

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

Chapter 18 . Oligopoly

TABLE 1 Abbott’s strategies market Danone’s strategies

Don’t market

Abbott $50m,

Abbott $30m,

Danone $50m

Danone $100m

Don’t

Abbott $100m,

Abbott $80m,

market

Danone $30m

Danone $80m

market

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

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

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

Agile High price

Low price

$7 m

$1 m

Enter $5 m

$0 m

Wanabe $10 m

Don’t enter $0 m

$5 m $0 m

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

Chapter 18 . Oligopoly

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

Microsoft’s strategies

Agree

Doesn’t agree

suit

Doesn’t suit

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

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

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

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

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 Multiple Choice Quiz 1.

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

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

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

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

Chapter 18 . Oligopoly

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

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

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

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Markets for Factors of Production ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

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

Chapter

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

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

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

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

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

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

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

Rent rate for factory site

D’ D Quantity of land/acre

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

LDPROF

 Additional Problems and Applications 1.

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

Nick Saban

D 1

Wage rate

Quantity/person

A normal coach

D 1

Quantity/person

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

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

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

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

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

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

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

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

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

 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

Economic Inequality

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

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

Income (cumulative percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

100

Households

Money Income (percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

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

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

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

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

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

Households

Market income (percentage)

Lowest 20 percent

Second 20 percent

Third 20 percent

Fourth 20 percent

Highest 20 percent

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

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

Market income (dollars) 5.0 9.0 20.0 30.0 36.0

Tax paid (dollars) 0.0 0.0 2.0 3.0 3.6

Benefits received (dollars) 4.3 4.3 0.0 0.0 0.0

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

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

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

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

Market income (dollars) 5.0 9.0 20.0 30.0 36.0

Tax paid (dollars) 0.0 0.0 2.0 3.0 3.6

Benefits received (dollars) 2.2 2.2 0.0 0.0 0.0

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

Income (percentage) 7.5 11.7 18.8 28.2 33.8

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

Chapter 20 . Economic Inequality

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

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

Market income (dollars) 5.0 9.0 18.0 27.0 32.4

Tax paid (dollars) 0.0 0.0 1.8 2.7 3.24

Benefits received (dollars) 3.87 3.87 0.0 0.0 0.0

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

Income (percentage) 9.7 14.1 17.7 26.6 31.9

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

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

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

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 Additional Problems and Applications 1.

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

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

Households (quintile)

(%)

Income (cumulative %)

First

7.4

Second

13.2

Third

38.7

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

C E

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

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

Professional Golfers

Income (cumulative percentage)

Lowest 20 percent

Bottom 40 percent

Bottom 60 percent

Bottom 80 percent

100 percent

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Chapter 20 . Economic Inequality

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

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

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

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

Chapter 20 . Economic Inequality

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

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

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

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

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

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

Chapter 20 . Economic Inequality

Wage rate (dollars per day)

20 15

SL 10 DH

DL 0

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

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 Multiple Choice Quiz 1.

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

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

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

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

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

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

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

GDP: A Measure of Total Production and Income ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Figure 21.1 shows the flows of income and expenditure in an economy. In 2013, U was $2 trillion, V was $1.5 trillion, W was $7 trillion, J was $1.5 trillion, and Z was zero. Calculate total income, net taxes, and GDP. Total income (which is flow Q) equals total expenditure, the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports of goods and services. Flow U is government expenditure on goods and services, G; flow W is consumption expenditure, C; flow J is investment, I; and flow Z is net exports of goods and services, NX. Total expenditure equals $7 trillion + $1.5 trillion + $2 trillion + $0, which is $10.5 trillion, so total income also equals $10.5 trillion. Net taxes equal total income minus consumption expenditure and saving. Total income is $10.5 trillion. Consumption expenditure is $7 trillion. Saving is the flow into the financial markets (flow V) and equals $1.5 trillion. So net taxes equal $10.5 trillion  $7 trillion  $1.5 trillion, which is $2 trillion. Total income equals total expenditure which equals GDP, so GDP equals $10.5 trillion.

Use the following information to work Problems 2 and 3. The national accounts of Parchment Paradise are kept on (you guessed it) parchment. A fire in the statistics office destroys some accounts, leaving only the following data:  GDP (income approach) $2,900

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 Consumption expenditure $2,000  Indirect taxes less subsidies $100  Interest, rent, and profit $500  Investment $800  Government expenditure $400  Wages $2,000  Net factor income from abroad $50  Net exports –$200 2. Calculate GDP (expenditure approach) and depreciation. For the expenditure approach, GDP equals the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. Fortunately, these data were saved from the fire. Hence GDP = C + I + G + NX = $2,000 + $800 + $400  $200 = $3,000. From the income approach, GDP equals the sum of wages plus interest, rent, and profit plus indirect taxes less subsidies plus depreciation. The value of the income approach GDP survived the fire and is $2,900. The sum of wages plus interest, rent, and profit plus indirect taxes less subsidies equals $2,000 + $500 + $100 = $2,600. So depreciation equals $2,900  $2,600 = $300. 3.

Calculate net domestic product at factor cost, the statistical discrepancy, and GNP. Net domestic product at factor cost equals the sum of wages, interest, rent, and profit. Once again, all these data were fortunately saved from the fire, so net domestic product at factor cost = $2,000 + $500 = $2,500. The statistical discrepancy equals GDP from the expenditure approach, $3,000 from problem 2, minus GDP from the income approach, $2,900. So the statistical discrepancy is $100. GNP equals GDP plus net factor income from abroad. From problem 2, GDP is $3,000. Net factor income from abroad is $50. So GNP equals $3,000 + $50 = $3,050.

Use the following information to work Problems 4 to 6. An economy produces only fun and food. The table shows the prices and the quantities of fun and food produced in 2020 and 2021. The base year is 2020. 4. Calculate nominal GDP in 2020 and 2021. Nominal GDP in 2020 is equal to (40 units of fun  $2) + (60 units of food  $3) = $260. Nominal GDP in 2021 is equal to (35 units of fun  $3) + (65 units of food  $2) = $235.

GDP data for 2020 Item Quantity Price Fun 40 $2 Food 60 $3 GDP data for 2021 Item Quantity Price Fun 35 $3 Food 65 $2

Chapter 21 . GDP: A Measure of Total Production and Income

Calculate the percentage increase in real GDP in 2021. In the base year, real GDP equals nominal GDP, so real GDP in 2020 is $260. Using prices from 2020, real GDP in 2020 is $260 and real GDP in 2021 is $265. Using 2020 prices, real GDP grew [($265  $260)/$260] x 100, or 1.9 percent.

If potential GDP was $270 in 2020 and it grew by 1 percent in 2021, in which phase of the business cycle is the economy? Explain. Real GDP in 2020 is $260 and in 2021 is $265. Between 2020 and 2021, real GDP grew so the economy is in the expansion phase of the business cycle.

Use the following information to work Problems 7 to 9. Expansion remains slow The Commerce Department reported that retail sales increased 1.3 percent in June. Net exports were up 0.8 percent in the first quarter and inventories held by businesses rose by 0.3 percent in June. Total sales by businesses rose 0.3 percent. Source: Commerce Department, 2013 7. Which component of GDP changed because retail sales increased? Which component of GDP changed because inventories held by businesses rise? The increase in retail sales means that consumption expenditure on goods and services has increased. The increase in inventories held by businesses means that investment has increased. 8.

Explain the effect of the rise in net exports on GDP. As net exports are part of the GDP, the rise in net exports means that the GDP increases.

Does the statement that total sales by businesses were up 0.3 percent mean that GDP increased by 0.3 percent? Explain your answer. The statement “total sales by businesses” does not specify whether these sales include final goods and intermediate goods or just final goods. If it includes intermediate goods, then the GDP is not up by 0.3 percent. In this case, the GDP might be up by more than 0.3 percent because some components of GDP—net exports—rose by more than 0.3 percent.

10. Read Eye on the Booms and Busts on p. 592 and explain why the expenditure approach and the income approach to calculate GDP led to conflicting stories concerning the peak in economic activity? What was the solution of the NBER committee to conclude about the change in economic activity? The two approaches did not give unified results concerning the peak in economic activity due to a statistical discrepancy. The NBER looked at the data on real personal income, real manufacturing, wholesale and retail sales, industrial production, and employment in order to conclude about this change in economic activity. © 2023 Pearson Education, Ltd.

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 Additional Problems and Applications 1.

Read Eye on Booms and Busts on p. 556 and work the following exercise: In Brazil, real GDP in the first quarter of 2019 was lower than in the fourth quarter of 2018 and was lower in the second quarter of 2019 than in the first quarter. In the United States, real GDP increased during the first two quarters of 2018. Based on this information, which country was in a recession in 2019? What features of the information provided led you to your conclusion? Brazil was in a recession because Brazil’s real GDP had decreased for two successive quarters.

Classify each of the following items as a final good or an intermediate good, and identify whether it is a component of consumption expenditure, investment, or government expenditure on goods and services:  Item 1. New cars bought by Hertz, the car rental firm. New cars bought by Hertz are a final good. It is part of investment.  Item 2. A new limousine for the president. A new limousine for the president is a final good. It is part of government expenditure on goods and services.  Item 3. Banking services bought by a student. Banking services bought by a student is a final service. It is part of consumption expenditure on goods and services.  Item 4. Aluminum sheets bought by Boeing. Aluminum sheets bought by Boeing are an intermediate good to be used in the production of airplanes.

Use the following information to work Problems 3 and 4. Kavo Parts is a Dutch company that supplies car parts, such as brake parts, water pumps, and wheel bearings, to Japanese companies. Many Japanese companies, such as Fujifilm, Canon, etc., have branches in the Netherlands. 3. Explain where these activities appear in the National Income and Product Accounts of the Netherlands. Kavo's production of parts are produced within the Netherlands, so they are considered as exports when sent to Japan. If any Japanese factors of production are employed in the Netherlands making these car parts (say, a supervisor from Honda), their income is part of “net factor income from abroad” and will be counted as part of Japan's GNP but not the Netherlands' GNP. As Kavo's is a Dutch firm, the output produced by Kavo (with non-Japanese resources) will be included in the Netherlands' GNP. Fujifilm’s and Canon's production in the Netherlands is included in the Netherlands' GDP because it represents production within the Netherlands. Expenditure on Fujifilm and Canon is counted as part of consumption expenditure (if the Fujifilm/Canon products and services are © 2023 Pearson Education, Ltd.

Chapter 21 . GDP: A Measure of Total Production and Income

purchased by Dutch consumers) or investment (if the Fujifilm/Canon products and services are purchased by Dutch firms) or government expenditure (if the Fujifilm/Canon products and services are purchased by the Dutch government) in the expenditure approach to GDP. If any Fujifilm/Canon products and services are imported from Japan, the value of these parts is included among Dutch imports and subtracted from the GDP. The incomes earned by the factors of production that produce Fujifilm/Canon products and services are part of the wages, interest, rent, and profit income that are used in the income approach to GDP. Finally, if any of the factors of production are from Japan (such as a Japanese supervisor), the income of that factor is not part of the Netherlands' GNP but of Japan's GNP. 4.

Explain where these activities appear in the National Income and Product Accounts of Japan. GDP data for 2017 When Japan imports the car parts from Item Quantity Price the Dutch company Kavo, the values of these parts are subtracted from Fish 100 $2 Japan's GDP as imports because they Berries 50 $6 were not produced in Japan. If any GDP data for 2018 Japanese factors of production are Item Quantity Price employed in the Netherlands, making these car parts (say, a supervisor from Fish 75 $5 Honda), their income is part of “net Berries 65 $10 factor income from abroad” and will be counted as part of Japan's GNP. Fujifilm/Canon products and services in the Netherlands are not directly included in Japan’s GDP unless some of the parts for these products are exported from Japan to the Netherlands. In that case, the value of the parts are included in Japan’s GDP as exports. The production of these products and services is included in Japan’s GNP if any Japanese-owned factors of production are used to produce the products and services, such as a Japanese supervisor sent from Japan to the Netherlands. The income of these factors appears in the Japanese National Income and Product Accounts as “net factor income from abroad.” Use the following data on the economy of Iberia to work Problems 5 and 6.  Net taxes $18 billion  Government expenditure $20 billion  Saving $15 billion  Consumption expenditure $67 billion  Investment $21 billion  Exports $30 billion 5. Calculate Iberia’s GDP. Because the value of income equals the value of production, that is, the value of income equals GDP, Y = C + S + NT = GDP. So for Iberia, GDP = $67 billion + $15 billion + $18 billion, which is $100 billion. © 2023 Pearson Education, Ltd.

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Calculate Iberia’s imports of goods and services. GDP equals C +I +G +NX. Rearranging, NX = GDP  C  I  G. So Iberia’s net exports equal $100 billion  $67 billion  $21 billion  $20 billion, which is $8 billion. Net exports equal exports  imports, so imports equal exports minus net exports. Iberia’s imports equal $30 billion  ($8 billion), which is $38 billion. Use the table, which shows an economy’s total production and the prices of the final goods it produced in 2017 and 2018, to work Problems 7 to 9. 7. Calculate nominal GDP in 2017 and 2018. Nominal GDP in 2017 is equal to (100 fish  $2) + (50 berries  $6) = $500. Nominal GDP in 2018 is equal to (75 fish  $5) + (65 berries  $10) = $1,025. 8.

The base year is 2017. Calculate real GDP in 2017 and 2018. In the base year, the real GDP equals the nominal GDP, so the real GDP in 2017 is $500. The real GDP in 2018 uses 2018 quantities and 2017 prices and so equals (75 fish  $2) + (65 berries  $6) = $540. Calculate the percentage increase in production in 2018. The percentage increase in production equals the percentage increase in the real GDP. The real GDP grew by [($540  $500)/$500] x 100, or 8.0 percent.

Use the following information to work Problems 10 and 11. In 2016, Germany witnessed an increase in the sales of used cars - €67.6 billion, up by 17percent from the 2015 level. This is higher than the sales of new cars in 2016- €61.1 billion, which was up only by 4.9% from the 2015 level. Source: autovistaintelligence.com, February 20, 2017 10. Where do new-car sales appear in the circular flow of expenditure and income? Explain how an increase in new- car sales affects real GDP. The purchase of a new car is counted as consumption expenditure and so it appears with the rest of consumption. An increase in new-car sales increases the real GDP.

Chapter 21 . GDP: A Measure of Total Production and Income

11. Where do sales of used cars appear in the circular flow of expenditure and income? Explain how an increase in used-car sales affects real GDP. Used-car sales are sales of second-hand goods, which were not produced in the current time period. For that reason they do not appear in the circular flow of expenditure and income. For the same reason, they do not affect the current real GDP. The commission payment to the used-car salesman is counted as part of GDP because it represents the production of a service. 12. The road less traveled If we are right, this year is different and global growth will rise to an above trend pace during the second half of 2013. Source: J.P. Morgan Global Data Watch, May, 2013 Does this news mean that the 2008–2009 recession was expected to end in the second half of 2013? Does recession end only when real GDP growth rises above trend? Even if the news is correct, it does not indicate that the recession was ending only in the second half of 2013. A recession ends when the GDP starts to increase—not when the GDP returns to the potential GDP.

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 Multiple Choice Quiz 1.

Gross domestic product is the market value of all the in a given time period. A. goods and services bought by Americans B. goods and services produced by American companies in all countries C. final goods and services produced by all firms located in the United States D. U.S.-produced goods and services bought in the United States Answer: C Answer C is the definition of GDP. 2.

A is a final good and is an intermediate good. A. new car bought by a student; a used SUV bought by a dealer B. new textbook; a used textbook C. new iPhone bought by a student; a new computer bought by Walmart to manage its inventories D. tank of gasoline bought by you; jet fuel bought by Southwest Airlines Answer: D The gasoline has been purchased by its ultimate user, so it is a final good; the jet fuel purchased by Southwest Airlines will be used to help produce an service, airline flights, so it is an intermediate good. 3.

Saving equals . A. income minus consumption expenditure minus net taxes B. income minus net taxes C. total income minus total expenditure D. net taxes minus government expenditure Answer: A Saving is what is left from income after consumption expenditure and net taxes are paid.

The expenditure approach to measuring GDP: A. Should result in a greater value of GDP when compared with the income approach. B. Computes the value of final goods and services produced within Nigeria in a given year. C. Is the sum of Nigerian consumption expenditure and Nigerian investment. D. Computes the value of final goods and services produced by Nigerians everywhere during a year. Answer: B It is the definition of the expenditure approach.

Chapter 21 . GDP: A Measure of Total Production and Income

When using the income approach to measure GDP at market prices, in addition to summing all factor incomes it is necessary to . A. subtract depreciation because profit is not reported as net profit B. add depreciation because capital depreciates when goods are manufactured C. add indirect taxes less subsidies to convert aggregate income from factor cost to market prices D. add a statistical discrepancy which is the sum of depreciation and indirect taxes less subsidies Answer: C Because factor cost does not include indirect taxes but does include subsidies, it is necessary to add indirect taxes and subtract subsidies to change the factor cost to the market prices. 6.

The following statements about the business cycle are correct except . A. it is a regular predictable cycle in real GDP around potential GDP B. from the peak to the trough, the economy is in a recession C. from the trough to the peak, the economy is in an expansion D. it is a periodic movement in economic activity including employment Answer: A The business cycle fluctuations around potential GDP are irregular and difficult to predict. 7.

Real GDP per person is not an accurate measure of the standard of living because it . A. includes the goods and services that governments buy B. omits the goods and services that people produce for themselves C. includes goods and services bought by firms D. omits the goods and services imported from other countries Answer: B In less developed nations, GDP is a poor measure of the standard of living because much of a person’s consumption is produced by the person themself.

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Jobs and Unemployment ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the following information gathered by a BLS labor market survey of four households to work Problems 1 and 2.  Household 1: Candy worked 20 hours last week setting up her Internet shopping business. The rest of the week, she completed application forms and attended two job interviews. Husband Jerry worked 40 hours at his job at GM. Daughter Meg, a student, worked 10 hours at her weekend job at Starbucks.

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Household 2: Joey, a full-time bank clerk, was on vacation. Wife, Serena, who wants a full-time job, worked 10 hours as a part-time checkout clerk.

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Household 3: Ari had no work last week but was going to be recalled to his regular job in two weeks. Partner Kosta, after months of searching for a job and not being able to find one, has stopped looking and will go back to school.

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Household 4: Mimi and Henry are retired. Son Hank is a professional artist, who painted for 12 hours last week and sold one picture. Classify each of the 10 people into the labor market category used by the BLS. Who are part-time workers and who are full-time workers? Of the part-time workers, who works part time for economic reasons? Candy is employed because she worked for more than 15 hours at her family business. Jerry is employed because he worked full time at General Motors. Their 17-year old daughter, Meg, is employed because she worked for more than 1 hour as a paid employee. All three are in the labor force and in the working-age population. Joey is employed because he is temporarily absent from his job. Serena is employed because she worked for more than 1 hour as a paid employee. Both are in the labor force and in the working-age population.

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Ari is unemployed because he is waiting to be recalled to his job. Ari is in the labor force and in the working-age population. Kosta is in the working age population but is not in the labor force so Kosta is a marginally attached worker. Mimi and Henry are both in the working-age population. Mimi is not in the labor force. Hank is employed because he worked for more than 1 hour in his own business. He is in the labor force. Candy, Meg, and Serena are part-time workers. Jerry and Joey are fulltime workers. Candy and Serena are part time for economic reasons. 2.

Calculate the unemployment rate and the labor force participation rate, and compare these rates with those in the United States in 2019. The labor force is 7 people and 1 of the people is unemployed. The U-3 unemployment rate is (1  7)  100, which is 14.2 percent. The unemployment rate is higher than the U.S. unemployment rate, which was 3.7 percent in July, 2019. The labor force is 7 people and the working age population is 10 people. The labor force participation rate is (7  10)  10, which is 70 percent. The labor force participation rate is more than the U.S. labor force participation rate, which was 63.0 percent in July, 2019.

Describe two examples of people who work part time for economic reasons and two examples of people who work part time for noneconomic reasons. Sam is an associate at JCPenney and would like to work 40 hours per week. However sales at JCPenney are slow and so he is scheduled to work only 25 hours per week. Maria is a server at Olive Garden and would like to work at least 40 hours per week. But Maria is scheduled for only 20 hours per week because Olive Garden’s sales are down. Both Sam and Maria work part time for economic reasons. Mike is a student who wants to work 20 hours per week at Cost Cutters hair styling so that he can attend class and study. Cost Cutters schedules him for 20 hours per week. Lorri is partially retired and wants to work only 15 hours per week at Walgreens so that she may spend most of her time with her spouse. Walgreens schedules Lorri for 15 hours per week. Both Mike and Lorri work part time for noneconomic reasons.

Explain the relationship between the percentage of employed workers who have part-time jobs and the business cycle. When the economy goes into a recession, the percentage of workers who have part-time jobs for economic reasons rises. When the economy goes into an expansion, the percentage of workers who have part-time jobs for economic reasons falls. The percentage of workers who have part-time

Chapter 22 . Jobs and Unemployment

jobs for noneconomic reasons does not change through the business cycle. Because one component of part-time workers rises in a recession and falls in an expansion, the total percentage of workers who have part-time jobs rises in a recession and falls in an expansion. 5.

Distinguish among the three types of unemployment: frictional, structural, and cyclical. Provide an example of each type of unemployment in the United States today. Frictional unemployment is unemployment that arises from normal labor turnover—from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. Structural unemployment is unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. And cyclical unemployment is the fluctuating unemployment over the business cycle that increases during a recession and decreases during an expansion. A college student graduating and entering the labor force to look for a job is frictionally unemployed. An assembly worker who is fired when the company moves production to Singapore is structurally unemployed. And an autoworker who is laid off when the economy contracts and Ford’s sales slump is cyclically unemployed.

Describe the relationship between the unemployment rate and the natural unemployment rate as the output gap fluctuates between being positive and being negative. When real GDP is less than potential GDP so that the output gap is negative, the unemployment rate is above the natural unemployment rate. When real GDP is greater than potential GDP so that the output gap is positive, the unemployment rate is below the natural unemployment rate. And, when real GDP equals potential GDP so that the output gap is zero, the unemployment rate equals the natural unemployment rate.

Use the following information to work Problems 7 and 8. Unemployment at 7.1% in Luxembourg below the European Average There are twice as many jobs as the labor force in Luxembourg, so 70% of the country’s workforce is made up of immigrants and cross-border workers from neighboring countries. The National Employment Agency matches the skills of jobseekers to company needs. Source: luxembourg.public.lu, June 5, 2015 7. Using the information provided in the news clip, which types of unemployment are present in a Luxembourgish economy? As there are twice as many jobs as the labor force, it can be safely stated that Luxembourg does not suffer from cyclical unemployment.

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Also, with the National Employment Agency working on matching workers with appropriate jobs, it is trying to reach a perfect match between demand and supply of labor, therefore it is trying to decrease structural unemployment that results from a mismatch between demand and supply of labor. Structural unemployment exists at a low rate. The remaining unemployment type is frictional unemployment. 8.

Why is Luxembourg’s workforce made up majorly of immigrants and cross-border workers? Explain the idea of cross-border employees. Immigration is when a person leaves his home country for better job opportunities abroad. In Luxembourg there are twice as many job opportunities than the national active population and because these jobs need to be filled-in, there was a need to employ immigrants and crossborder workers to keep up production. Cross-border workers are people who live close to the borders in neighboring countries like France and Germany and who have jobs in Luxembourg.

Read Eye on Full Employment on pp. 582-583. In which year, 2010 or 2019, was real GDP below potential GDP? How can you tell from the graph on p. 584? The Z-Pop ratio shows that real GDP was below potential GDP. The ZPop ratio is the percentage of the working-age population that is fully utilized. The figure shows that before the 2008-2009 recession, 95.2 percent of the working-age population was fully utilized but in 2010, the Z-Pop ratio fell to 89.7 percent. Because the Z-Pop ratio in 2010 that is less than the ZPop ratio prior to the 2008-2009 recession, the economy is producing less than potential GDP. Real GDP is less than potential GDP. Additionally, the graph on page 584 shows that in 2010, the output gap was negative, which means that real GDP is below potential GDP.

Chapter 22 . Jobs and Unemployment

 Additional Problems and Applications 1.

Read Eye on Full Employment on pp. 582–583, then work the following exercises.  Compare the duration of unemployment in 2019 with that in 2000 and explain whether the difference was most likely the result of frictions, structural change, or the business cycle. The duration of unemployment was longer in 2019 than in 2000. In 2000, the business cycle was at a peak. In 2019, the economy is in a slow expansion, with the unemployment rate lower than the natural unemployment rate and the economy is at more than full employment. So it is most likely that the differences in the duration of unemployment is due to structural change. Structural unemployment fluctuates with the pace of technological change, and that change is driven by fierce international competition.  How does the unemployment of marginally attached workers influence the duration of unemployment in 2019 compared with that in 2000? U3 is the official measure of unemployment. U5 measures unemployment by including discouraged workers and other marginally attached workers. When the economy moves into a recession, both the official number of unemployed workers and the number of marginally attached workers increase. And, when the economy moves into an expansion, both the official number of unemployed workers and the number of marginally attached workers decrease. Because U5 and U3 fluctuate together and the number of marginally attached workers has no effect on the duration of unemployment.

The Bureau of Labor Statistics reported that in the second quarter of 2008 the working-age population was 233,410,000, the labor force was 154,294,000, and employment was 146,089,000. Calculate for that quarter the labor force participation rate and the unemployment rate. The labor force participation rate equals the number of people in the labor force divided by the working-age population, then multiplied by 100. (154,294,000 ÷ 233,410,000) × 100, which is 66.1 percent. The unemployment rate equals the number of unemployed workers divided by the labor force, then multiplied by 100. The number of unemployed workers equals the labor force minus the employment. So in the second quarter of 2008 the number of unemployed workers equaled 154,294,000 – 146,089,000, which is 8,205,000. Thus the unemployment rate equals (8,205,000 ÷ 154,294,000) × 100, which is 5.3 percent. In July 2011, in the economy of Sandy Island, 10,000 people were employed and 1,000 were unemployed. During August 2011, 80 people lost their jobs and didn’t look for new ones, 20 people quit their jobs and © 2023 Pearson Education, Ltd.

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retired, 150 people who had looked for work were hired, 50 people became discouraged workers, and 40 new graduates looked for work. Calculate the change in the unemployment rate from July 2011 to August 2011. 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. To calculate the unemployment rate, the number of people unemployed and the number employed are needed. The number of people who are unemployed at the end of August 2011 equals the number unemployed in July 2011 plus people who lost their jobs and who stayed in the labor market, plus new workers entering the labor market, such as new graduates, minus people who were hired and people who stopped looking for work, that is, became discouraged workers. So the number of people unemployed equals 1,000 + 40 − 150 − 50, which is 840. Next the number of people who are employed at the end of August equals the number employed in July minus people who lost jobs plus people who were hired, so the number employed is 10,050. The unemployment rate equals the number unemployed expressed as a percentage of the labor force. The labor force equals the number employed plus the number unemployed, so 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. Between July and August, the unemployment rate fell by 1.4 percent from 9.1 percent to 7.7 percent. The BLS survey reported the numbers in the table for a small community of 280 people. Calculate the unemployment rate and the labor force participation rate in this community. The number of employed people is 150 + 30, which is 180. The number of unemployed people is 20 + 10, which is 30. The labor force is 180 + 30, which is 210. So the unemployment rate is (30 ÷ 210) × 100, which is 14.3 percent. The total working age population is 150 + 30 + 30 + 20 + 10, which is 240. The labor force is 210. Therefore, the labor force participation rate is (210 ÷ 240) × 100, which is 87.5 percent.

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Chapter 22 . Jobs and Unemployment

Describe the trends and fluctuations in the unemployment rate in the United States from 1949 through 2019. In which periods was the unemployment rate above average and in which periods was it below average? Between 1949 and 2019, the unemployment rate has fluctuated, falling in expansions and rising in recessions. It was generally lower than average from 1949 to 1958, though during recessions it rose. The unemployment rate fell again to below its average during the late 1960s but then generally rose above average in the 1970s and hit its post World War II peak, near 10 percent, in the 1982 recession. The unemployment rate, while falling through the 1980s, was generally above average. It rose again during the 1990-1991 recession but by the middle of the 1990s expansion it had fallen below its average. There was a slight rise around 2000, but the unemployment rate generally stayed near or a little below its average for most of the 2000s until 2008 when it rose well above its average during the most recent recession. Since 2009 the unemployment rate has fallen as the economy emerged from the 2008-2009 recession. Describe how the labor force participation rate in the United States changed between 1960 and 2019. Contrast and explain the different trends in the labor force participation rates of women and men. Between 1960 through 2019, the labor force participation rate for men trended downward, from 83 percent to about 70 percent. The labor force participation rate for women trended upward, from 37 percent to 60 percent in about 1999 and has fallen slightly since then. The overall labor force participation rate trended slowly upward, from 59 percent to about 67 percent in 1999 and has fallen a little since then. The female participation rate increased for four reasons: more women pursued a college education and so increased their potential wages in the job market; technological change in the work place created a large number of white-collar jobs with flexible hours that women found attractive; technological change in the home increased the time available for paid employment; and, families wanted two incomes to balance tight budgets. The male labor force participation rate decreased for three reasons: some men retired early because of an increase in wealth; some men left the labor force because they lost jobs when they were older and finding a new job was difficult; and, more men remained in full-time education. Explain why the natural unemployment rate is not zero and why the unemployment rate fluctuates around the natural unemployment rate. The natural unemployment rate includes frictional unemployment and structural unemployment. There are always people looking for work from just normal labor market turnover, so fictional unemployment is never zero. Similarly technological change and/or changes in international competition will always create some unemployment, so structural

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Unemployment is never zero. Because its components are never zero, the natural unemployment rate is never zero. Unemployment fluctuates around the natural unemployment because cyclical unemployment, which is included in the total unemployment but not in natural unemployment, fluctuates during the business cycle. Cyclical unemployment is negative during strong expansions and positive during recessions, so unemployment will sometimes be less than natural unemployment and sometimes more than natural unemployment. Use the following information to work Problems 8 and 9. Brazil’s Unemployment Crisis is the Worst in 20 Years From the otherwise favorable rate of unemployment in 2012 of 4.5 percent, Brazil’s unemployment hit a staggering 13.7 percent in 2017 with more than 14 million unemployed. Brazil is suffering from an unemployment crisis even worse than the 11 percent rate of 2003. Adding to this is the unsustainable public debt, the falling price of oil (so lack of investments in this field), corruption and the need for reforms. Source: Forbes, May 1, 2017

In the depth of the 2008–2009 recession, the unemployment rate in Ames peaked at 5.7 percent. In El Centro, it peaked at 30.3 percent. Using the information in the news clip, how much of the unemployment is cyclical and how much is normal? According to the information, the bigger percentage of this increase in the unemployment rate is cyclical, because only 5 years ago, everything seemed ideal and the unemployment rate was at its natural level. Brazil is suffering due to dire economic issues, mainly in the oil sector, which is shrinking due to the decrease in the global price of oil, and this leads to laying off of workers and negatively reflects on other sectors in the economy. The unemployment rate of 13.7 percent includes the cyclical unemployment for the most part in addition to the other types of unemployment, does it also include all people suffering from lack of job opportunities? Brazil's 13.7 percent doesn't reflect discouraged workers, the people who lost hope of finding work so they got discouraged and left the labor force. They certainly exist given that the recession lasted for two years so far and the fact that a big economic sector (the oil industry) was affected. This 13.7 percent also doesn't reflect part-time workers who are part-timers due to economic reasons, as they were not able to find full-time jobs due to the recession. Finally, this percentage does not include the marginally attached—people who didn't actively look for work in the past four months due to the low probability of finding one. So, if all of those groups were accounted for, the 13.7 percent rate would have been greater.

Chapter 22 . Jobs and Unemployment

a. Multiple Choice Quiz 1.

The BLS count Jody as being unemployed if she . A. had a job last month but not this month B. doesn’t have a job because the U.S. factory where she worked cannot compete with cheap Chinese imports C. wants a job and looked for a job last year but has now stopped looking D. wants a job and is willing to take a job but after searching last week cannot find a job Answer: D To be counted as unemployed, a person must be without a job, available for work, and made specific efforts to find a job within the past 4 weeks.

A marginally attached worker is a person who . A. works part time for economic reasons B. works part time for noneconomic reasons C. doesn’t work, is available and willing to work, but hasn’t looked for job recently D. has no job but would like one and has gone back to school to retrain Answer: C Answer C is essentially the definition of a marginally attached worker. 3.

If the BLS included all marginally attached workers as being unemployed, the would be . A. unemployment rate; higher B. labor force; unchanged C. labor force participation rate; lower D. unemployment rate; lower Answer: A Marginally attached workers are unemployed, so the unemployment rate would be higher. 4.

When the economy goes into recession, the biggest increase in unemployment is . A. structural because jobs are lost in most states B. cyclical because jobs are lost in many industries as they cut production C. frictional because the creation of jobs slows D. the combination of structural and frictional as few new jobs are created. Answer: B Cyclical unemployment is the unemployment resulting from a recession.

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The economy is at full employment when all unemployment is . A. structural B. cyclical C. structural and cyclical D. structural and frictional Answer: D Answer D is the definition of when the economy is at full employment.

Potential GDP is the value of real GDP when . A. the unemployment rate equals the natural unemployment rate B. there is no frictional unemployment C. there is no structural unemployment D. the unemployment rate is zero Answer: A When real GDP equals potential GDP, the unemployment rate equals the natural unemployment rate. 7.

When the unemployment rate the natural unemployment rate, real GDP is potential GDP and the output gap is . A. exceeds; below; negative B. is below; below; negative C. exceeds; above; positive D. is below; above; negative Answer: A When the unemployment rate exceeds the natural unemployment rate, the economy is in a recession with real GDP is less than potential GDP so the output gap is negative.

Chapter

The CPI and the Cost of Living ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

In Canada, the reference base period for the CPI is 2002. By 2012, prices had risen by 21.6 percent since the base period. The inflation rate in Cana-da in 2013 was 1.1 percent. Calculate the CPI in Canada in 2013. As 2002 is the reference base period in Canada, in 2002 the CPI equaled 100. Between 2002 and 2012, prices increased by 21.6 percent. The formula for the percentage rise in prices is [(CPI in 2012 − 100) ÷ 100] × 100. So, [(CPI in 2012 − 100)] = 21.6 percent. Solving the formula for the CPI in 2012 shows that the CPI in 2012 is 121.6. Finally, with an inflation rate of 1.1 percent in 2013, the CPI in 2013 equals 121.6 × (1.011) = 122.9. In Brazil, the reference base period for the CPI is 2000. By 2016, prices had risen by 187 percent since the base period. The inflation rate in Brazil in 2017 was 3.4 percent, and in 2018, the inflation rate was 3.7 percent. Calculate the CPI in Brazil in 2017 and 2018. Brazil’s CPI in 2019 was 318. Did Brazil’s inflation rate increase or decrease 2019? Because 2000 is the reference base period for Brazil, the CPI in that year is 100. Between 2000 and 2016 prices rose by 187 percent. Over this period, the formula for the percentage rise in prices is [(CPI in 2016  100)  100]  100. So, [(CPI in 2016  100)] = 187 percent. Solving the formula for the CPI in 2016 shows that the CPI in 2016 is 287. The price level in 2017 equals the price level in 2016, 287, multiplied by 1.034. (The 1.034 comes from the observation that the price level in 2017 equals the price level in 2016, which accounts for the “1,” plus the inflationary increase of 3.4 percent, which accounts for the “0.034.”) So the price level in 2017 equals (287  1.034), which is 297. The price level in 2018 equals the price level in 2017, 297, multiplied by 1.037. So the price level in 2018 equals (297  1.037), which is 308. The inflation rate in Brazil in 2019 equals [(318  308)  308]  100, which is 3.2 percent. Brazil’s inflation rate decreased in 2019.

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The table shows the quantities of the goods Suzie bought and the prices she paid during two consecutive weeks. Suzie's CPI market basket contains the goods she bought in Week 1. Calculate the cost of Suzie's CPI market basket in Week 1 and in Week 2. What percentage of the CPI market basket is gasoline? Calculate the value of Suzie's CPI in Week 2 and her inflation rate in week 2. Suzie’s CPI market basket contains 15 cups of coffee, 1 book, and 25 gallons of gasoline. The cost of her market basket in Week 1 is (15 cups × $2.25 a cup) + (1 book × $25) + (25 gallons of gasoline × $2.00 a gallon), which is $33.75 + $25.00 + $50.00, or $ 108.75. The cost of her market basket in Week 2 is (15 cups × $2.25 a cup) + (1 book × $12.50) + (25 gallons of gasoline × $2.50 a gallon), which is $33.75 + $12.50 + $62.50, or $108.75. Her market basket in Week 2 does not include concert tickets, because she purchased no tickets in the base week. Gasoline accounted for $50 of her $108.75 market basket, which is ($50 ÷ $108.75) × 100 or 46 percent. Her CPI in Week 2 is equal to [$108.75÷ $108.75] × 100, which is equal to 100. The CPI in the base week is 100, so the inflation rate in week 2 equals ([100 − 100.0] ÷ 100) × 100, which is 0 percent.

Use the following information to work Problems 4 and 5. The GDP price index in Australia in 2013 was about 98.6, and nominal GDP in 2013 was AUD 382.79 billion. The GDP price index in 2015 was about 99.3, and nominal GDP in 2015 was AUD 406.1 billion. 4. Calculate real GDP in 2013 and 2015 and the growth rate from 2013 to 2015. Real GDP = (Nominal GDP / GDP price index) × 100 Real GDP in 2013 = (AUD 382.79 billion  98.6) × 100 = AUD 388.225 billion Real GDP in 2015 = (AUD 406.1 billion  99.3) × 100 = AUD 408.963 billion  The growth rate or the percentage increase in real GDP = ([AUD 408.963 billion  AUD 388.225 billion]  AUD 388.225 billion)  100 = 5.342% 5.

What was the percentage increase in nominal GDP from 2013 to 2015? Was there inflation or deflation from 2013 to 2015? The percentage increase in nominal GDP = ([AUD 406.1 billion  AUD 382.79 billion]  AUD 382.79 billion)  100 = 6.089% To know if there was inflation or deflation, the percentage change in the price index should be calculated, it’s equal to: ([99.3  98.6]  98.6)  100 = 0.71%, because it’s a positive number, we’re dealing with an inflation from 2013 to 2015. © 2023 Pearson Education, Ltd.

Chapter 23 . The CPI and the Cost of Living

The table shows the prices that Terry paid for some of his expenditures in June and July 2019. Explain and discuss why these prices might have led to commodity substitution or outlet substitution.

Item

Price in Price in June July (dollars per unit)

Steak Bread Bacon Milk Tomatoes Apples Bananas Chicken Lettuce

4.11 3.25 3.62 2.62 1.60 1.18 0.62 1.28 1.64

4.01 3.12 3.64 2.62 1.62 1.19 0.66 1.26 1.68

Terry will substitute other products, commodity substitution, or other locations to buy a product, outlet substitution, if the price rises. The larger the price increase, the greater the incentive for these substitutions. Bananas had the largest percentage price hike, so Terry could well have substituted other products (say apples, for which the price rise was a smaller amount) or have purchased his bananas at a different location to save on the price paid. Tomatoes and lettuce also had a large price hike. Terry might substitute apples for these (commodity substitution) or else purchased them at a less expensive location (outlet substitution). Steak and, to a lesser extent, chicken fell in price. Terry might have substituted these for bacon, which rose in price. 7.

In 2019, Annie, an 80-year-old, is telling her granddaughter Mary about the good old days. Annie says that in 1935, you could buy a nice house for $15,000 and a jacket for $5. Mary says that in 2019 such a house costs $250,000 and such a jacket costs $80. The CPI in 1935 was 16.7 and in 2019 it was 250.1. Which house and which jacket have the lower prices? The 2019 house price that is equivalent to $15,000 price in 1935 equals the CPI in 2019 divided by the CPI in 1935 and then multiplied by $15,000. So the 2019 house price is (250.1  16.7)  $15,000, which is $224,641. The price for a house of $15,000 in 1935 is lower than its price in 2019. The 2019 jacket price that is equivalent to $5 in 1935 equals the CPI in 2019 divided by the CPI in 1935 and then multiplied by $5. So the 2019 jacket price is (250.1  16.7)  $5, which is $75. So the $5 for a jacket in 1935 is the lower priced jacket.

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Use the following information to work Problems 8 and 9. In 2016, Korean CPI increased by 1% as food and non-alcoholic beverage prices increased by 2.3%, transport prices decreased by 2.2%, housing, water, electricity, gas and other fuel prices decreased by 0.8%, and recreation and culture increased by 1.8%. Food and non-alcoholic beverages, Transport, Housing water, electricity, gas and other fuels, and Recreation and culture account for 13.77%, 11.1%, 17.02%, and 5.72% of the CPI basket respectively. Source: stats.oecd.org, June 22, 2017 8. Given the weights and price variations of each category, what percentage change in the Korean CPI during 2016 is accounted for by the changes in the prices of the categories specified in the data above? Food and non-alcoholic beverages contribute 2.3% 13.77% = 0.317 percentage points toward the change in the CPI. Transport contributes (-2.2%) 11.1% = - 0.244 percentage points. Housing, water, electricity, gas and other fuels contribute (-0.8) 17.02% = - 0.136 percentage points. Recreation and culture contribute 1.8 5.72% = 0.103 percentage points. 9.

Given the changes in the prices of the four categories given, by what percentage did the prices of the other items in the CPI basket change? The summation of the contribution of each category to the change in the CPI gives the net change of the CPI resulting from those 4 categories only, which is: 0.317 + (-0.244) + (-0.136) + 0.103 = 0.04 percentage point change. Since the overall increase in the CPI was 1%, the remaining factors contributed 0.96 toward the CPI change. The factors mentioned make up 47.61% of the basket, so the remaining factors make up 52.39% of the market basket, so they must have increased by 1.8324% = (0.96  52.39)  100.

10. Read Eye on Box Office Hits on p. 608 and using BLS data for the CPI in 1982 and 1997, determine which movie had the greater real box office revenues, E.T.: The Extra-Terrestrial, which earned $435 million in 1982 or Titanic, which earned $601 million in 1997. From the BLS, the CPI in 1982 = 96.5 and the CPI in 1997 = 160.5. To convert the dollars earned by E.T.: The Extra-Terrestrial into 1997 dollars, multiply the 1982 dollars, $435 million, by the 1997 CPI and divide by the 1982 CPI. This procedure gives $435 million × 160.5 ÷ 96.5, which is $723 million. This result shows that E.T.: The Extra-Terrestrial had greater real box office than Titanic.

Chapter 23 . The CPI and the Cost of Living

 Additional Problems and Applications 1.

Read Eye on Box Office Hits on p. 608 and then compare the method used by Box-Office Mojo on p. 608 to calculate real box-office receipts with the method used on p. 604 to calculate the real price of a postage stamp. Compare and contrast the real variables that each method calculates. The real price of a stamp was calculated using the CPI; Box-Office Mojo calculated the real box office receipts using the price of movie tickets. The formulas used are effectively the same: Multiply the product, the stamp price or box office revenue, by the current period price index and divide by the price index for the relevant period, that is, the period of the stamp price or box office revenue. The difference between the two methods revolves around what price index is used. Box-Office Mojo uses each year’s price of a movie ticket; that is, this calculation uses the price of one good. The textbook used the CPI, which incorporates the prices of 80,000 goods consumers purchase.

Pete is a student who spends 10 perItem Price in cent of his expenditure on books and Books and supplies 172.6 supplies, 30 percent on tuition, 30 Tuition 169.0 159.0 percent on rent, 10 percent on food Rent Food and drink 129.8 and drink, 10 percent on transportaTransportation 115.4 tion, and the rest on clothing. The Clothing 92.9 price index for each item was 100 in 2009. The table shows the prices in 2019. What is Pete’s CPI in 2019? (Hint: The contribution of each item to the CPI is its price weighted by its share of total expenditure.) Did Pete experience a higher or lower inflation rate between 2009 and 2019 than the student whose CPI is shown on p. 609? Pete’s CPI in 2019 equals (0.10 × 172.6) + (0.30 × 169.0) + (0.30 × 159.0) + (0.10 × 129.8) + (0.10 × 115.4) + (0.10 × 92.9) = 149.5. Pete’s inflation is slightly lower than the inflation for the student on page 609. Pete spends less in sum on the items that have risen most rapidly—books and supplies, tuition, and rent—and more on the item that rose much less rapidly than inflation—clothing. Pete’s inflation rate has averaged about 3.7 percent per year, which the figure on page 609 shows is a bit less than the average inflation rate over the years of the student whose CPI is on page 609. The people on Coral Island buy only juice and cloth. The CPI basket contains the quantities bought in 2019. The average household spent $22 on juice and $28 on cloth in 2019 when the price of juice was $2 a bottle and the price of cloth was $7 a yard. In the current year, 2020, juice is $5 a bottle and cloth is $8 a yard. Calculate the CPI and the inflation rate in 2020.

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The average household on Coral Island spent $22 on juice and $28 on cloth. The price of juice was $2 a bottle, so the average household purchased 11 bottles of juice. The price of cloth was $7 a yard, so the average household purchased 4 yards. Therefore, the CPI market basket is 11 bottles of juice and 4 yards of cloth. In 2019, the CPI market basket cost $50 ($22 on juice and $28 on cloth). In 2020, the CPI market basket cost (11 bottles of juice × $5 a bottle) + (4 yards of cloth × $8 a yard) = $55 + $32 = $87. So, the CPI in 2020 equals ($99.8 ÷ $50) × 100, which is 174. The inflation rate on Coral Island between 2020 and 2019 is equal to [(174 − 100) ÷ 100] × 100, which is 74 percent. 4.

The table shows the Week 1 Week 2 quantities of the goods Price Price Item that Harry bought and the Quantity (per unit) Quantity (per unit) prices he paid during two Coffee 5 cups $3.00 4 cups $3.25 consecutive weeks. 5 $1.00 10 $1.00 Harry’s CPI market basket iTune songs contains the goods he Gasoline 10 gallons $2.00 10 gallons $3.00 bought in Week 1. Calculate Harry’s CPI in Week 2. What was his inflation rate in Week 2? Harry’s CPI market basket contains 5 cups of coffee, 5 iTunes songs, and 10 gallons of gasoline. The cost of his market basket in Week 1 is (5 cups  $3.00 a cup) + (5 songs  $1.00 each) + (10 gallons of gasoline  $2.00 a gallon), which is $15.00 + $5.00 + $20.00, or $40.00. The cost of his market basket in Week 2 is (5 cups  $3.25 a cup) + (5 songs  $1.00 each) + (10 gallons of gasoline  $3.00 a gallon), which is $16.25 + $5.00 + $30.00, or $51.25. His CPI in Week 2 is equal to [($51.25)  ($40.00)]  100, which is 128.1. The CPI in the base week is 100, so the inflation rate equals ([128.1  100.0]  100)  100, which is 28.1 percent.

Use the following information to work Problems 5 and 6. The base year is 2017. Real GDP in 2017 was $10 trillion (2017 dollars). The GDP price index in 2020 was 112, and real GDP in 2013 was $11 trillion (2017 dollars). 5. Calculate nominal GDP in 2017 and in 2020 and the percentage increase in nominal GDP from 2017 to 2020.

In the base year, the nominal GDP equals the real GDP. So, in the base year of 2017, nominal GDP = $10 trillion. In general, nominal GDP = real GDP × price level ÷ 100. So, in 2020, nominal GDP = $11 trillion × 112 ÷ 100, which is $12.32 trillion. The percentage increase in nominal GDP is equal to [($12.32 trillion − $10 trillion) ÷ $10 trillion] × 100, which is 23.2 percent.

Chapter 23 . The CPI and the Cost of Living

What was the percentage increase in production from 2017 to 2020, and by what percentage did the cost of living rise from 2017 to 2020? The percentage increase in production equals the percentage increase in re-al GDP, [($11 trillion − $10 trillion) ÷ $10 trillion] × 100, which is 10 percent. The percentage increase in the cost of living equals the percentage increase in the GDP price index. In the base year, the GDP price index equals 100. So the percentage increase in the GDP price index equals [(112 − 100) ÷ 100] × 100, which is 12 percent.

In 1934, the average wage rate was $0.55 an hour and in 2018 the average wage rate was $22.67 an hour. The CPI in 1934 was 13.4 and in 2018 it was 251.1. Which real wage rate is higher? The 2018 wage rate that is equivalent to $0.55 in 1934 equals the CPI in 2018 divided by the CPI in 1934 and then multiplied by $0.55. So the 2018 wage rate is (251.1 ÷ 13.4) × $0.55, which is $10.31. The real wage rate in 1934 is 0.55/13.4 * 100, which is $4.10, and the real wage rate in 2018 is 22.67/251.1 * 100, which is $9.03. The wage rate of $22.67 in 2018 is the higher wage rate.

Imagine that you are given $1,000 to spend and told that you must spend it all buying items from a Sears catalog. But you do have a choice of catalog. You may select from the 1903 catalog or today’s catalog from Sears.com. You will pay the prices quoted in the catalog that you choose. Which catalog will you choose and why? Refer to any biases in the CPI that might be relevant to your choice. The 1903 catalog is attractive because prices quoted in the 1903 catalog are much lower than the prices quoted on Sears.com today. So the $1,000 buys more goods from the 1903 Sears catalog. Sears.com is attractive because the goods available on Sears.com are vastly improved and different from those available in the 1903 Sears catalog. The choice of whether to buy from the 1903 Sears catalog or from Sears.com will differ among students. However, two factors that play a role in this choice are, first, the quality of most goods today is higher than in 1903 and, second, the presence of a huge number of new goods available on Sears.com compared to the 1903 Sears catalog. These last two factors are the same as the corresponding two biases in the CPI: the quality change bias and the new goods bias.

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Use the following information to work Problems 9 and 10. Money market funds are yielding almost nothing Last month, the interest rate on a money market fund averaged 0.08 percent a year and on 5-year CDs it was 2.6 percent a year. The inflation rate was 0.1 percent a year. Source: USA Today, August 12, 2009 9. Calculate the real interest rate on each of these financial assets. The real interest rate equals the nominal interest rate minus the inflation rate. Therefore, the real interest rate on a money fund was (0.08 percent)  (0.10 percent), which is 0.02 percent. The real interest rate on a 5-year CD was (2.60 percent)  (0.10 percent), which is 2.50 percent. 10. To maintain these real interest rates in the coming months, how will these nominal rates change if the inflation rate increases to 0.2 percent a year? If the inflation rate increases by 0.1 percentage points, then to maintain the same real interest rates, the nominal interest rates on these assets will increase by 0.1 percentage points.

Chapter 23 . The CPI and the Cost of Living

 Multiple Choice Quiz 1.

The CPI measures the average prices paid by for . A. urban consumers; a fixed basket of consumption goods and services B. urban consumers; the average basket of goods and services they buy C. all consumers; housing, transportation, and food D. everyone who earns an income; the necessities of life Answer: A Answer A is the definition of the CPI. 2.

In May 2017, Statistics Estonia reported that the CPI increased by 3.3 percent from its previous level in May 2016. Which of the following statements is true? A. The base year is definitely 2016. B. The price level increased from May 2016 to May 2017 and the annual inflation rate is 3.3 percent. C. We need only this given information in order to calculate the value of both CPI's. D. The price level increased by 3.3 from the base year. Answer: B It is the only correct conclusion because nothing in the given information allows a conclusive conclusion that 2016 is the base year and we cannot calculate the CPIs from this percentage. Source: http://www.stat.ee/main-indicators, June 9, 2017 3.

When the price level , the inflation rate . A. rises rapidly; increases B. rises rapidly; is high C. falls; is zero D. rises slowly; falls Answer: B When the price level rises rapidly, the inflation rate, which is the growth rate of the price level, is high.

The CPI bias arises from all of the following items except . A. the introduction of new goods and services B. the improved quality of goods C. the goods and services bought by poor people D. consumers’ responses to price changes Answer: C The CPI’s biases do not include anything specific to the goods and services purchased by poor people.

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Of the alternative measures of the price level, overcomes the bias of the CPI and is a better measure of the cost of living because it . A. GDP price index; uses a current basket B. PCEPI; uses a current basket of all consumption goods C. PCEPI excluding food and energy; is less volatile D. GDP price index; includes all goods and services bought by Americans Answer: B The PCEPI is based on the current consumption bundle and thereby avoids the biases in the CPI. 6.

If nominal GDP increases by 5 percent a year and the GDP price index rises by 2 percent a year, then real GDP increases by . A. 7 percent a year B. 3 percent a year C. 2.5 percent a year D. 10 percent a year Answer: B Growth in nominal GDP can be separated into growth in the GPD price index plus growth in real GDP. 7.

When the CPI increases from 200 in 2016 to 210 in 2017 and the nominal wage rate is constant at $10 an hour, the real wage rate . A. increases by 10 percent B. increases to $15 an hour C. decreases by 5 percent D. is $10 an hour Answer: C The nominal wage rate falls from [($10 ÷ 200) × 100], which is $5.00, to [($10 ÷ 210) × 100], which is $4.76, a fall of 5 percent. 8.

When the price level is rising at and the real interest rate is 1 percent a year, the nominal interest rate is 3 percent a year. A. 4 percent a year B. 3 percent a year C. 2 percent a year D. 1 percent a year Answer: C The nominal interest rate equals the real interest rate plus the inflation rate, so if the nominal interest rate is 3 percent a year and the real interest rate is 1 percent a year, the inflation rate must be 2 percent a year.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

Potential GDP and the Natural Unemployment Rate

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Use the events in List 1, which occur in Slovenia one at a time, to work Problems 1 to 4. Many young people are leaving Slovenia for better jobs in neighboring countries. The CPI in Slovenia falls. XLAB d.o.o. developed groundbreaking software that increases the productivity of workers. Imports of clothes increased. The 2014 black ice wave paralyzed Slovenia: railways became nonoperational, roads were cut off, and whole areas went without electrical power. 1.

Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction any changes occur. The groundbreaking software changes the production function by shifting it upward. The black ice storm changes the production function by shifting it downward. The black ice storm decreases the demand for labor because most companies came to a standstill. The demand for labor increases because the developed software increases productivity. The young citizens leaving Slovenia will change the supply of labor by decreasing it. Both the CPI falling and the imports of clothes increasing do not change the production function, the supply of labor, or the demand for labor.

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Which of the events increase the equilibrium quantity of labor and which decrease it? Young people leaving for neighboring countries decreases the equilibrium quantity of labor. The equilibrium quantity of labor increases due to the increased demand for labor resulting from the new software. The black ice storm hitting Slovenia destroyed the capital stock, decreased the demand for labor, and decreased the equilibrium quantity of employment.

Which of the events raise the real wage rate and which lower it? The young people leaving the country will result in increasing the equilibrium real wage rate. The new software that increased the demand for labor will increase the equilibrium real wage rate. The black ice storm results in decreasing the demand for labor and thus decreasing the real wage rate.

Which of the events increase potential GDP and which decrease it? The new software increases the potential GDP. The storm and the immigration of the young workers decrease the potential GDP.

Use the information set out in the tables above about the economy of Athabasca to work Problems 5 and 6. 5.

Calculate the quantity of labor employed, the real wage rate, and poten tial GDP. The real wage rate is $8 per hour, because that is the real wage that sets the quantity of labor demanded equal to the quantity of labor supplied. The equilibrium quantity of labor is 3 million hours per year. The production function shows that the potential GDP is $27 million.

If the labor force participation increases, explain how employment, the real wage rate, and potential GDP change. If the labor force participation increases, the supply of labor increases. The increase in the supply of labor lowers the real wage and increases em ployment. The increase in employment increases potential GDP.

Use the following information to work Problems 7 and 8. Thousands of local workers arrive to many European countries from war-torn Syria as refugees after fleeing their country. 7.

Explain how the real wage rate, employment, and potential GDP in the European countries in question would change . The supply of labor to those European countries increases, which leads to an increase in equilibrium employment and to a decrease in the equilibrium real wage rate. The potential GDP increases.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

Explain how employment, the real wage rate, and potential GDP would change in Syria. The supply of labor in Syria decreases, which leads to a decrease in the equilibrium Syrian employment and which increases the Syrian real wage rate. The Syrian potential GDP decreases.

Two island economies, Cocoa Island and Plantation Island, are identical in every respect except one. A survey tells us that at full employment, people on Cocoa Island spend 2,000 hours a day on job search, while the people on Plantation Island spend 1,000 hours a day on job search. Which economy has the greater level of potential GDP? Which has the higher real wage rate? And which has the higher natural unemployment rate? Plantation Island has the greater level of potential GDP because its labor force spends less time searching and more time employed. Cocoa Island has the higher real wage rate. We know that Cocoa Island has the higher real wage rate because the supply of labor is less on Cocoa Island, since workers spend more time searching for jobs. As the supply of labor decreases, the real wage rate increases. The increased search, on Cocoa Island means that Cocoa Island has the higher natural unemployment rate.

10. Decoding ‘natural’ rate of unemployment slumps in July Unemployment is a normal feature of our economy and the Congressional Budget Office believes the “natural” unemployment rate increased from 5 percent in 2007 to 6 percent in 2012. Source: The Wall Street Journal, September 7, 2012 Provide some reasons why the natural unemployment rate might have increased. There are several possible reasons why the natural unemployment rate increased. First, the severe recession that occurred after 2007 ed the government to increase the length of time for which unemployed workers could collect unemployment benefits. These more generous unemployment benefits increased the natural unemployment rate. Second, the real minimum wage was higher in 2012 than in 2007. The higher real minimum wage increases job rationing, which also leads to an increase in the natural unemployment rate

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11. Read Eye on U.S. Potential GDP on p. 626 and then explain why U.S. po tential GDP per worker per week is greater than that in Europe. What could induce Europeans to work the same hours as Americans and would that close the gap between potential GPD per worker in the two econo mies? U.S. potential GDP is higher than European potent ial GDP for two reasons: First, U.S. capital per worker and U.S. technology exceed those in Europe. Consequently, the U.S. production function lies above the European production function. Second, U.S. workers work more hours than do European workers. Both these differences mean that U.S. potential GDP exceeds European potential GDP. European workers would work more hours if taxes and unemployment benefits were lower in Europe. These changes would help close the gap between U.S. potential GDP and European potential GDP but would not eliminate it.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

 Additional Problems and Applications Read Eye on Potential GDP on p. 626 and then use the following information to work Problems 1 and 2. In South Korea, real GDP per hour of labor is $22, the real wage rate is $15 per hour, and people work an average of 46 hours per week. 1.

Draw a graph of the demand for and supply of labor in South Korea and the United States. Mark a point at the equilibrium quantity of labor per person per week and the real wage rate in each economy. Explain the difference in the two labor markets. Figure 24.1 shows the labor market in South Korea and also, based on data from page 626 of the text, in the United States. The demand for labor in the United States exceeds the demand for labor in Korea because the quantity of capital per worker in the United States exceeds that in Korea and U.S. technology is generally more productive than Korean technology. The U.S. supply of labor is less than the Korean supply of labor because of the income effect: U.S. income is higher than income in Korea, which increases the demand for leisure in the United States and thereby decreases the supply of labor in the United States.

Draw a graph of the production functions in Korea and the United States. Mark a point on each production function that shows po tential GDP per hour of work in each economy. Explain the difference in the two pro duction functions. Figure 24.2 shows the two production functions. The information used for the U.S. production function is based on the data from page 626 of the text. The U.S. production function is higher than the production function in Korea because the United States has more capital per worker than Korea and because U.S. technology is generally more advanced that Korean technology.

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Use the following list of events that occur one at a time to work Problems 3 to 6. Huge reserves of oil are discovered and extracted from the Italian coastline. The Juventus football club wins the UEFA Champions League. The minimum wage rate in Italy increases. A European invention got introduced to all the factories. It greatly increases productivity of labor. Housewives in Italy decide to go back to look for work increasing the labor force. 3.

Sort the items into four groups: those that change the production function, those that change the demand for labor, those that change the supply of labor, and those that do not change the production function, the demand for labor, or the supply of labor. Say in which direction each change occurs. The increase in the supply of oil changes the production function by shifting it upward. The European invention changes the production function by shifting it upward. The increase in the supply of oil increases the demand for labor. The European invention that increased workers’ productivity will increase the demand for labor. Housewives re-entering the labor force increases the supply of labor. Both Juventus becoming champions and the incr eased minimum wage rate have no effect on the production function, the supply of labor, or the demand for labor. However, the higher wage rate causes movements along the demand and supply of labor curves (not shifts) by increasing the quantity of labor supplied and decreasing the quantity of labor demanded.

Which of the events increase the equilibrium quantity of labor and which decrease the equilibrium quantity of labor? The productivity-enhancing invention increases the equilibrium quantity of labor. Housewives re-entering the labor force also increases the equilibrium quantity of labor. The oil extraction increases the equilibrium quantity of labor as well. However, the increased minimum wage rate decreases the equilibrium quantity of labor.

Which of the events raise the real wage rate and which of the events lower the real wage rate? The invention, the higher minimum wage, and the oil extraction increase the equilibrium real wage rate. Housewives re-entering the labor force decreases the equilibrium real wage rate.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

Which of the events increase potential GDP and which decrease potential GDP? The European invention, housewives re-entering the labor force, and the new oil extraction all increase the potential GDP. The increased minimum wage rate decreases the potential GDP.

Use the two tables above about the economy of Nautica to work Problems 7 and 8. 7.

What is the quantity of labor employed, potential GDP, the real wage rate, and total labor income? The real wage rate is $0.60 per hour, because that is the real wage that sets the quantity of labor demanded equal to the quantity of labor supplied. The equilibrium quantity of labor is 30 hours per day. The production function shows that the potential GDP with this amount of employment is $240 per year. Total labor income is $0.60 × 30 hours = $18 per week.

Suppose that the government introduces a minimum wage of $0.80 an hour. What is the real wage rate, the quantity of labor employed, poten tial GDP, and unemployment? Does the unemployment arise from job search or job rationing? Is the unemployment cyclical? Explain. The minimum wage of $0.80 an hour is greater than the equilibrium real wage rate, so the real wage rate equals the minimum wage, $0.80 an hour. At this wage rate the quantity of labor supplied is 40 hours per day but the quantity of labor demanded is 20 hours per day. Hence employment is 20 hours per day. At this level of employment, potential GDP is $180 per year. Unemployment equals the difference between the quantity of hours supplied, 40 per day, and the quantity of hours demanded, 20 per day, or 20 hours per day of unemployment. This unemployment reflects job rationing from the minimum wage. It is not cyclical.

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An eyewitness account of Sri Lanka’s remarkable recovery from the Boxing Day tsunami The 2004 tsunami that hit Southeast Asia was devastating to Sri Lanka both in terms of human life lost and economic costs. Whole villages were wiped out and more than 40,000 people died, either killed by the tsunami itself or by the diseases that followed. Source: Mail Online, June 20, 2015 Explain the effect of the tsunami on the Sri Lankan economy. How did it affect the production function, the labor demand and/or supply, and potential GDP? After the tsunami hit, the supply of labor decreased due to the numerous deaths and the demand for labor decreased due to the destruction of capital. The production function shifted downward as a result of the decrease in capital as well. The potential GDP decreased. However, the demand for labor increased after the reconstruction effort began in the years that followed the tsunami.

Chapter 24 . Potential GDP and the Natural Unemployment Rate

 Multiple Choice Quiz 1.

Nigeria’s value of real GDP when the economy employs all available resources of production is called: A. Actual GDP B. Potential GDP

C. Real GDP measured at current market prices. D. Real GDP per capita Answer: B The question refers to the potential GDP (by definition). 2.

The demand for labor curve shows the relationship between A. the quantity of labor employed and firms’ profits

B. all households’ willingness to work and the real wage rate C. the quantity of labor businesses are willing to hire and the real wage rate D. the labor force and the real wage rate Answer: C 3.

Answer C is the definition of the demand for labor curve.

The supply of labor is the relationship between

A. the quantity of labor supplied and leisure time forgone B. the real wage rate and the quantity of labor supplied C. firms’ willingness to supply jobs and the real wage rate D. the labor force participation rate and the real wage rate Answer: B 4.

Answer B defines the supply of labor.

Households’ labor supply decisions are influenced by all of the following except . A. the opportunity cost of taking leisure and not working B. the after-tax wage rate C. unemployment benefits

D. the number of full-time jobs available Answer: D The number of full-time jobs available reflects firms’ demand for labor not households’ supply of labor.

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The full-employment quantity of labor . A. increases if labor becomes more productive B. cannot increase because everyone who wants a job has one C. increases as the economy moves along its production function D. decreases if the income tax rates decrease

Answer: A

The increase in the productivity of labor increases the demand for labor, thereby raising the full-employment quantity of labor.

The natural unemployment rate

A. increases if unemployment benefits become more generous B. increases in a recession C. increases as the average age of the labor force rises D. decreases as firms outsource manufacturing jobs Answer: A More generous unemployment benefits decrease the cost of searching for a job and thereby increase the amount of job search. 7.

Job rationing

A. increases the natural unemployment rate B. has no effect on the natural unemployment rate C. increases labor turnover as firms compete for high quality labor D. decreases the demand for labor, which lowers the real wage rate Answer: A Job rationing decreases the quantity of labor demanded and thereby raises the natural unemployment rate. 8.

An efficiency wage results in all of the following except A. a decrease in the rate of labor turnover B. an increase in the full-employment quantity of labor C. greater work effort D. an increase in the cost of monitoring work effort

Answer: B

An efficiency wage decreases employment.

Economic Growth ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Explain why sustained growth of real GDP per person can transform a poor country into a wealthy one. The reason that the sustained growth of real GDP per person can transform a poor country into a wealthy one is that economic growth is like compound interest. In other words, as the economy grows, in future years the growth rate is applied to an increasingly larger real GDP per person, so the gain also increases proportionately.

In 2005 and 2006, India’s real GDP grew by 9.2 percent a year and its population grew by 1.6 percent a year. If these growth rates are sustained, in what years would  Real GDP be twice what it was in 2006? Using the Rule of 70, India’s real GDP doubles in 70 ÷ 9.2 = 7.6 years. So starting from January 1, 2007 real GDP would be twice what it was on January 1, 2006 midway through the year 2014. 

Real GDP per person be twice what it was in 2006? The growth rate of India’s real GDP per person equals 9.2 percent − 1.6 percent = 7.6 percent. Using the Rule of 70, India’s real GDP per person doubles in 70 ÷ 7.6 = 9.2 years. So starting from January 1, 2006 real GDP would be twice what it was on that date a little ways through the year 2015.

Describe how potential GDP per person has grown since 1960. Since 1960, U.S. potential GDP per person has grown but the growth rate has slowed in every decade. In the 1960s the annual growth rate of potential GDP per person was a little under 3.0 percent. By the 1990s it was 1.75 percent and by the 2010s had slowed still further to around 0.85 percent. As a result, the number of years it takes for U.S. potential GDP to double has risen from 24 years to 82 years.

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Explain the link between labor hours, labor productivity, and real GDP. Labor productivity = (Real GDP)  (Aggregate hours). So, Real GDP = (Labor productivity)  (Aggregate hours). Real GDP grows when labor productivity increases or when aggregate labor hours increase.

Explain how saving and investment in capital change labor productivity. Why do diminishing returns arise? Provide an example of diminishing returns. Use a graph of the productivity curve to illustrate your answer. Saving and investment in new physical capital increase labor productivity. Diminishing returns, however, occur: as capital per hour of labor rises, additional increases in capital per hour of labor raise labor productivity by smaller amounts. Diminishing returns arise because the first increases in capital boost labor productivity tremendously while, once more capital is accumulated, later increases have a smaller effect on labor productivity. For instance, when a wheat farm acquires its first combine, the workers’ productivity skyrockets higher because the wheat can be harvested in a much shorter time. But when the farm acquires its second combine, the increase in labor productivity is much smaller because the wheat already is being harvested efficiently. An increase in physical capital, which is the result of saving and investment, results in a movement along the productivity curve, as illustrated in Figure 25.1 by the arrow. The savings and investment has increased capital per hour of labor so there has been a movement along the productivity curve to a higher level of labor productivity.

Explain how advances in technology change labor productivity. Do diminishing returns arise? Provide an example of an advance in technology. Use a graph of the productivity curve to illustrate your answer. Advances in technology increase labor productivity. Technological advances allow producers to produce more goods and services without changing the quantity of resources utilized. Labor productivity is equal to (real GDP) ÷ (aggregate hours), so the technological advance that boosts real GDP without changing aggregate hours boosts labor productivity. Technological change is not subject to diminishing returns. For instance, the technological change in the production of computer chips has boosted the productivity of millions. An advance in technology results in an upward shift of the productivity curve, as illustrated in Figure 25.2 where

Chapter 25 . Economic Growth

the productivity curve shifts from PC0 to PC1. At any amount of capital per hour of labor, labor productivity PC1 is greater than labor productivity along PC0. Of course, along both productivity curves, increases in capital remain subject to diminishing returns.

Explain how an increase in human capital changes labor productivity. Do diminishing returns arise? Provide an example of an increase in human capital. Use a graph of the productivity curve to illustrate your answer. Increases in human capital increase labor productivity. Moreover, human capital is not subject to diminishing returns. When workers’ human capital increases, they become more productive. For example, as more students graduate from college with advanced knowledge of DNA, the development and production of new, DNA-based drugs increases. An increase in human capital results in an upward shift of the productivity curve, as illustrated in Figure 25.3 where the productivity curve shifts from PC0 to PC1. At any amount of capital per hour of labor, labor productivity PC1 is greater than labor productivity along PC0. Of course, along both productivity curves, increases in capital remain subject to diminishing returns.

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What were the sources of labor productivity growth in the U.S. economy during the fifty years since 1960? How did the 1960s differ from the more recent decades? Labor productivity has grown because of capital accumulation, (rapid) human capital growth, and technological change. The 1960s differ from other decades because labor productivity growth was most rapid in that decade. Labor productivity growth slowed dramatically in the 1970s because technology and capital growth during that decade was devoted to offsetting high oil prices and because of increasing taxes and government regulation. Labor productivity growth rose in the 1990s with the widespread adoption of computers and dramatic health-care advances.

Draw productivity curves to illustrate the changes in labor productivity that occurred in the U.S. economy in the 1960s and contrast the change with that after 2007. What were the new technologies that arrived in the 1960s?

Figure 25.4 illustrates the 1960s and Figure 25.5 illustrates the period after 2007. The growth rate of physical capital and human capital growth in the 1960s was about 2 percent, which is twice that after 2007. The growth rate of technological change in the 1960s was about 0.8 percent, also about twice that after 2007. Technologies associated with transistors, computers, the laser, plastics, passenger jets, the interstate highway system, and shopping malls grew rapidly in the 1960s.

Chapter 25 . Economic Growth

10. What can governments in Africa do to encourage economic growth and raise the standard of living in their countries? Governments in Africa have to focus on increasing economic freedom within their countries. They need to end any wars in which they are involved to return to the rule of law and provide secure property rights. They also need to provide greater access to education to improve their citizens’ human capital as well as establish truly free markets. 11. Slowing down growth China’s GDP growth target for the 12th Five-Year-Plan period 2011–2015 is 7 percent a year. This largely symbolic goal (China’s average growth rate for the past five years was a whopping 11 percent a year) shows that the central government wants to fundamentally restructure the economy. Source: The Daily Telegraph, September 25, 2011 If China reduces its economic growth rate from 11 percent a year to 7 percent a year, how many additional years will it take for GDP to double? In what year will China’s GDP quadruple? Using the Rule of 70, if the growth rate is 11 percent, China’s GDP will double in 70 ÷ 11 = 6.36 years while if the growth rate is 7 percent, China’s GDP will double in 70 ÷ 7 = 10.00 years. Slowing the growth rate to 7 percent means it will take 3.64 more years to double GDP. For China’s GDP to quadruple, it needs to double twice, so at a growth rate of 7 percent it will take China 20 years to quadruple its GDP. At this rate, GDP will quadruple from its level in 2013 in the year 2033. 12. Read Eye on Rich and Poor Nations on p. 661. Which nations are the richest and which are growing the fastest? What are the conditions that lead to higher incomes and faster growing incomes? The richest nations are the United States, Europe’s “Big 4” nations, Hong Kong, and Taiwan. The nation growing the most rapidly is China, though Hong Kong and Taiwan have also grown rapidly in the recent past. Rapid economic growth requires three key factors: Economic freedom, secure property rights, and reliance upon free markets. Once these factors are in place, good incentives to save, invest, and innovate are important for speeding economic growth. Allowing for free international trade and creating a sound education system also help bring more rapid economic growth.

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 Additional Problems and Applications 1.

Read Eye on Rich and Poor Nations on p. 661 and distinguish between a low and high incomes and a low and high economic growth rates. What are the key features of an economy that are present when incomes are high or fast growing and absent when incomes are low and stagnating or growing slowly? Provide an example of an economy with  Low income and slow growth rate  Low income and rapid growth rate  High income with sustained growth over many decades. The difference between low and high incomes versus low and high economic growth rates is important. A nation’s current income tells where it is now while the growth rate tells how rapidly its current income is changing. A nation with a high income or a fast-growing income will have met the preconditions for economic growth: economic freedom, secure property rights, and markets. These nations also frequently will have good incentive mechanisms to save, invest and innovate; government policies that encourage saving and research and development; free international trade; and, a high quality of education. Nations with low income or slow growth often need some of the necessary preconditions for growth. They also tend to lack good incentives to save, invest, and innovate; no government policies to encourage saving and research and development; restricted international trade; and poor schooling. Currently Zimbabwe is an economy with an extremely low income and an extremely slow growth rate; China is an economy with a relatively low income and a very high growth rate; and the United States is an economy that has enjoyed sustained growth over many decades.

Use the following information to work Problems 2 and 3. China’s growth rate of real GDP in 2005 and 2006 was 10.5 percent a year and its population growth rate was 0.5 percent a year. 2. If these growth rates continue, in what year would real GDP be twice what it was in 2006? Using the Rule of 70, China’s real GDP doubles in 70  10.5 = 6.7 years. So starting from January 1, 2006, real GDP would be twice what it was on that date about two thirds of the way through the year 2012. 3.

If these growth rates continue, in what year would real GDP per person be twice what it was in 2006? The growth rate of China’s real GDP per person equals 10.5 percent  0.5 percent = 10.0 percent. Using the Rule of 70, China’s real GDP per person doubles in 70  10.0 = 7.0 years. So starting from January 1, 2006, real GDP would be twice what it was in 2006 in 2013.

Explain how an increase in physical capital and an increase in human

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capital change labor productivity. Use a graph to illustrate your answer. Saving and investment increase the amount of capital. The increase in the physical capital leads to an increase in labor productivity and a movement along a productivity curve. Formal education and training, as well as job experience, increase human capital. An increase in human capital increases labor productivity and shifts the productivity curve. Figure 25.6 illustrates this outcome by the shift in the productivity curve from PC0 to PC1. At any amount of capital per hours of labor, labor productivity (real GDP per hour of labor) is greater along productivity curve PC1 than along productivity curve PC0. 5.

The table describes labor productivity in an economy. What must have occ urred in this economy during year 1?

Capital per hour of labor

Between year 1 and year 2, the output per hour of labor (labor productivity) increased for every level of capital per hour of labor. There was either technological advances and/or growth in human capital. 6.

10 20 30 40 50 60 70

Describe and illustrate in a graph what happened in the economy in the table if in year 1, capital per hour of labor was 30 and in year 2 it was 40. Figure 25.7 shows the productivity curves for the two years. PC1 is the productivity curve for year 1 and PC2 is the curve for year 2. The productivity curve shifted higher, as illustrated in the figure. This upward shift was the result of either technological advances and/or growth in human capital. The quantity of capital per hour of labor also increased because of saving and investment in new capital. With these changes the economy moved from point A in year 1 to point B in year 2.

Real GDP per hour of labor In year 1 In year 2 7 13 18 22 25 27 28

9 17 24 30 35 39 42

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China invests almost 50 percent of its annual production in new capital compared to 15 percent in the United States. Capital per hour of labor in China is about 25 percent of that in the United States. Explain which economy has the higher real GDP per hour of labor, the faster growth rate of labor productivity, and which experiences the more severe diminishing returns. The United States has the higher real GDP per hour of labor because the U.S. productivity curve lies above the Chinese productivity curve and the United States has more capital per hour of labor than does China. China’s growth of productivity exceeds U.S. growth of productivity because China is increasing its capital per hour of labor more rapidly that the United States. The United States experiences more severe diminishing returns because the U.S. capital per hour of labor exceeds that in China.

Use the following information to work Problems 8, 9, and 10. Dear Silicon Valley: Forget flying cars, give us economic growth We have made enormous advances in computing technology. In Silicon Valley at Alphabet’s X labs, people are working on transformative technologies that include driverless cars, high-altitude balloons that deliver the Internet to remote regions of the world, self-navigating drones, and flying wind turbines tethered to a ground station. But despite today’s advances in technology, our economic growth rate has slowed. Source: MIT Technology Review, June 21, 2016 8. How would you explain the disconnect between the advances in technol ogy described in the news clip and the pace of real GDP growth? Advances in technology shift the productivity curve upward and increase real GDP per hour of labor. But the advances described in the clip— driverless cars, high-altitude balloons, self-navigating drones, and flying wind turbines—have not yet been completely perfected and so have not yet left the labs in their finished forms. We can see these technologies on the horizon but many sectors have to benefit from these technologies. 9.

Thinking about the perpetual motion machine of economic growth (Figure 25.5 on p. 652), what are the missing ingredients that make some of today’s amazing technologies fail to deliver faster economic growth? Some of these technologies—high-altitude balloons and flying wind turbines—appear to be similar to the technologies developed on the 1970s insofar as they are dealing with problems—lack of Internet access, pollution from exploiting energy resources—that do not lead to new and better jobs. Consequently, in spite of technological advances, job creation has been slow.

10. Of the preconditions for economic growth and the policies that might achieve faster growth, which are already present in Silicon Valley (and

Chapter 25 . Economic Growth

the rest of the U.S. economy), and which, if any, might need to be strengthened? All of the preconditions are present in Silicon Valley. Allowing for additional free trade and perhaps relaxing some business regulations that make it difficult to hire the best person for the job, even if that person is an immigrant, might help speed economic growth. The United States could also encourage saving, which would increase the growth of capital and boost economic growth.

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 Multiple Choice Quiz 1.

If real GDP increases from $5 billion to $5.25 billion and the population increases from 2 million to 2.02 million, real GDP per person increases by percent. A. 5.0 B. 1.0 C. 2.5 D. 4.0 Answer: D Real GDP grows by 5 percent and the population grows by 1 percent, so real GDP per person grows by 4 percent. 2.

If the population growth rate is 2 percent, real GDP per person will double in 7 years if real GDP grows by percent per year. A. 7 B. 10 C. 12 D. 14 Answer: C For real GDP per person to double in 7 years, the growth rate of real GDP per person must be 10 percent. If the population growth rate is 2 percent, then real GDP must grow at 12 percent. 3.

All of the following increase labor productivity except . A. the accumulation of skill and knowledge B. an increase in capital per hour of labor C. an increase in consumption D. the employment of a new technology Answer: C An increase in consumption has nothing to do with changing labor productivity. 4.

The increase in real GDP per hour of labor that results from an increase in capital per hour of labor . A. is constant and independent of the quantity of capital B. is larger at a small quantity of capital than at a large quantity of capital C. is smaller at a small quantity of capital than at a large quantity of capital D. decreases as technology advances Answer: B Answer B describes the law of diminishing returns.

Chapter 25 . Economic Growth

The increase in real GDP per hour of labor that results from an advance in technology makes labor productive . A. more; at all quantities of capital B. less; and capital more productive C. more; only at a large quantity of capital D. more; and capital less productive Answer: A Figure 25.2 in the book shows that answer A is correct.

The classical growth theory is that real GDP per person . A. only temporarily rises and then returns to the subsistence level B. grows forever C. is constant and does not change D. increases as the population grows Answer: A If real GDP per person rises above the subsistence level, a population explosion occurs that drives it back down to the subsistence level.

In new growth theory, the source of economic growth is . A. more leisure B. new and better jobs C. the persistent want for a higher standard of living D. an ever increasing growth rate of capital per hour of labor Answer: C The persistent drive for a higher standard of living leads to persistent innovations and technological advances that create persistent economic growth.

An economy can achieve faster economic growth without . A. markets and property rights B. people being willing to save and invest C. incentives to encourage the research for new technologies D. an increase in the population growth rate Answer: D The other answers are necessary conditions for economic growth.

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Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

On January 1, 2020, Terry’s Towing Service owned 7 tow trucks valued at $525,000. During 2020, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2020, the market value of all of the firm’s trucks was $600,000. What was Terry’s gross investment? Calculate Terry’s depreciation and net investment. His gross investment was $180,000. His depreciation, which equals the initial market value of the trucks plus gross investment minus the ending market value of the trucks, was $105,000. His net investment, equal to gross investment minus depreciation, was $75,000.

Use the following information to work Problems 2 and 3. The Bureau of Economic Analysis reported that the U.S. capital stock was $57.3 trillion at the end of 2016, $59.8 trillion at the end of 2017, and $62.9 trillion at the end of 2018. Depreciation in 2017 was $3.2 trillion, and gross in vestment during 2018 was $3.8 trillion. 2.

Calculate U. S. net investment and gross investment during 2017. Net investment equals the change in the quantity of capital. So in 2017, U.S. net investment was $59.8 trillion $57.3 trillion, which is $2.5 trillion. Gross investment equals net investment plus depreciation. So in 2017, U.S. gross investment was $2.5 trillion + $3.2 trillion, which is $5.7 trillion.

Calculate U.S. depreciation and net investment during 2018. Net investment equals the change in the quantity of capital. So in 2018, U.S. net investment was $62.9 trillion $59.8 trillion, which is $3.1 trillion. Depreciation equals gross investment minus net investment. So in 2018, U.S. depreciation was $3.8 trillion $3.1 trillion, which is $0.7 trillion.

Sam takes a summer job painting houses. During the summer, he earns an after-tax income of $3,000 and he spends $1,000 on goods and services. What was Sam’s saving during the summer and the change, if any, in his wealth? © 2023 Pearson Education, Ltd.

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Sam’s saving is equal to his after -tax income minus his consumption expenditure, which is $3,000 − $1,000 = $2,000. Sam’s wealth increased by the amount of his saving, $2,000. 5.

What is the market for financial capital? What is financial capital? Explain why, when the real interest rate rises, the demand for loanable funds does not change but the quantity of funds demanded decreases. Financial markets are where savers and borrowers transact their business. Financial markets include loan markets, bond markets, and stock markets. Financial assets, such as stocks and bonds, are traded in financial markets. Financial capital is the funds that firms use to buy their (physical) capital. An increase in the real interest rate decreases the quantity of loanable funds demanded and results in a movement upward along the demand for loanable funds curve. The demand for loanable funds curve does not shift. The factor that changes the demand for loanable funds, that is, changes the entire relationship between the real interest rate and the quantity of loanable funds demanded is the expected rate of profit. When the expected profit changes, the demand for loanable funds changes and the loanable funds demand curve shifts.

With an increase in political tension, many governments increased de fense spending, which decreased government budget surpluses. Show, on a graph, the effects of a decrease in government budget surpluses if there is no Ricardo-Barro effect. Explain how the effects differ if there is a partial Ricardo-Barro effect. Figure 26.1 shows the initial private supply of loanable funds curve, PSLF0 and the initial total supply of loanable funds curve, SLF0 . The horizontal difference between the two curves, indicated by the long grey arrow, is the amount of the initial government budget sur pluses. If the governments begin to run smaller budget surpluses and there is no RicardoBarro effect, the private supply of loanable funds curve remains the same, PSLF0 . The total supply of loanable funds curve shifts leftward, in the figure to SLF1 . In the figure, the decrease in the government surpluses equals the length of the short grey arrow facing left. If the governments begin to run smaller

Chapter 26 . Finance, Savin g, and Investment

budget surpluses and there is a full Ricardo-Barro effect, the total supply of loanable funds curve remains the same, SLF0 . The private supply of loanable funds curve shifts rightward to PSLF1 because households increase their saving to exactly offset the lessened government surplus. The shift is equal to the reduction in the government surplus and equals the length of the short grey arrow facing right (which is the same amount as the short, leftward facing arrow). If there is a partial Ricardo-Barro effect, the effects are partway between those with no Ricardo-Barro effect and a full Ricardo-Barro effect. The private supply of loanable funds curve shifts rightward but not all the way to PSLF1 and the total supply of loanable funds curve shifts leftward but not all the way SLF1 . 7.

Brazil’s high-speed train project Brazil’s bullet-train project is one of the most ambitious parts of the government’s plan to invest $235 billion over the next decade in transportation networks and energy projects—part of its effort to reduce costs and boost economic growth. Source: The Wall Street Journal, August 12, 2013 Draw a graph of the loanable funds market. Suppose that the Brazilian government borrows the required funds in the loanable funds market. How will this borrowing change the real interest rate and the quantity of saving? The increase in government expenditure in Brazil increases the demand for loanable funds. As a result, the demand for loanable funds curve shifts rightward. Figure 26.2 shows this change as the shift in the demand for loanable funds curve from DLF0 to DLF1. The increase in the demand for loanable funds raises the real interest rate in Figure 26.2 from 5 percent to 6 percent. Figure 26.2 also shows that the increase in the demand for loanable funds increases the equilibrium amount of loanable funds-in the figure, from $1.0 trillion to $2.0 trillion. Equivalently, the equilibrium quantity of saving (and investment) increases from $1.0 trillion to $2.0 trillion.

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Celtic Tiger purrs A banking crisis forced Ireland to seek a $91.61 billion bailout from the EU and the IMF. Under the terms of its bailout, the government must reduce its budget deficit from 10 percent of GDP to 8.6 percent in 2012. Ireland’s economic growth started to pick up despite the cutbacks in government spending. Source: The Wall Street Journal, September 22, 2011 Explain the effect of the cut in the budget deficit on the loanable funds market in Ireland. Why might the economy have grown strongly? The decrease in the budget deficit decreases the demand for loanable funds. The demand curve for loanable funds shifts leftward and the real interest rate falls. Ireland’s economy might have grown rapidly because the fall in the real interest rate increased investment and consumption expenditure, which offset the effects from the decrease in budget deficit.

Read Eye on Financial Markets on p. 687. Describe some of the financial services provided by fintech firms. How has fintech changed the quantity of personal loans? How has crowdfunding changed the interest rate on personal loans? Fintech firms provide several financial services. Some fintech firms have created apps that allow payments to be made via a smartphone or online. Others make personal loans available online. Some fintech firms allow crowdfunding of entrepreneurs and businesses. Fintech has increased the quantity of personal loans. In 2018, fintech ac counted for almost 40 percent of personal loans made in the United States. The share of fintech personal loans has grown quickly because they are often easier and cheaper to obtain than traditional loans and the interest rate they charge is lower than that charged by traditional lenders. Crowdsourcing has increased the supply of loanable funds. The increase in the supply of loanable funds lowered the interest rate.

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 Additional Problems and Applications 1.

Read Eye on Fintech on p. 687. Explain how fintech has changed the loanable funds market. Using data and making assumptions, draw a gra ph of the loanable funds market to illustrate the effects of fintech on the interest rate. Fintech increased the supply of loanable funds. Fintech increased the supply of loanable funds by giving individuals the ability to fund startups and entrepreneurs via avenues such as Kickstarter. From 2013 to 2018, fintech personal loans increased by approximately $50 billion, or about one third of all personal loans. Figure 26.3 shows the effect of fintech in the market for loanable funds. DLF and SLF0 show the market for loanable funds in the absence of fintech and SLF1 shows the supply curve in the market for loanable funds with fintech. The presence of fintech increased the equilibrium quantity of loanable funds by one third, from $1.2 trillion to $1.6 trillion, and lowered the real interest rate, from 4 percent to 3 percent.

Mona, who owns a factory for Lebanese traditional clothing, knows this year, her initial 15 machines valued at LBP 900,000 will decrease in value by 20 percent. She bought four new sewing machines valued at LBP 100,000. Calculate Mona's depreciation, her net investment, and the value of her capital stock at the end of the year. Her depreciation was LBP 180,000. Her gross investment was LBP 400,000 for the new sewing machines. Her net investment equals gross investment minus depreciation, so her net investment was LBP 220,000. The value of her capital stock at the end of the year is the value of her initial capital stock plus her net investment, which equals LBP 1,120,000.

The saving rates in France and the disposable income data for all quarters in 2016 are given in Table 1: TABLE 1 Saving Rate Disposable Income Year 2016 % Millions of Euros 1 st Quarter 14.9468 342,407 2 nd Quarter 14.3385 343,636 3 rd Quarter 14.5237 345,756 4 th Quarter 15.0203 347,056

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What portion of disposable income is not saved? Given the relation between wealth and saving, and based only on the information given in the table, what do you think happened to wealth in the quarters mentioned? Can saving exceed the change in wealth and vice versa? Why and how can the change differ? What is not saved of the disposable income is spent on consumption. Savings add to wealth. As the savings rate decreased from the 1st to the 2nd quarter of 2016, the addition to wealth decreased [The savings can also be calculated and shown to have decreased: (14.9468 x 342,407)/100 = € 51,178.9 in the 1 st Quarter, and in the 2 nd Quarter: (14.3385 x 343,636)/100 = €49,272.25]. As the saving rate increased during the remaining periods (from 2nd to 3rd and then to the 4th quarter), it means that the addition to wealth was increasing as well. Since wealth does not depend only on savings, but also depends on the market value of assets, savings may exceed the change in wealth or the change in wealth may exceed savings depending on the change in the market value of assets.] 4.

Rana works at the local library in her village in Egypt and earns EGP 8,500 per month. She always worries about her future but the most she can put aside monthly is EGP 2,300 from her salary. What are Rana's living expenses and is her wealth changing? Rana’s living expenditure is equal to her after -tax income minus her saving, which is EGP 8,500 EGP 2,300 = EGP 6,200. Rana’s wealth is increasing every month by EGP 2,300.

A stock market boom of 2019 increased wealth by trillions of dollars. Explain the effect of this increase in wealth on the equilibrium real interest rate, investment, and saving. The increase in wealth decreased people’s saving and thereby decreased the supply of loanable funds. The decrease in the supply of loanable funds raised the equilibrium real interest and decreased the equilibrium quantity of loanable funds. The equilibrium quantity of investment and saving also decreased.

Chapter 26 . Finance, Savin g, and Investment

Use the following information to work Problems 6 and 7. According to OECD data, household saving in Belgium as a percentage of disposable income was on a continuous decrease from 2011 to 2015. It fell from 6.56 percent in 2011 to 5.71 in 2012, to 4.94 in 2013, to 4.61 in 2014, till it reached 4.18 in 2015. 6.

What does it mean that the saving rate is on a continuous decrease and what does it means if it becomes negative? Is it worrying to have such a trend? Why? What can the government do to increase saving? A decreasing saving rate means that each year, household consumption expenditure as a percentage of disposable income is increasing more and more so that less and less remains to be saved. If the saving rate becomes negative, it means that consumption expenditure exceeds disposable income. It’s worrying in the sense that the supply of loanable funds is decreasing. It would have been more worrisome, though, if the r ate reaches a negative trend because it would mean that people are borrowing and need to eventually repay those debts. The government can use some policies to increase saving by eliminating taxes on interest income in the stock market or on bank deposits interest gains.

Explain how the decreasing Belgian saving rate affects the market of loanable funds and the equilibrium interest rate. The decrease in the savings rate decreases the supply of loanable funds as less money is put aside. It does not affect the demand for loanable funds. Demand for loanable funds curve will not shift but the supply of loanable funds curve will shift to the right; therefore, the interest rate will decrease.

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Use the following information to work Problems 8 and 9. IMF says it battled crisis well The International Monetary Fund (IMF) reported that it acted effectively in combating the global recession, especially in Eastern Europe. The IMF made $163 billion available to developing countries. The IMF required countries with large deficits to cut spending or not increase it, but it urged the United States, Western European countries, and China to run deficits to stimulate their economies. 8.

Source: The Wall Street Journal, September 29, 2009 Explain how an increase in government expenditure will change the government’s budget balance and the loanable funds market. An increase in government expenditure increases a budget deficit or decreases a budget surplus. In the absence of a Ricardo-Barro effect, the increase in a budget deficit increases the demand for loanable funds while a decrease in budget surplus decreases the supply of loanable funds. On both counts the real interest rate rises and investment is crowded out.

Why do you think the IMF required countries with large deficits, like those in Eastern Europe, to cut spending rather than increase it? The IMF was probably concerned that further increases in these nations’ budget deficits might have caused potential lenders to the nations to wor ry that the default risk on those nations’ debts was becoming quite high. Such a concern would have decreased the supply of loanable funds to those nations and possibly raised the r eal interest they must pay quite substantially.

Present Value Appendix Exercise 10. With an interest rate of 20 percent, what is the present value on December 31, 2020 of payments of $400 on December 31 each year for the next 3 years starting in 2021? The present value of the payment 1 year in the future is ($400)/(1 + 0.20) = $333.33. The present value of the payment 2 years in the future is ($400)/(1 + 0.20)2 = $277.78. The present value of the payment 3 years in the future is ($400)/(1 + 0.20)3 = $231.48. The present value of all three payments is the sum of each individual present value, or $333.33 + $277.78 + $231.48 = $842.59.

Chapter 26 . Finance, Savin g, and Investment

 Multiple Choice Quiz 1.

Financial capital is the . A. money used to buy stocks and bonds B. money used to buy physical capital

C. funds that savers supply and buyers of physical capital borrow D. money in the bank Answer: B Answer B is essentially the definition of financial capital. 2.

If the price of a government bond in Germany is €75 and the owner of the bond is entitled to a 4 percent interest payment per year, then the interest payment is _________. A. €30 B. €18.75 C. €3 D. €20

Answer: C

The interest paid on an asset is equal to the price multiplied by the interest rate, then divided by 100.

In the loanable funds market, an increase in

A. the real interest rate increases the demand for loanable funds B. expected profit increases the demand for loanable funds C. expected profit doesn’t change the demand for loanable funds, but the quantity of loanable funds demanded increases D. the real interest rate doesn’t change the demand for loanable funds, but the quantity of loanable funds demanded increases Answer: B

The increase in expected profit increases the demand for loanable capital, which means the demand curve for loanable capital shifts rightward.

The supply of loanable funds increases

A. when the demand for loanable funds increases B. when people increase saving as the real interest rate rises C. when disposable income increases or wealth decreases D. if net taxes decrease or expected future income increases Answer: C An increase in disposable income or decrease in wealth influence people to increase their saving, which increases the supply of loanable funds.

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An increase in expected profit the quantity of loanable funds.

the real interest rate and

A. decreases; decreases B. increases; decreases C. decreases; increases D. increases; increases Answer: D

An increase in expected profit increases the demand for loanable funds, which increases the real interest rate and the quantity of loanable funds.

A government budget surplus

A. increases the supply of loanable funds B. raises the real interest rate C. decreases the demand for loanable funds and lowers the real interest rate D. decreases net taxes, increases disposable income, and increases saving Answer: A

A government budget surplus is a source of loanable funds and so increases the supply of saving.

Crowding out occurs when

A. households’ budgets are in deficit and saving decreases B. the government budget is in surplus, so people have paid too much tax C. the government budget is in deficit and the real interest rate rises D. the government budget is in deficit but taxpayers are rational and the Ricardo-Barro effect operates Answer: C

When the government budget is in deficit, the demand for loanable funds increases, thereby raising the real interest rate. The higher real interest rate decreases—crowds out—private investment.

An increase in the government budget deficit

A. increases private saving and investment B. increases private saving and decreases investment C. increases the supply of private saving and decreases investment D. decreases private saving and investment Answer: B The increase in the budget deficit raises the real interest rate, which increases private saving and decreases investment.

Chapter

The Monetary System ANSWERS TO CHAPTER CHECKPOINT

 Problems and Applications 1.

What is money? Would you classify any of the items in List 1 as money? Money is any commodity or token that is generally accepted as a means of payment.  Frequent flier miles The frequent flier miles act as a unit of account. However, they might not serve as a store of value because they often have expiration dates. They are not money.  Civil War Greenbacks Civil War Greenbacks were issued to finance the civil war. They are not money.  A $5 off your next purchase voucher The $5 off your new purchase acts as a store of value and a unit of account. It is a medium of exchange only at the store in question. The $5 off is not money.  U.S. postage stamps The value of U.S. postage stamps is that they can only be used to pay postage. A U.S. postage stamp is not money.  A bank loan A bank loan means that you borrowed money from the bank. It does not share any of the characteristics of money, so it is not money.  A $50 discount voucher for your next laptop The $50 discount off your next laptop acts as a store of value but only at the store which honors them and usually only when presented with cash. They are not a widespread medium of exchange (only for your next laptop!) but if they are in dollars, the coupons are a unit of account. Store coupons are not money.  A $20 traveler's check A $20 traveler's check acts as a store of value, a unit of account, and a medium of exchange. Therefore, it is money.

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What are the three vital functions that money performs? Which of the following items perform some but not all of these functions, and which perform all of these functions? Which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value.  A blank check A blank check is signed with the amount left to be filled in by the receiver of the check. It does not perform all three functions of money. It is not money.  A checking account at the Bank of America A checkable deposit at the Bank of America performs all three functions of money. It is money.  A $10 bill A $10 bill performs all three functions of money. It is money.  A diamond ring A diamond ring is a store of value, but it is neither a medium of exchange nor a unit of account. It is not money.  The nickel used to produce coins The nickel used to produce coins does not perform the three functions of money. It is not money.  Ancient Roman coins Ancient Roman coins are collector’s coins. Hence, they will not be used as a means of payment nor a unit of account, but they are a store of value. They are not money.  Cox Communications bonds Cox Communications bonds can act as a store of value, but they are not a unit of account nor a medium of exchange. They are not money.

3. Serge deposits €8,500 that he held as currency in his checkable deposit account at BNP Paribas. What is the immediate change in M1 and M2? M1 and M2 are left unchanged. The reason is that only the composition of M1 has changed but not the total amount of M1: currency held by individuals and businesses and traveler's checks decreased by €8,500 and checkable deposits owned by individuals and businesses increased by €8,500. M2 does not change because none of the components of M2 are affected.] 4.

Terry takes $100 from his checking account and deposits the $100 in his savings account. What is the immediate change in M1 and M2? M1 decreases by $100 and M2 remains unchanged.

Suppose that banks had deposits of $500 billion, a desired reserve ratio of 4 percent and no excess reserves. The banks had $15 billion in notes and coins. Calculate the banks’ reserves at the central bank. The banks’ total desired reserves equal $500 billion × 0.04, which is $20 © 2023 Pearson Education, Ltd.

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billion. Of these $20 billion in desired reserves, banks have $15 billion in notes and coins, leaving $5 billion at the central bank. 6.

Explain the Fed’s policy tools and briefly describe how each works. The Federal Reserve has four policy tools: changing the required reserve ratio, changing the discount rate, open market operations, and extraordinary crisis measures. The Fed can set the required reserve ratio, the fraction of deposits that banks must keep as reserves. If the Fed raises the required reserve ratio, banks are unable to make as many loans because they must keep more of their deposits as reserves. The Fed can change the discount rate, the interest rate it charges banks for loans of reserves. If the Fed raises the discount rate, banks will borrow fewer reserves. Open market operations are the purchase or sale by the Fed of government securities. If the Fed sells government securities, banks will have fewer reserves. Extraordinary crisis measures include quantitative easing, when the Fed increases banks’ reserves by large-scale open market operations, credit easing, when the Fed buys private securities or makes loans to financial institutions, and Operation Twist, when the Fed buys long-term government securities and sells short-term government securities in an effort to lower the long-term interest rate.

The table shows a bank’s balance sheet. The bank has no excess reserves and there is no currency drain. Calculate the bank’s desired reserve ratio. The bank’s deposits are $200 million

Assets

Liabilities (millions of dollars)

Reserves at the Fed Cash in vault Securities Loans

20 5 75 100

Checkable deposits Savings deposits

80 120

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and its reserves, which are composed of the reserves at the Fed plus the cash in its vault, are $25 million. Therefore the desired reserve ratio equals ($25 million) ÷ ($200 million) = 0.125 or 12.5 percent. 8.

Banque du Liban, the central bank of Lebanon, buys LBP 500 million of securities from Byblos Bank. If Byblos Bank has a desired reserve ratio of 0.3 and a currency drain ratio of 0.1, calculate the bank’s excess reserves as soon as the open market purchase is made. Did the monetary base change? Calculate the maximum amount of new money that the Lebanese banking system can create. Excess reserves = actual reserves - desired reserves. The new reserves created by Banque du Liban’s purchase are LBP 500,000,000. Desired reserves have not changed, so the excess reserves are LBP 500,000,000 LBP 0, which is = LBP 500,000,000. So the monetary base increased by LBP 500,000,000. The maximum amount of new money that the banking system can make is equal to the monetary base multiplied by the money multiplier. The (1  C / D) , where C/D is the currency drain ratio money multiplier is ( R / D  C/D) and R/D is the desired reserve ratio. In this case, the currency drain equals 0.1 and the desired reserve ratio is 0.3, so the money multiplier is 1.01  0.40, or 2.525. So the total increase in the quantity of money is LBP 500,000,000  2.525, which is LBP 1,262,500,000.]

Use the following information to work Problems 9 and 10. If the desired reserve ratio is 5 percent, the currency drain ratio is 20 percent of deposits, and the central bank makes an open market purchase of $1 million of securities, calculate the change in The monetary base and the change in its components. With the $1 million purchase of government securities, the monetary base increases by $1 million. Initially the component of the monetary base that changes is banks’ deposits at the Fed, that is, banks reserves held at the Fed, increase.

10. The quantity of money, and how much of the new money is currency andhow much is bank deposits. The change in the quantity of money equals (money multiplier)  (change (1  C / D) in the monetary base). The money multiplier is , where C/D (R / D  C/D) is the currency drain ratio and R/D is the desired reserve ratio. The money multiplier equals (1 + 0.2)  (0.05 + 0.2) = 1.2 ÷ 0.25 = 4.8. So the change in the quantity of money equals (4.8)  ($1 million) = $4.8 million. One way to determine how much of the increase in money is in currency and how much is in deposits relies on two observations. First, note that c + d = $4.8 million, where c is currency and d is deposits. Then by rearranging, d = $4.8 million  c. Next, note that the entire $1 million increase © 2023 Pearson Education, Ltd.

Chapter 27 . The Monetary System

in the monetary base must be held as either currency or reserves. Reserves equal the desired reserve ratio multiplied by the amount of deposits, or (0.05)  d. Thus $1 million = c + (0.05)  d. Now, use the first formula for d, namely d = $4.8 million  c, in the second formula to give $1 million = c + (0.05)  [($4.8 million)  c]. Multiply through by 0.05 to get $1 million = c + (0.05)  ($4.8 million)  (0.05) × (c). Simplify to obtain $1 million = 0.95 × c + $0.24 million. Solve this last formula for c and the result is c = $0.80 million. Because d = $4.8 million  c, with c = $0.8 million, d equals $4.0 million. Use this information to work Problems 11 and 12. South Korea: Bank reserves raised To rein in spending, the Bank of Korea raised the required reserve ratio to 7 percent from 5 percent—first time in almost 17 years. With higher required reserves, banks will have to cut the amount of loans they make. Source: The New York Times, November 24, 2006 11. Explain why a higher required reserve ratio means that banks will have to cut the amount of loans they can make. Banks are not free to use the reserves they hold as they choose because they must hold the amount they are required to hold, that is, they cannot loan these reserves. A higher required reserve ratio means that from their reserves, banks must increase the quantity they hold as required reserves. A bank’s excess reserves therefore decrease and it is these excess reserves that banks can loan. The decrease in excess reserves means that banks cannot loan as much and so they will decrease the amount of loans they make. 12. Assuming that the currency drain is zero and that the desired reserve ratio equals the required reserve ratio, calculate the change in the money multiplier that results from the increase in Korea’s required reserve ratio. (1  C / D) , where C/D is the currency drain The money multiplier is ( R / D  C/D) ratio and R/D is the desired reserve ratio. If the currency drain is zero, then C = 0. When the desired reserve ratio is 5 percent, the money multiplier equals 1  0.05 = 20.0. And when the desired reserve ratio is 7 percent, the money multiplier equals 1  0.07 = 14.3. So the increase in the required reserve ratio lowered the money multiplier from 20.0 to 14.3.

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 Additional Problems and Applications 1.

Read Eye on Creating Money on pp. 718–719. When the Fed engaged in QE between 2008 and 2014, by how much did the monetary base increase? Which component of the monetary base increased most, currency or bank reserves? In the fall of 2008, the Fed doubled the monetary base in QE1. In 2010 and 2011, the Fed's actions in QE2 increased by monetary base to more than three times its pre-crisis level. And in 2012 and 2013, a further gradual QE3 raised the monetary base to four times its normal level. Banks’ reserves increased dramatically. There was a much smaller increase in currency. 2. What happened to the money multiplier between 2008 and 2014? What would the money multiplier have been if the currency drain ratio had increased? What would the money multiplier have been if the banks’ desired reserve ratio had not changed? The money multiplier fell by an unprecedented amount. The money multiplier is (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the desired reserve ratio. Typically C/D is about 0.11 and R/D is about 0.01 so the money multiplier is 1.11/0.12, which is approximately 9. In 2008 the currency ratio hardly changed but the desired reserve ratio skyrocketed over 0.10 and still higher to about 0.20 in recent years. This drastic increase in banks’ desired reserve ratio lead to a huge fall in the money multiplier to less than 4.0. If the currency drain ratio had increased, the money multiplier would have fallen even more. If the desired reserve ratio had not changed, then because the desired reserve ratio has hardly changed, the money multiplier would not have changed; it would have remained equal to about 9. 3. What are the three functions that money performs? Which of the items in List 1 perform some but not all of these functions and which of the items are money? Money acts as a medium of exchange; is a unit of account; and is a store of value.  A credit card A credit card represents a convenient way to access an immediate loan. The credit card is not a medium of exchange, a unit of account, or a store of value, so a credit card is not money.  A checkable deposit at Citibank A checkable deposit at Citibank performs all three functions of money. It is money.

Chapter 27 . The Monetary System

 A $10 bill A $10 performs all three functions of money. It is money.  A diamond ring A diamond ring is a store of value, but it is neither a medium of exchange nor a unit of account. It is not money.  Your credit card Your credit card represents a convenient way to access an immediate loan. The credit card is not a medium of exchange, a unit of account, or a store of value, so a credit card is not money.  Ancient Greek coins Ancient Greek coins are collector’s coins. Hence, they will not be used as a means of payment nor a unit of account, but they are a store of value. They are not money.  Ford bonds Ford bonds can serve as a store of value. But they are not a medium of exchange nor a unit of account, so they are not money 4.

Pam buys $1,000 worth of American Express travelers’ checks and pays for her purchase using funds from her checking account. What is the immediate change in M1 and M2? Neither M1 nor M2 changes. The reason is that only the composition of M1 has changed but not the total amount of M1. M1 is part of M2 and none of the other components of M2 are affected.

The table gives information about items on a bank's balance sheet. Calculate the bank's deposits that are part of M1, deposits that are part of M2, and the bank's loans, securities, and reserves. The only deposits that are part of M1 are the checkable deposits of $500 million. The entire $1,600 million of deposits is part of M2. Total loans are $1,050 million. Securities are $500 million. Reserves are deposits at the Fed plus currency = $30 million + $20 million = $50 million.

Explain why is it that when the Central Bank of the Republic of China (CBC) decreases the required reserve ratio, monetary base does not change. Will changing the currency drain ratio have the same effect? Explain what happens to the monetary base and the quantity of money when the CBC increases the discount rate and sells government securities. When the CBC decreases the required reserve ratio, excess reserves increase and thus the ability of banks to lend more increases, a process © 2023 Pearson Education, Ltd.

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that will create money. New money creation increases the quantity of money, but desired reserves remain constant (required reserves decreased but excess reserves increased by the same amount), so the monetary base does not change. The CBC doesn't have control over currency drains. If the CBC increases the discount rate, the banks pay a higher price for the reserves that they borrow from the CBC. Therefore, banks are less willing to borrow reserves and increase their lending, and both the quantity of money and the monetary base will decrease. When the CBC sells government securities, the reserves of the banking system decrease. When the CBC sells securities in an open market operation, buyers pay for the securities with bank reserves and money, which decreases the monetary base. As bank reserves decrease, banks have to decrease their lending, which decreases the quantity of money.

Chapter 27 . The Monetary System

Use the table, which shows commercial Assets Liabilities bank’s balance sheet, to work Problems 7 (millions of dollars) and 8. The commercial banks’ desired reReserves at central 25 Checkable deposits bank serve ratio on all deposits is 5 percent Cash in vault 15 Savings deposits and there is no currency drain. Securities 60 7. Calculate the banks’ excess reLoans 100 serves. If the banks use all these excess reserves to make loans, what is the quantity of loans made and the quantity of total deposits after the loans have been made? The banks’ total deposits are $200 million, so the banks’ desired reserves are 0.05  $200 million, which is $10 million. The banks’ reserves are the sum of the reserves at the central bank plus the cash in their vaults, so the banks have $40 million in reserves. The banks’ excess reserves are $40 million  $10 million = $30 million. The banks can loan $30 million. When the banks have made the loans, the banks’ total deposits are $230 million, the sum of the initial demand deposits ($90 million) plus the deposits created by the loans ($30 million) plus the initial savings deposits ($110 million). 8.

Calculate the quantity of bank loans and the quantity of total deposits when the banks have no excess reserves? The banks increase their loans by $30 million, so the total will be $130 million. Until the loans are spent, the banks’ total deposits are $230 million; after the loans are spent, the banks’ deposits are $200 million. The money multiplier is 20, so the total increase in deposits and loans is 20  $30 million = $600 million.

Use the following information to work Problems 9, 10, and 11. China lowers reserve requirements The People’s Bank of China lowered the required reserve ratio from 13.5 percent to 13 percent but it remained much higher than in other countries. Source: Bloomberg News, September 6, 2019 9. Compare the required reserve ratio in China and the required reserve ratio on checkable deposits in the United States today. The required reserve ratio is higher in China, 13 percent, then in the United States, where it is 3 percent on checkable deposits below a specified amount and 10 percent on checkable deposits above the amount.

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10. If the currency drain ratio in China is 10 percent of deposits and the desired reserve ratio equals the required reserve ratio, calculate the money multipliers in China and compare it with the U.S. money multiplier. (1  C / D) The money multiplier is , where C/D is the currency drain (R / D  C/D) ratio and R/D is the desired reserve ratio. In China, the money multiplier equals (1 + 0.10) ÷ (0.13 + 0.10), or 4.78. In the United States, using the higher required reserve ratio (that is, 10 percent on deposits) the money multiplier (1 + 0.10) ÷ (0.10 + 0.10), or 5.5. The higher required reserve ratio in China makes the Chinese money multiplier smaller than the U.S. money multiplier. 11. If the currency drain ratio in China is 10 percent of deposits, by how much did the money multiplier change when the required reserve ratio changed as described in the news clip? (1  C / D) The money multiplier is , where C/D is the currency drain (R / D  C/D) ratio and R/D is the desired reserve ratio. In China, before the change the money multiplier equals (1 + 0.10) ÷ (0.135 + 0.10), or 4.68. After the change, the money multiplier equals (1 + 0.10) ÷ (0.13 + 0.10), or 4.78. The (small) decrease in the required reserve ratio creates a (small) increase in the money multiplier.

Chapter 27 . The Monetary System

 Multiple Choice Quiz 1.

A commodity or token is money if it is . A. generally accepted as means of payment B. a store of value C. used in a barter transaction D. completely safe as a store of value Answer: A Answer A is the definition of money. 2.

Money in the United States today includes . A. currency and deposits at both banks and the Fed B. the currency in people’s wallets, stores’ tills, and the bank deposits that people and businesses own C. currency in ATMs and people’s bank deposits D. the banks’ reserves and bank deposits owned by individuals and businesses Answer: B Only currency outside of banks is part of money. 3.

Rick withdraws $500 from his savings account, keeps $100 as currency, and deposits $400 in his checking account. A. M1 increases by $400 and M2 decreases by $500. B. M1 does not change, but M2 decreases by $500. C. M1 does not change, but M2 decreases by $400. D. M1 increases by $500 and M2 does not change. Answer: D When the $500 was in the savings account, none of it was counted as M1 although all was counted as M2. When the funds are changed to currency and checkable deposits, all of it becomes part of M1 and hence all of it remains as M2. 4.

Commercial banks’ assets include . A. bank deposits of individuals and businesses and bank reserves B. loans to individuals and businesses and government securities C. bank reserves and the deposits in M2 D. government securities and borrowed funds Answer: B The discussion in the text about banks’ assets shows that banks’ assets include securities and loans.

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The Fed’s policy tools include all the following except A. required reserve ratio and open market operations B. quantitative easing C. discount rate D. taxing banks’ deposits at the Fed Answer: D Answer D is not a Fed policy tool.

A commercial bank creates money when it does all the following except . A. decreases its excess reserves B. makes loans C. creates deposits D. puts cash in its ATMs Answer: D Currency inside of a bank is not money, regardless of whether the currency is in a teller’s till or is in an ATM.

An open market of $100 million of securities . A. purchase; increases bank reserves B. sale; increases bank reserves C. purchase; decreases the Fed’s liabilities D. sale; increases the Fed’s liabilities Answer: A When the Fed purchases government securities, it effectively pays for (at least part of) the purchasing by increasing banks’ reserves.

The money multiplier . A. increases if banks increase their desired reserve ratio B. increases if the currency drain ratio increases C. is 1 if the desired reserve ratio equals the currency drain ratio D. decreases if banks increase their desired reserve ratio Answer: D If banks increase their desired reserve ratio, they will make fewer loans, which decreases the size of the money multiplier.

Chapter

Money, Interest, and Inflation ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Draw a graph to illustrate the demand for money. On the graph show the effect of an increase in real GDP and the effect of an increase in the number of families that have a credit card. A demand for money curve is illustrated as MD0 in Figure 28.1. An increase in real GDP increases the demand for money and the demand for money curve shifts rightward. Figure 28.1 illustrates this change as the shift from MD0 to MD1. An increase in the number of families with credit cards decreases the demand for money. The demand for money curve shifts leftward, from MD0 to MD2 in Figure 28.1

If the Fed makes a decision to cut the quantity of money, explain the short-run effects on the quantity of money demanded and the nominal interest rate. In the short run, the decrease in the quantity of money raises the nominal interest rate, so the quantity of money demanded decreases.

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The Fed conducts an open market purchase of securities. Explain the effects of this action on the nominal interest rate in the short run and the value of money in the long run. If the Fed conducts an open market purchase of securities, the quantity of money increases in both the short run and long run. In the short run, the increase in the quantity of money lowers the nominal interest rate. In the long run, the price level rises which lowers the value of money.

Use this information to work Problems 4 and 5. In 2016, Belarus was at full employment. The inflation rate was 11.85 percent a year, the quantity of money grew by 3.8 percent a year, the real interest rate was 9.15 a year, and real GDP fell by 2.625 a year. 4. Calculate the nominal interest rate. The nominal interest rate equals the real interest rate plus the inflation rate, so it is equal to 9.15 percent a year plus 11.85 percent a year, which is 21 percent a year. 5.

Did the velocity of circulation increase or decrease in 2016? (Hint: Use the quantity theory of money). Why might it have changed this way? The growth rate of velocity equals inflation (11.85 percent a year) plus real GDP growth (−2.625 percent a year) minus money growth (3.8 percent a year), which is + 5.425 percent a year. Therefore, the velocity of circulation increased by 5.425 percent a year. The growth rate was positive, which means that people were spending their money at a higher rate than previously, perhaps because they expected that inflation would increase in the future.

If the quantity of money is $3 trillion, real GDP is $10 trillion, the price level is 0.9, the real interest rate is 2 percent a year, and the nominal interest rate is 7 percent a year, calculate the velocity of circulation, the value of M  V, and nominal GDP. The velocity of circulation, V is equal to (P  Y)  M, where P is the price level, Y is real GDP and M is the quantity of money. Using this formula gives V = (0.9  $10 trillion)  $3 trillion, which equals 3. M  V is equal to $3 trillion  3, or $9 trillion. Nominal GDP is P  Y, where P is the price level and Y is real GDP. So, nominal GDP equals 0.9  $10 trillion, which is $9 trillion. Nominal GDP also equals M  V.

Chapter 28 . Money, Interest, and Inflation

The velocity of circulation is growing at 1 percent a year, the real interest rate is 3 percent a year, the nominal interest rate is 12 percent a year, and the growth rate of real GDP is 2 percent a year. Calculate the inflation rate, the growth rate of money, and the growth rate of nominal GDP. The inflation rate is the difference between the nominal interest rate and the real interest rate. Therefore, the inflation rate is 12 percent a year − 3 percent a year, which is 9 percent a year. Money growth + Velocity growth = Inflation + Real GDP growth. Rearranging this formula gives Money growth = Inflation + Real GDP − Velocity. Inflation is 9 percent, the real GDP growth is 2 percent, and velocity growth is 1 percent, so money growth equals 9 percent + 2 percent − 1 percent, which is 10 percent a year. The growth rate of the nominal GDP is the sum of the inflation rate plus the growth rate of the real GDP. So the growth rate of the nominal GDP is 9 percent a year + 2 percent a year, which is 11 percent a year.

Suppose that the government passes a new law that sets a limit on the interest rate that credit card companies can charge on overdue balances. As a result, the nominal interest rate charged by credit card companies falls from 15 percent a year to 7 percent a year. If the average income tax rate is 30 percent, explain how the after-tax real interest rate on overdue credit card balances changes. The fall in the nominal interest rate lowers the real after-tax interest rate on credit cards. The after-tax real interest rate equals the after-tax nominal interest rate minus the inflation rate. Before the government’s new law, the after-tax nominal interest rate is equal to (15 percent) – (0.30) × (15 percent), which is 10.5 percent. With the new law, the after-tax nominal interest rate is equal to (7 percent) – (0.30) × (7 percent), which is 4.9 percent. So with no change in the inflation rate, the government has decreased the after-tax real interest rate by 5.6 percentage points.

Annualized inflation in Venezuela soars to 1,000 percent Inflation in Venezuela hit a monthly rate of 23.3 percent in June and it was feared that it would soon move into unstoppable hyperinflation. The country faced constant looting and social unrest. Source: PanAm Post, July 15, 2016 9. What is hyperinflation? Is Venezuela in a hyperinflation? A hyperinflation occurs when the inflation rate exceeds 50 percent per month. While close, Venezuela is not in a hyperinflation because the inflation rate is less than 50 percent per month. 10. Compare inflation in Venezuela in 2016 with that in Germany in 1923. Why did Germany print money in 1923 and create hyperinflation? Why is

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Venezuela printing money today? Why does a high inflation rate bring looting and social unrest? Inflation in Venezuela in 2016, while high, was significantly less than it was in Germany in 1923. Germany printed trillions of German marks to help pay reparations that were imposed on it after World War I. Venezuela is printing money to help pay for its government spending. High inflation brings looting and unrest because of the costs it creates. High inflation increases the tax on interest income and leads to very large shoeleather costs. It also leads to very high confusion costs and uncertainty costs, which decrease the nation’s real GDP. 11. Read Eye on Inflation on p. 742. Why did inflation increase during the 1970s? In which decades did velocity growth break the link between money growth and inflation? Inflation increased in the 1970s because the growth rate of the quantity of money increased. Velocity broke the link between money growth and inflation in the 1990s and after 2000. In the 1990s, velocity increased, which increased the inflation rate above what it otherwise would have equaled. After 2000 and particularly after 2010, however, velocity decreased, which lowered the inflation rate from what it otherwise would have equaled.

Chapter 28 . Money, Interest, and Inflation

 Additional Problems and Applications 1.

Read Eye on Inflation on p. 742 and explain what causes inflation. Why is it easier to predict the decade-average inflation rate than the inflation rate in a single year? Inflation is the result of growth in the quantity of money that is faster than growth in real GDP. It is easier to predict decade-average inflation rates rather than single-year inflation rates because during a single year factors other than the growth rate of money can change and these factors can affect the single-year inflation rate. In particular, in any given year velocity and real GDP can have large changes, which have large effects on that year’s inflation rate. But over a decade, these changes “cancel out” so that over a decade the primary factor driving changes in the inflation rate is changes in the monetary growth rate.

If the Fed doubled the quantity of money and nothing else changed, what would happen to the price level in the short run and the long run? What would happen to the inflation rate? If the Fed doubled the quantity of money, in the short run the nominal interest rate falls so investment and consumption increase. This increase in demand starts to raise the price level. In the long run, the price level changes by the same percentage change in the quantity of money. So in the long run, the price level will double. The inflation rate rises while the price level was rising but after the price level had reached its new equilibrium, the inflation rate would fall to zero (unless the Fed continued to increase the quantity of money).

Suppose that banks launch an aggressive marketing campaign to get everyone to use debit cards for every conceivable transaction. They offer prizes to new debit card holders and introduce a charge on using a credit card. How would the demand for money and the nominal interest rate change? The demand for money increases as people use their debit cards more often and use money (rather than credit cards) more often for transactions. Because the demand for money increases, the nominal interest rate rises.

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Draw a graph of the money market to illustrate equilibrium in the short run. If the growth rate of the quantity of money increases, explain what happens to the real interest rate and the nominal interest rate in the short run. Figure shows the money market in the short run. In the short run, the increase in the growth rate of the quantity of money lowers the nominal interest rate. In figure below, the increase in the growth rate of the quantity of money increases the quantity of money from $4 trillion to $6 trillion and lowers the nominal interest rate from 6 percent to 4 percent. As the inflation rate does not change in the short run, the real interest rate also falls.

The Fed conducts an open market sale of securities. Explain the effects of this action in the short run on the nominal interest rate and in the long run on the value of money and the price level. The sale of securities decreases the quantity of money. In the short run, the nominal interest rate rises. In the long run, the price level falls, which raises the value of money.

What is the quantity theory of money? Define the velocity of circulation and explain how it is measured. The quantity theory of money is the proposition that when real GDP equals potential GDP, 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 in a year that the each dollar of money gets used to buy final goods and services. The formula used to measure the velocity of circulation is V = (P  Y)  M, where P is the price level, Y is real GDP, and M is the quantity of money.

The velocity of circulation is constant, real GDP is growing at 2 percent a year, the real interest rate is 1 percent a year, and the nominal interest rate is 2 percent a year. Calculate the inflation rate, the growth rate of money, and the growth rate of nominal GDP. The inflation rate is the difference between the nominal interest rate and the real interest rate. So the inflation rate is 2 percent a year − 1 percent a year, which is 1 percent a year. As the velocity of circulation is constant, its growth rate is zero. Then, Money growth + Velocity growth = Inflation + Real GDP growth. Rearranging, Money growth = Inflation + Real GDP growth − Velocity, which is 1 percent a year + 2 percent a year − 0 percent a year = 3 percent a year. The growth rate of the nominal GDP is the sum of the inflation rate plus the growth rate of the real GDP. So, the growth © 2023 Pearson Education, Ltd.

Chapter 28 . Money, Interest, and Inflation

rate of nominal GDP is 1 percent a year + 2 percent a year, which is 3 percent a year. 8. Sara has $400 in currency and $4,000 in a bank account on which the bank pays no interest. The inflation rate is 3 percent a year. Calculate the amount of inflation tax that Sara pays in a year. Sara has $4,400 of money. With inflation at 3 percent per year, Sara “pays” an inflation tax of 3 percent per year on the money she holds. Therefore, Sara pays an inflation tax of 0.03 × $4,400, or $132 per year. Use the following information to work Problems 9 to 12. ECB changing stance The European Central Bank (ECB) has the main objective of maintaining inflation in the euro area below 2%. To achieve this strategy of price stability, it follows a two-pillar analytical approach to assess the risks to price stability and its monetary policy actions: the economic analysis and the monetary analysis. The monetary pillar, which makes use of the quantity theory of money, was heavily criticized by many in that it was not relevant to monetary policy decisions. In November 2013, a paper published by the ECB itself casted doubt on the quantity theory of money effectiveness stating that countries with moderate or low inflation don't fit this theory. Sources: ecb.europa.eu, June 3, 2005 9. What is implied by this news clip about the ECB's position prior to 2013 about the velocity of circulation, the equation of exchange, and the quantity theory of money? It implies that the ECB considered the velocity of circulation to be more or less constant. If that is the case, then the quantity theory of money predicts that lower monetary growth will lead to a lower inflation rate. It shows that the ECB believed that the equation of exchange and the quantity theory of money were useful tools to help predict the inflation rate. That is why monetary analysis formed one of the two pillars used as analysis tools by the ECB. 10. What is implied by this news clip and the ECB paper about both the position of the critics of the ECB's use of monetary analysis and the ECB's position after 2013 concerning the velocity of circulation, the equation of exchange, and the quantity theory of money? Even though the equation of exchange is always correct because it is an identity, the quantity theory of money assumes that the velocity of circulation is stable and predictable. This news clip implies that critics believed that the velocity of circulation was neither stable nor predictable, which makes the quantity theory less useful in predicting the relationship between monetary growth and inflation. The working paper published by the ECB stated that there is no tie between the growth rate of the quantity of money and the inflation rate in countries with low or moderate inflation rates.

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11. Look at the graph in Eye on Inflation (p. 738), say it referred to recent data in the Euro area instead of the United States. Which period was both closest to the inflation target rate and a perfect fit to the quantity theory of money? Looking at the inflation rate in the decades of the 1960s, 1970s, 1980s, 1990s, 2000s, and 2010s, the inflation rates in the 1960s, 1990s, and 2010s were close to the target rate of 2 percent, but only in the 1960s did the velocity not change. Therefore, the 1960s is the period where the quantity theory of money worked perfectly and inflation was close to the target 2 percent. 12. Continue imagining that the graph in Eye on Inflation (p. 738) refers to Europe. Hypothetically, if in 2010s, the inflation rate and the M2 growth rate are as shown, but the velocity of circulation didn’t change and was constant, by how much should real GDP change to validate the quantity theory of money? It should have increased by 5 percent. The figure shows that in the 2010s, the money growth rate is approximately 6.5 percent a year and the inflation rate is approximately 1.5 percent. If the velocity growth rate is zero, the real GDP growth rate is equal to the money growth rate minus the inflation rate, which is which is 6.5−1.5, which is 5 percent a year.]

Chapter 28 . Money, Interest, and Inflation

 Multiple Choice Quiz 1.

Holding money provides a benefit . A. because it is a means of payment B. because its opportunity cost is low C. which is constant no matter how much money is held D. because most money is in bank deposits Answer: A Answer A describes the benefit from holding money.

The opportunity cost of holding money . A. is determined by the inflation rate B. is zero because money earns no interest C. equals the nominal interest rate on bonds D. equals the real interest rate on bonds Answer: C By holding money rather than bonds, the holder loses the return on the bonds, which is the nominal interest rate.

The quantity of money demanded increases if . A. the supply of money increases B. the nominal interest rate falls C. banks increase the interest rate on deposits D. the price of a bond falls Answer: B The nominal interest rate is the opportunity cost of holding money, so a decrease in the nominal interest rate increases the quantity of money demanded.

If the Fed increases the quantity of money, people will be holding . A. too much money, so they buy bonds and the interest rate rises B. too much money, so they buy bonds and the interest rate falls C. the quantity of money they demand and banks will hold more money D. more money and will increase their demand for money Answer: B People initially are holding more money than they want, so they buy bonds in order to hold less money, which raises the price of bonds and lowers their interest rate.

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In the long run, money market equilibrium determines the . A. real interest rate B. price level C. nominal interest rate D. economic growth rate Answer: B In the long run, money market equilibrium determines the value of money, 1/P. 6.

If the quantity theory of money is correct and other things remain the same, an increase in the quantity of money increases . A. nominal GDP and the velocity of circulation B. the price level and potential GDP C. real GDP D. nominal GDP and the price level Answer: D An increase in the quantity of money has no effect on real GDP or velocity, so an increase in the quantity of money raises the price level and hence also raises nominal GDP. 7.

In the long run with a constant velocity of circulation, the inflation rate . A. is constant and equals the money growth rate B. equals the money growth rate minus the growth rate of real GDP C. equals the growth rate of real GDP minus the growth rate of money D. is positive if the economic growth rate is positive Answer: B If velocity is constant, the growth rate of velocity is 0 percent, so the equation of exchange demonstrates that answer B is correct.

The costs of inflation do not include . A. the cost of running around to compare prices at different outlets B. the increased opportunity cost of holding money C. the tax on money held by individuals and businesses D. an increase in saving and investment Answer: D Answer D is incorrect because inflation decreases saving and investment.

Aggregate Supply and Aggregate Demand ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

As more people in India have access to higher education, explain how potential GDP and aggregate supply will change in the long run. Increased access to higher education means that India’s labor force will be more highly educated and have more human capital. In the long run, this change will increase both India’s potential GDP and aggregate supply.

Explain the effect of each of the following events on the quantity of U.S. real GDP demanded and the demand for U.S. real GDP:  The world economy goes into a strong expansion. As the world economy goes into a strong expansion, U.S. exports increase. As a result, U.S. aggregate demand increases and the U.S. AD curve shifts rightward.  The U.S. price level rises. The rise in the U.S. price level decreases the quantity of U.S. real GDP demanded. There is a movement upward along the U.S. AD curve.  Congress raises income taxes. The tax hike decreases aggregate demand and shifts the AD curve leftward.

The Philippines is at full employment when the Central Bank increases the quantity of money, other things remaining the same. Explain the effect of the increase in the quantity of money on aggregate demand in the short run. An increase in the quantity of money increases aggregate demand and shifts the AD curve rightward.

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The table sets out an economy’s aggrePrice level Real GDP Real GDP gate demand and aggregate supply (GDP demanded supplied price index) (billions of 2012 dollars) schedules. What is the macroeconomic 90 900 600 equilibrium? If potential GDP is $600 100 850 700 billion, what is the type of macroeco110 800 800 nomic equilibrium? Explain how real 120 750 900 GDP and the price level will adjust in 130 700 1,000 the long run. The macroeconomic equilibrium occurs at real GDP of $800 billion and a price level of 110. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied. If potential GDP is $600 billion, real GDP exceeds potential GDP. There is an inflationary gap. In the long run, the money wage rate rises. As the money wage rate rises, aggregate supply decreases so that real GDP decreases and the price level rises. Eventually aggregate supply decreases enough so that real GDP equals potential GDP, at which point adjustment stops.

Suppose that the Indian economy has an inflationary gap and the world economy goes into a recession. Explain the effect of the recession on India's real GDP and unemployment in the short run. A global recession decreases exports and thereby decreases India's aggregate demand so that the Indian AD curve shifts leftward. In the short run, the decrease in aggregate demand decreases India's real GDP and increases India's unemployment.

Explain the effect of the European Central Bank’s action that cuts the quantity of money on the macroeconomic equilibrium in the short run. Explain the adjustment process that returns the economy to full employment. A cut in the quantity of money decreases aggregate demand. As shown in Figure 29.1, the AD curve shifts leftward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level falls and the real GDP decreases. In Figure 29.1, the new short-run equilibrium occurs at the price level of 100 and a real GDP of $15.5 trillion. This equilibrium reflects a recessionary gap. Full employment is restored as the money wage rate falls. The aggregate supply increases and the AS curve shifts rightward. Eventually, the aggregate supply increases enough so that that the real GDP returns to the potential GDP level and the economy is back at full employment. .

Chapter 29 . Aggregate Supply and Aggregate Demand

Use Figure 29.2 to work Problems 7 to 9. Initially, the economy is at point B. 7. Some events change aggregate demand from AD0 to AD1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, describe 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 increases the quantity of money and lowers the interest rate; or if the U.S. foreign exchange rate falls or foreign income increases. After the change in aggregate demand, equilibrium real GDP is $1.1 trillion and the equilibrium price level is 105. The economy has an inflationary gap. 8. Some events change aggregate supply from AS0 to AS1. Describe two possible events. What is the new equilibrium point? If potential GDP is $1 trillion, does the economy have an inflationary gap, a recessionary gap, or no gap? Aggregate supply decreases when the aggregate supply curve shifts from AS0 to AS1. 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 real GDP is $0.9 trillion and the equilibrium price level is 105. The economy is at an equilibrium with a recessionary gap. 9. Some events change aggregate demand from AD0 to AD1 and aggregate supply from AS0 to AS1. What is the new macroeconomic equilibrium? After the changes, equilibrium real GDP is $1.0 trillion and the equilibrium price level is 110. The economy is at a full-employment equilibrium.

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Use the following information to work Problems 10 and 11. Japan economic recovery under way as deflation eases Consumer prices excluding fresh food declined 0.4 percent from a year earlier—the smallest drop since 2009. The unemployment rate unexpectedly fell to 4.9 percent from 5.1 percent—the first decrease since September. The economy will emerge from its slump “soon.” Source: Bloomberg, January 27, 2011 10. Explain the effect of a high value of the U.S. dollar on U.S. aggregate demand and aggregate supply. On an AS-AD graph, show the macroeconomic equilibrium in Japan in 2010. Show why economic recovery is under way and deflation is easing. Figure 29.3 shows the situation in Japan. At the start of 2010, the potential GDP was ¥565 trillion while the real GDP was ¥550 trillion. Then aggregate demand increased, so the AD curve shifted rightward from AD0 to AD1 and aggregate supply also increased, so the AS curve shifted rightward from AS0 to AS1. The increase in aggregate supply was larger than the increase in aggregate demand. However, the increase in aggregate supply was only slighter larger than the increase in aggregate demand, so the price level fell by only 0.4 percent. Both the increase in aggregate demand and the increase in aggregate supply increased the real GDP, so the unemployment rate fell to 4.9 percent. With both aggregate demand and aggregate supply increasing, the Japanese economy was heading back to the potential GDP. As the increase in aggregate demand picks up speed, eventually the price level will no longer fall so that Japan will no longer experience deflation. 11. Explain the effect of a high value of the U.S. dollar on U.S. real GDP and the price level. Use an AS-AD graph to illustrate your answer. The high value of the dollar decreases aggregate demand but it does not change aggregate supply. Figure 29.3 illustrates this change. Without the ..

Commented [A1]: Provide us a Question: AQ

Chapter 29 . Aggregate Supply and Aggregate Demand

effects from Brexit, the aggregate demand curve would be AD0 and U.S. real GDP would equal $20.5 trillion. Brexit shifts the aggregate demand curve to AD1 and decreases U.S. GDP to $20.3 trillion. 12. Read Eye on Recession on p. 773. What caused the 2008–2009 recession and how dowe know that a decrease in aggregate supply played a role? The financial crisis decreased the supply of loanable funds so that investment, particularly construction, decreased. The decrease in investment decreased aggregate demand. The decrease in aggregate demand was partially offset by an increase in government spending. Simultaneously, the rise in oil prices and in the money wage rate decreased aggregate supply. Accordingly, the recession was caused by the financial crisis, an increase in oil prices, and an increase in the money wage rate. We know that the recession involved a decrease in aggregate supply because if only aggregate demand decreased, the price level would have fallen. But the price level rose. The rise in the price level requires a decrease in aggregate supply.

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 Additional Problems and Applications 1.

Read Eye on Recession on p. 773. What, according to the mainstream theory of the business cycle, is the most common source of recession: a decrease in aggregate demand, a decrease in aggregate supply, or both? Which is the most likely component of aggregate demand to start a recession? How does the aggregate demand multiplier influence a recession? According to mainstream theory, fluctuations in aggregate demand are the major source of recessions. Investment is the component of aggregate demand whose decrease starts recessions. The aggregate demand multiplier means that recessions will be deeper. An initial decrease in aggregate demand is reinforced by the aggregate demand multiplier so that the resulting decrease in real GDP (and increase in unemployment) is larger than would otherwise be the case.

Suppose that the United States is at full employment. Explain the effect of each of the following events on aggregate supply: • Union wage settlements push the money wage rate up by 10 percent. Illustrate the effect of this event on the graph. • The price level increases. • Potential GDP increases.  Union wage settlements push the money wage rate up by 10 percent. The higher money wage rate decreases U.S. aggregate supply and the U.S.AS curve shifts leftward.  The price level increases. The higher price level increases the quantity of real GDP supplied and there is a movement upward along the U.S. AS curve.  Potential GDP increases. The increase in t h e potential GDP increases U.S. aggregate supply and the U.S. AS curve shifts rightward.

Suppose that Germany is at full employment. Then the government cut transfer payments, and all other influences on aggregate demand remain the same. Explain the effect of the tax increase on aggregate demand in the short run.

Chapter 29 . Aggregate Supply and Aggregate Demand

The transfer payment cut decreases the aggregate demand and shifts the AD curve leftward. Aggregate supply does not change. Use the following information to work Problems 4 and 5. In China, the price of imported natural gas that is heavily used in local production fluctuates frequently. This causes China's short-run macroeconomic equilibrium to fluctuate. Someone suggested that the government raise transfer payments when the price of natural gas rises in a way that counters the decrease in the macroeconomic equilibrium. 4. How would such an action influence aggregate demand? Raising transfer payments increases disposable income, increases consumption, and increases aggregate demand, so the AD curve shifts rightward. 5.

How would such an action influence aggregate supply and macroeconomic equilibrium? Raising transfer payments will not affect the aggregate supply. However, it works to stabilize or moderate the decrease in the macroeconomic equilibrium. When the price of natural gas increases, the aggregate supply decreases, and the AS curve shifts leftward. In the short run, the real GDP decreases. To moderate this, transfer payments are raised, which leads to the AD curve shifting rightward. In the short run, the real GDP increases.

The table sets out the aggregate demand and aggregate supply schedules in Japan. Potential GDP is 600 trillion

Price level (GDP price index)

Real GDP Real GDP demanded supplied (trillions of 2005 yen)

75 600 yen. What is the short-run macroeco85 550 nomic equilibrium? Does Japan have 95 500 an inflationary gap or a recessionary 105 450 gap and what is its magnitude? 115 400 125 350 The macroeconomic equilibrium oc135 300 curs at real GDP of ¥500 trillion and a price level of 95. This price level is the only price level at which the quantity of real GDP demanded equals the quantity of real GDP supplied Because potential GDP is ¥600 trillion, real GDP is less than potential GDP. There is a recessionary gap equal to real GDP minus potential GDP, which is ¥100 trillion.

400 450 500 550 600 650 700

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The U.S. economy is at full employment when the world price of oil rises. On an AS–AD graph, show the effect of the world oil price rise on U.S. macroeconomic equilibrium in the short run. Explain the adjustment process that restores the economy to full employment. A rise in the world price of oil decreases aggregate supply. As Figure 29.4 shows, the AS curve shifts leftward from AS0 to AS1. The new short-run equilibrium occurs where the AS1 curve intersects the AD curve, at the price level of 120 and real GDP of $19.75 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. Full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward.

The U.S. economy is at full employment when the global economy goes into recession. Explain the effects of the global recession on the U.S. macroeconomic equilibrium in the short run. Explain the adjustment process that restores the economy to full employment. As the world economy goes into recession, U.S. exports decrease so the U.S. aggregate demand decreases and the U.S. AD curve shifts leftward. Figure 29.5 illustrates this change, with the AD curve shifting leftward from AD0 to AD1. The new short-run equilibrium occurs where the AS curve intersects the AD1 curve. The price level falls and real GDP decreases. In Figure 29.5, the new short-run equilibrium occurs at the price level of 100 and real GDP of $19.5 trillion. The economy is in an equilibrium with a recessionary gap. There is a surplus of labor because employment has decreased. This surplus gradually lowers the money wage rate. In the long run, full employment is restored as the money wage rate falls. Aggregate supply increases and the AS curve shifts rightward. The increase in aggregate supply raises real GDP and employment so that the economy ultimately returns to potential GDPand full employment. ..

Chapter 29 . Aggregate Supply and Aggregate Demand

Use the following information to work Problems 9 and 10. House GOP changes course on infrastructure House Republicans abandoned plans to slash U.S. infrastructure spending and now say they are trying to find ways to pay for a multiyear highwayconstruction program, which will exceed $300 billion. Source: The Wall Street Journal, September 30, 2011 9. Explain the effect of the government’s increased expenditure on infrastructure on U.S. aggregate demand and aggregate supply. In the short run, the increased expenditure on infrastructure increases aggregate demand and has no effect on aggregate supply. In the long run, when the infrastructure is completed, expenditure on it drops to zero so there is no long-run effect on aggregate demand. However in the long run when the infrastructure comes on line, potential GDP increases, which increases aggregate supply. 10. The United States in 2011 has a recessionary gap. Use the AS-AD model to show the effect on U.S. real GDP as the new infrastructure is completed. In 2011 the U.S economy was at point A and the potential GDP is $15.3 trillion, as shown by the Potential GDP0 line. The economy has a recessionary gap. As time passes and the infrastructure is completed, potential GDP increases to Potential GDP1 and the aggregate supply increases to AS1. The economy moves to point B, with an equilibrium closer to the potential GDP.

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 Multiple Choice Quiz 1.

Aggregate supply increases when A. the price level rises

B. the money wage rate falls C. consumption increases D. the money price of oil increases Answer: B

A fall in the money wage rate increases aggregate supply and shifts the AS curve rightward.

When potential GDP increases, A. aggregate demand increases

B. aggregate supply increases C. both aggregate demand and aggregate supply increase D. the price level rises Answer: B

As Figure 29.2 in the text shows, an increase in potential GDP increases aggregate supply.

The quantity of real GDP demanded increases if A. the buying power of money increases

B. the money wage rate rises C. the price level falls D. the nominal interest rate falls Answer: C

Changes in the price level bring movements along the AD curve and change the quantity of real GDP demanded.

An increase in expected future income increases . A. consumption expenditure, which increases current aggregate demand B. investment, which increases current aggregate supply C. the demand for money, which decreases current aggregate demand D. future consumption expenditure and has no effect on current aggregate demand

Answer: A

Consumption expenditure increases as consumers buy bigticket items now with the idea of paying for them in the future.

Chapter 29 . Aggregate Supply and Aggregate Demand

Macroeconomic equilibrium occurs when the quantity of real GDP equals the quantity of . A. demanded; real GDP supplied B. demanded; potential GDP C. supplied; potential GDP D. demanded; real GDP supplied and potential GDP

Answer: A

Macroeconomic equilibrium occurs where the AD curve intersects the AS curve, which is the point at which the quantity of real GDP demanded equals the quantity of real GDP supplied.

If the economy is at full employment and the Fed increases the quantity of money, . A. aggregate demand increases, a recessionary gap appears, and the money wage rate starts to rise B. aggregate supply increases, the price level starts to fall, and an expansion begins C. aggregate demand increases, an inflationary gap appears, and the money wage rate starts to rise D. potential GDP and aggregate supply increase together and the price level does not change

Answer: C

An increase in the quantity of money can set off a demandpull inflation by increasing aggregate demand, thereby creating an inflationary gap.

Over the past decade, the demand for goods produced in China has brought a sustained increase in demand for China’s exports that has outstripped the growth of supply. As a result, China has experienced a . A. period of stable prices and sustained economic growth B. rising price level and demand-pull inflation C. rising price level and cost-push inflation D. rising price level and a falling real wage rate

Answer: B

Aggregate demand has increased far more than aggregate supply, so the price level has risen and the economy has had a demand-pull inflation.

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Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications The table shows disposable income and saving in an economy. Use the table to answer Problems 1 and 2. 1. Calculate consumption expenditure at each level of disposable income. Over what range of disposable income is there dissaving? Estimate the level of disposable income at which saving is zero. When disposable income is $0, consumption expenditure is $5 trillion; when disposable income is $10 trillion, consumption expenditure is $13 trillion; when disposable in-

Disposable income Saving (trillions of dollars)

0 10 20 30 40 50

come is $20 trillion, consumption expenditure is $21 trillion; when disposable income is $30 trillion, consumption expenditure is $29 trillion; when disposable income is $40 trillion, consumption expenditure is $37 trillion; when disposable income is $50 trillion, consumption expenditure is $45 trillion. Saving is zero when disposable income is $25 trillion. 2.

Calculate the marginal propensity to consume. If wealth increases by $10 trillion, in which direction will the consumption function change? The marginal propensity to consume is the change in consumption expenditure divided by the change in disposable income. When disposable income increases by $10 trillion from $40 trillion to $50 trillion, consumption expenditure increases from $37 trillion to $45 trillion, an increase of $8 trillion. So the MPC equals $8 trillion ÷ $10 trillion, 0.80. If wealth increases by $10 trillion, the consumption function shifts upward.

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Use the table to work Problems 3, 4, and 5. The table shows real GDP, Y, the components of planned expenditure, and aggregate planned expenditure (in millions of dollars) in an economy in which taxes are constant. Planned expenditure Y

0 2 4 6 8 10 12

2.0 Q 4.4 5.6 6.8 8.0 9.2

1.75 1.75 R 1.75 1.75 1.75 1.75

1.0 1.0 1.0 S 1.0 1.0 1.0

1.25 1.25 1.25 1.25 T 1.25 1.25

0 0.4 0.8 1.2 1.6 U 2.4

6.0 6.8 7.6 8.4 9.2 10.0 V

Find the value of Q, R, S, T, U, and V. Q = 3.2; R = 1.75; S = 1.0; T = 1.25; U= 2.0; V = 10.8. All of the answers are calculated using the formula AE = C + I + G + X − M.

Calculate the marginal propensity to consume and the marginal propensity to import. What is equilibrium expenditure? The marginal propensity to consume equals the change in consumption expenditure divided by the change in disposable income. Because taxes are constant, the change in real GDP equals the change in disposable income. When real GDP increases from $4 million to $6 million, consumption expenditure increases from $4.4 million to $5.6 million. MPC equals the change in consumption, $1.2 million, divided by the change in real GDP, $2.0 million, which is 0.60. The marginal propensity to import equals the change in imports divided by the change in real GDP. When real GDP increase from $4 million to $6 million, imports increase from $0.8 million to $1.2 million. The marginal propensity to import equals the change in imports, $0.4 million, divided by the change in real GDP, $2.0 million, which is 0.20. Equilibrium expenditure is $10 million because this is the level of real GDP at which aggregate expenditure equals real GDP.

If investment crashes to $0.55 million but nothing else changes, what is equilibrium expenditure and what is the multiplier? Equilibrium expenditure becomes $8 million because when real GDP equals $8 million, (the new) aggregate expenditure equals real GDP. The $1.20 million decrease in investment lead to a $2.0 million decrease in real GDP. So the multiplier is $2.00 million  $1.20 million, which is 1.67.

Chapter 30 . Aggregate Expenditure Multiplier

Figure 30.1 shows aggregate planned expenditure when the price level is 100. When the price level increases to 110, aggregate planned expenditure changes by $0.5 trillion. What is the quantity of real GDP demanded when the price level is 100 and 110? When the price level is 100, the AE curve in Figure 30.1 is the relevant aggregate expenditure curve. The equilibrium real GDP is then $5 trillion, so when the price is 100, the quantity of real GDP demanded is $5 trillion. When the price level increases to 110, aggregate expenditure falls by $0.5 trillion so the aggregate expenditure curve in Figure 30.1 would shift downward by $0.5 trillion. Thenew AE curve shows that equilibrium real GDP is $3 trillion. So when the price level is 110, the quantity of real GDP demanded is $3 trillion.

Use the following information to work Problems 7 and 8. Greece Economy Shrinking Austerity measures refer to the government cutting its expenditure and raising taxes to decrease the country’s budget deficit. As result of Greece following austerity measures, its GDP fell by 1.2 percent in the first quarter of 2017 from its level in the previous quarter. Sources: qz.com, March 09, 2017 7.

Explain the process by which a decrease in government expenditure, at a constant price level, changes equilibrium expenditure and real GDP. The decrease in government expenditure has a multiplied effect on equilibrium expenditure and GDP. The initial decrease in government expenditure decreases GDP by the same amount. However, many workers become unemployed as a result of the decrease in government projects and other expenditure. The disposable income of these workers is lower so as a result, they decrease their consumption expenditure. This reduces equilibrium expenditure even more. The decrease in consumption expenditure means that some workers producing consumption goods and services will also have a lower disposable income as they lose their jobs or work less hours, resulting in their consumption expenditure falling. The induced decrease in consumption expenditure is why the decrease in government expenditure has a multiplier effect on equilibrium expenditure and GDP. The GDP of Greece decreased by a multiplied effect.

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Did aggregate demand increase or decrease? What determines this change in aggregate demand that results from a decrease in government expenditure? As government expenditure is decreased, aggregate demand will decrease. This decrease will depend on the size of the multiplier.

Read Eye on the Multiplier on p. 796. Why do multiplier estimates differ? What conditions would be consistent with a large multiplier? Multiplier estimates differ because there is disagreement among economists about the crowding out effect on investment. Barro says the multiplier is only 0,.8 because private expenditure is crowded out by government expenditure, while the Council of Economic Advisers thinks there isless crowding out so they estimate the multiplier to be 1.6. The multiplier estimates also differ because of differences in how they are estimated. Barro, for instance, used the large increases in government expenditure during wars to construct his estimate of the multiplier. For the multiplier to be large requires that the economy has a large recessionary gap.

Chapter 30 . Aggregate Expenditure Multiplier

 Additional Problems and Applications 1.

Economists of the European Central Bank found that the multiplier in Spain is higher during recessions than during expansions. Sources: ft.com, June 10, 2015 Hypothetically, if the government increased spending by €10 million to close an output gap of €20,000 million during a recession, should it decrease government spending by more or less to close a similar output gap during an expansion? The government should decrease government spending more during an expansion than during a recession. The multiplier during this hypothetical recession was 2.1 which is €21 million ÷ €10 million. According to the news clip, the multiplier during a recession is higher than the multiplier during an expansion, so the multiplier during the hypothetical expansion is less than 2.1, say 1.5. Therefore, closing an output gap of €21 million requires government expenditure to decrease by €21 million ÷ 1.5 or €14 trillion.

The table shows disposable income and consumpDisposable Consumption income expenditure tion expenditure in an economy. Use the table to (billions of dollars) work Problems 2 and 3. 200 350 2. Calculate saving at each level of disposable 400 500 income. Over what range of disposable income 600 650 does consumption expenditure exceed 800 800 1,000 950 disposable income? Calculate autonomous consumption expenditure. When disposable income is $200 billion, saving is −$150 billion; when disposable income is $400 billion, saving is −$100 billion; when disposable income is $600 billion, saving is −$50 billion; when disposable income is $800 billion, saving is $0; and, when disposable income is $1,000 billion, saving is $50 billion. Consumption expenditure exceeds disposable income when disposable income is less than $800 billion. Autonomous consumption expenditure is consumption expenditure when disposable income is $0. Extrapolating from the table above, autonomous consumption expenditure is $200 billion. 3.

Calculate the marginal propensity to consume. At what level of disposable income will saving be zero? If expected future income increases, in which direction will the consumption function change? The marginal propensity to consume equals the change in consumption expenditure divided by the change in disposable income. Because the consumption function is linear, the MPC is the same at all levels of disposable income. So the MPC = ($500 billion − $350 billion)  ($400 billion −$200 billion) = ($150 billion)  ($200 billion), which is 0.75. Saving is equal to zero when disposable income equals $800 billion. If expected future income increases, consumption increases and the consumption function shifts upward. ..

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Use the following information to work Problems 4 to 6. In an economy with no exports and no imports, autonomous consumption is $1 trillion, the marginal propensity to consume is 0.8, investment is $5 trillion, and government expenditure on goods and services is $4 trillion. Taxes are $4 trillion and do not vary with real GDP. 4. If real GDP is $30 trillion, calculate disposable income, consumption expenditure, and aggregate planned expenditure. What is equilibrium expenditure? Disposable income equals GDP minus net taxes. GDP is $30 trillion, taxes are $4 trillion, so disposable income is $30 trillion − $4 trillion, which is $26 trillion. Consumption expenditure equals the sum of autonomous consumption expenditure plus induced consumption expenditure. Induced consumption expenditure equals MPC times disposable income, so induced consumption expenditure equals (0.8) × ($26 trillion), which is $20.8 trillion. Autonomous consumption is given as $1 trillion, so total consumption expenditure equals $1 trillion + $20.8 trillion, which is $21.8 trillion. Aggregate planned expenditure equals the sum of consumption expenditure plus investment plus government expenditures (plus exports and minus imports if there is international trade). Aggregate planned expenditure equals $21.8 trillion + $5 trillion + $4 trillion, which is $30.8 trillion. Equilibrium expenditure equals $34 trillion. To check this answer, note that when expenditure is $34 trillion, real GDP equals $34 trillion so disposable income equals $30 trillion. Therefore consumption expenditure is $25 trillion. Aggregate planned expenditure equals consumption expenditure, $25 trillion, plus investment, $5 trillion, plus government expenditure on goods and services, $4 trillion, which is $34 trillion and equals real GDP. 5.

If real GDP is $30 trillion, explain the process that takes the economy to equilibrium expenditure. If real GDP is $40 trillion, explain the process that takes the economy to equilibrium expenditure. If real GDP is $30 trillion, aggregate expenditure exceeds real GDP. Firms find their inventories falling below their target levels, and in response, they increase production to restore inventories to their target levels. As firms increase production, real GDP increases and the economy moves toward its equilibrium expenditure of $34 trillion. If real GDP is $40 trillion, real GDP exceeds aggregate planned expenditure. Inventories rise above their target levels. Firms slash production to drive inventories back to their target levels and so real GDP decreases. The economy moves toward its equilibrium expenditure of $34 trillion.

If investment increases by $0.5 trillion, calculate the change in equilibrium expenditure and the multiplier. If investment increases by $0.5 trillion, the AE curve shifts upward by $0.5 ..

Chapter 30 . Aggregate Expenditure Multiplier

trillion. Since there are no income taxes (taxes are fixed at $4 trillion) and 1 because there are no imports or exports, the multiplier equals . (1 − MPC) With the MPC equal to 0.8, the multiplier equals 5.0. The change in equilibrium expenditure equals the change in autonomous expenditure times the multiplier. The change in autonomous expenditure is the change in investment, which is $0.5 trillion. The multiplier is 5.0. So the change in equilibrium expenditure is equal to ($0.5 trillion) × (5.0), which is $2.5 trillion. Use the following information to work Problems 7 and 8. The figure shows the aggregate demand curve in an economy. Suppose that aggregate planned expenditure increases by $0.75 trillion for each $1 trillion increase in real GDP. 7. If investment increases by $1 trillion, calculate the change in the quantity of real GDP demanded if the price level is constant at 105. Because aggregate planned expenditure increases by 0.75 of any change in real GDP, the multiplier for the change in real GDP is equal to 1/(1 − 0.75), which is 4.0. Hence a $1 trillion increase in investment increases the quantityof real GDP demanded by $4 trillion when the price level is constant at 105. 8.

Compare the shift of the AD curve with the $1 trillion increase in investment. Explain the magnitude of the shift of the AD curve. The AD curve shifts rightward by $4 trillion dollars. The overall increase in aggregate demand exceeds the initial increase in investment because of the multiplier. The increase in investment increases people’s disposable income, which leads to still further increases in consumption expenditure.

Use the following information to work Problems 9 and 10. Foreign Direct Investment in UK The United Kingdom tops the list of European countries that attract the most foreign direct investment. Foreign direct investment is when foreign businesses undertake projects in the country. Last year, Britain attracted 1,144 projects which created 44,665 jobs. Sources: The Telegraph, May 23, 2017 9.

Why would the increase in foreign direct investments create new jobs and what happens next? Explain the process of the changes in equilibrium expenditure and real GDP that result from the increase in foreign direct investment. ..

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When foreign direct investment occurs in a country, it means that new firms will open or existing firms will have more operations; therefore, they have to employ more workers so new jobs are created. Foreign direct investment will have a multiplier effect on equilibrium expenditure and GDP. The initial investment increases expenditure by an equal amount, but the new workers now have higher disposable incomes and increase their consumption expenditure, so equilibrium expenditure increases more. The workers producing the additional consumption goods and services will have a higher disposable income, so they will consume more. The induced consumption expenditure is the reason behind foreign direct investment having a multiplier effect on equilibrium expenditure and on GDP. The aggregate planned expenditure curve shifts upward by an amount equal to the additional investment. Equilibrium expenditure and real GDP, which are determined at the intersection of the aggregate expenditure curve and the 45-degree line, increase by more than the initial rise in investment. 10. What determines the increase in aggregate demand resulting from the foreign direct investment? The increase in aggregate demand is determined by the multiplier. The larger the multiplier, the larger is the increase in aggregate demand while the smaller the multiplier, the smaller is the increase in aggregate demand.

Chapter 30 . Aggregate Expenditure Multiplier

 Multiple Choice Quiz 1.

The consumption function shows how an increase in influences . A. income; households’ aggregate planned expenditure B. nominal GDP; consumption expenditure C. disposable income; consumption expenditure D. consumption as a fraction of income; real GDP Answer: C Answer C is the definition of the consumption function.

The marginal propensity to consume tells us by how much changes when changes. A. consumption expenditure; wealth B. the real interest rate; planned consumption C. expected future income; the percentage of income spent D. consumption expenditure; disposable income Answer: D Answer D explains what the marginal propensity to consume measures.

Induced expenditure includes . A. consumption expenditure, government expenditure, and exports B. investment, exports, and imports C. consumption expenditure and imports D. consumption expenditure, investment, and government expenditure Answer: C Consumption expenditure and imports both change when real GDP changes, so both are induced expenditure.

The aggregate planned expenditure curve increases. A. slopes upward because induced expenditure increases as income B. is horizontal because autonomous expenditure is constant when income C. shifts upward if induced expenditure increases as income D. slopes upward because autonomous expenditure Answer: A Aggregate expenditure increases when real GDP increases because induced expenditure increases when real GDP increases.

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If real GDP planned expenditure, the economy converges to equilibrium expenditure because inventories and firms increase production. A. exceeds; pile up B. exceeds; are run down C. is less than; are run down D. is less than; pile up

Answer: C

If real GDP is less than planned expenditure, the difference is made up by unplanned decreases in inventories which leads firms to boost their production.

The multiplier equals divided by . A. the marginal propensity to consume; autonomous expenditure B. 1; (1 – Slope of the AE curve) C. 1; Slope of the AE curve D. Slope of the AE curve; the marginal propensity to consume Answer: B Answer B correctly gives the formula for the multiplier.

The multiplier will increase if the marginal propensity to consume or the marginal tax rate . A. increases; decreases B. increases; increases C. decreases; increases D. decreases; decreases Answer: A Both an increase in the marginal propensity to consume and a decrease in the marginal tax rate increase the amount of spending from an increase in income, thereby increasing the size of the multiplier.

A rise in the price level shifts the AE curve . A. upward and creates a movement up along the AD curve B. downward and creates a movement up along the AD curve C. upward and shifts the AD curve rightward D. downward and shifts the AD curve leftward Answer: B The AE curve shifts downward because real wealth decreases; there is movement along the AD curve because a change in the price changes the aggregate quantity of real GDP demanded.

The Short-Run Policy Tradeoff

Chapter

ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications Data 2020 Data 2021 Price Real GDP Unemployment Price Real GDP Unemployment (trillions of rate (trillions of rate level level (2019 = 100) 2019 dollars) (2019 = 100) 2019 dollars) (percent) (Percent) A 102 11.0 9 A 108 11.1 9 B 104 11.1 7 B 110 11.2 7 C 106 11.2 5 C 112 11.3 5 D 110 11.4 3 D 116 11.5 3 The left part of the table describes four situations that might arise in 2020, depending on the level of aggregate demand. The right part of the table describes four situations that might arise in 2021. Use the table to work Problems 1 to 4. 1. Plot the short-run Phillips curve and aggregate supply curve for 2020 and mark the points A, B, C, and D on each curve that correspond to the data in the left part of the table.

A B C D

Inflation rate Unemployment rate (percent per year) (percentage) 2 9 4 7 6 5 10 3

Price level (2019 = 100) 102 104 106 110

Real GDP (trillions of 2019 dollars) 11.0 11.1 11.2 11.4

Use the data in the table above to plot the Phillips curve and the aggregate supply curve. In the table the inflation rates are calculated as the change in the price level divided by the initial price, all multiplied by 100. Then the inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.1 (on the next page). The aggregate supply curve is plotted in Figure 31.2 (on the next page) using the data in the problem, which is reproduced in the table above.

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In 2020, the outcome turned out to be row C of the left side of the table. Plot the short-run Phillips curve for 2021 and mark the points A, B, C, and D that correspond to the data in the right side of the table.

A B C D

Inflation rate (percent per year) 1.9 3.8 5.7 9.4

Unemployment rate (percentage) 9 7 5 3

Use the table above to plot the Phillips curve. The table and inflation rates are constructed similarly to that in Problem 1. The inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.3. 3.

Compare the short-run Phillips curve of 2021 with that of 2020. The Phillips curve shifted slightly downward.

What is Okun’s Law? If the natural unemployment rate is 6 percent, does this economy behave in accordance with Okun’s Law? Okun’s law is a relationship between unemployment and GDP. Okun’s law states that for each percentage point that the unemployment rate is above (below) the natu-

Chapter 31 . The Short-Run Policy Tradeoff

ral unemployment rate, real GDP is 2 percentage points below (above) potential GDP. The economy in the two tables does not behave in accordance with Okun’s law. For instance, in 2020, because the natural unemployment rate is 6 percent, potential GDP is $11.15 trillion. When the unemployment rate is 7 percent, according to Okun’s law real GDP should be $10.9 trillion, 2 percent lower. But the table shows that when the unemployment rate is 7 percent, real GDP is $11.1 trillion. Similar calculations show that Okun’s law also fails to hold for the 2021 data. 5.

Suppose that the natural unemployment rate is 7 percent in 2019 and it decreases to 6 percent in 2020 with no change in expected inflation. Explain how the short-run and long-run tradeoffs change. A decrease in the natural unemployment rate means that both the shortrun and long-run Phillips curves shift leftward.

Suppose that the natural unemployment rate is 7 percent and the expected inflation rate in 2020 is 3 percent a year. If the inflation rate is expected to rise to 5 percent a year in 2021, explain how the short-run and the long-run Phillips curves will change. The short-run Phillips curve shifts upward because there is a rise in the expected inflation rate. There is no change to the long-run Phillips curve.

The inflation rate is 2 percent a year, and the quantity of money is growing at a pace that will maintain that inflation rate. The natural unemployment rate is 7 percent, and the current unemployment rate is 9 percent. In what direction will the unemployment rate change? How will the short-run Phillips curve and the long-run Phillips curve shift? The current unemployment rate is greater than the natural unemployment rate. So, over time, the unemployment rate decreases until it equals the natural unemployment rate. Because the current unemployment rate is greater than the natural unemployment rate, the economy has moved along its SRPC to a point to the right of the LRPC. At this point, the current inflation rate is less than the expected inflation rate. So, over time, people revise downward their expected inflation rate and the short-run Phillips curve shifts downward. The long-run Phillips curve does not shift.

From 1991 until 2018, the average inflation rate in Russia was 11 percent. Explain how a history of high inflation might influence the short-run and long-run Phillips curves in Russia. The history of high inflation means that people are very cautious about being caught unawares by another outburst of inflation. Their expected inflation rates change rapidly, which means the short-run Phillips curve shifts rapidly. As a result, any higher inflation rate is unlikely to be unexpected for long because people rapidly revise their expected inflation rate,

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which means that any decrease in unemployment from the higher inflation is short-lived. Use the following information to work Problems 9 and 10. Changing course, Australia raises interest rate The Reserve Bank of Australia (the central bank) raised its overnight rate (equivalent to the U.S. federal funds rate) by a quarter of a percentage point, to 3.25 percent a year, amid concerns about rising inflation. The interest rate rise came earlier than many economists had expected. Source: The New York Times, October 6, 2009 9. Sketch the Phillips curves if expected inflation is 2 percent a year and the natural unemployment rate is 5 percent. Figure 31.4 shows the long-run Phillips curve, LRPC, which is vertical at the natural unemployment rate of 5 percent. It also shows the short-run Phillips curve, SRPC, which intersects the long-run Phillips curve at the expected inflation rate, 2 percent. 10. If with the Reserve Bank’s “concerns about rising inflation,” people increase the expected inflation rate, explain how the short-run tradeoff will change. An increase in the expected inflation rate does not change the long-run Phillips curve. The short-run Phillips curve will shift upward by the amount of the increase in the expected inflation rate. The short-run tradeoff between inflation and unemployment will worsen. 11. Read Eye on the Tradeoff on p. 817. How can the Phillips curve account for the combination of inflation and unemployment in 2018? Do the data for that year mean that there is no tradeoff? In 2018 the inflation rate increased slightly and the unemployment rate fell. There was a tradeoff between inflation and unemployment for that year along a shortrun Phillips curve that did not change.

Chapter 31 . The Short-Run Policy Tradeoff

 Additional Problems and Applications 1.

Read Eye on the Tradeoff on p. 817. Suppose that the U.S. economy has fully recovered from the 2008–2009 recession. The natural unemployment rate has fallen to 4 percent and the expected inflation rate is zero. How would the short-run and long-run Phillips curves change? Would the tradeoff be more or less favorable than that of 2018? Draw a graph to illustrate your answer. A decrease in the natural unemployment rate shifts the long-run and short-run Phillips curve leftward. This change makes the tradeoff between inflation and unemployment more favorable. The fall in the expected inflation rate shifts the short-run Phillips curve downward but has no effect on the long-run Phillips curve. This change makes the tradeoff between inflation and unemployment more favorable. These changes are illustrated in Figure 31.5. The long-run Phillips curve shifts from LRPC0 to LRPC1 and the short-run Phillips curve shifts from SRPC0 to SRPC1. As illustrated in the figure, the new short-run Phillips curve has a more favorable tradeoff.

In an economy, the natural unemployment rate is 4 percent and the expected inflation rate is 3 percent a year. Draw a graph of the short-run and long-run Phillips curves that display this information. Label each curve. Figure 31.6 shows the short-run and long-run Phillips curves. The long-run Phillips curve, LRPC, is vertical at the natural unemployment rate of 4 percent. The short-run Phillips curve, SRPC, intersects the long-run Phillips curve at the expected inflation rate, 3 percent.

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Data 2020 Data 2021 Price Real GDP Unemployment Price Real GDP Unemployment level (trillions of rate level (trillions of rate (2019 = 100) 2019 dollars) (2019 = 100) 2019 dollars) (percent) (Percent) A 102 10.0 8 A 108 10.3 8 B 104 10.1 6 B 110 10.4 6 C 106 10.2 4 C 112 10.5 4 D 110 10.4 2 D 116 10.7 2 The left part of the table describes four possible situations that might arise in 2020, depending on the level of aggregate demand in 2020. The right part of the table describes four possible situations that might arise in 2021. Use the table to work Problems 3 and 4. 3. Plot the short-run Phillips curve and aggregate supply curve for 2020 and mark the points A, B, C, and D on each that correspond to the data in the left part of the table.

A B C D

Inflation rate (percent per year) 2 4 6 10

Unemployment rate (percentage) 8 6 4 2

Price level (2019 = 100) 102 104 106 110

Real GDP (trillions of 2019 dollars) 10.0 10.1 10.2 10.4

The figures are above. Also above is a table with the data necessary to plot the Phillips curve and the aggregate supply curve. In the table the

Chapter 31 . The Short-Run Policy Tradeoff

inflation rates are calculated as the change in the price level divided by the initial price, all multiplied by 100. Then the inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.7. The aggregate supply curve is plotted in Figure 31.8 using the data in the problem, which is reproduced in the table above. 4.

In 2020, the outcome turned out to be row D of the left side table. Plot the short-run Phillips curve for 2021 and mark the points A, B, C, and D that correspond to the data in the right part of the table.

A B C D

Inflation rate (percent per year) 1.8 0 1.8 5.5

Unemployment rate (percentage) 8 6 4 2

Use the table above to plot the Phillips curve. The table is constructed similarly to that in Problem 3. The inflation rates and unemployment rates are plotted as the Phillips curve in Figure 31.9.

Explain the relationship between the long-run Phillips curve and potential GDP and the short-run Phillips curve and the aggregate supply curve. The long-run Phillips curve and potential GDP are closely related. When the economy is producing at potential GDP, the unemployment rate is the natural unemployment rate and the economy is on its long-run Phillips curve. Potential GDP does not change when the price level changes, so the natural unemployment rate does not change when the price level or the inflation rate changes. The short-run Phillips curve and the aggregate supply curve also are related. The inflation rate is defined as the percentage change in the price

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level. So, starting from any given price level last period, the higher the inflation rate, the higher is the current period’s price level. With this in mind, moving upward along the AS curve, the price level rises and real GDP increases. So, moving upward along the AS curve, as the price level rises, the inflation rate also increases. And as real GDP increases, unemployment decreases. So, a movement up along the AS curve corresponds to a movement up along the short-run Phillips curve, in which the inflation rate rises and the unemployment rate decreases. 6.

The inflation rate is 3 percent a year, and the quantity of money is growing at a pace that will maintain the inflation rate at 3 percent a year. The natural unemployment rate is 4 percent, and the current unemployment rate is 3 percent. In what direction will the unemployment rate change? How will the short-run Phillips curve and the long-run Phillips curve shift? The current unemployment rate is less than the natural unemployment rate. So, over time, the unemployment rate increases until it equals the natural unemployment rate. Because the current unemployment rate is less than the natural unemployment rate, the economy has moved along its SRPC to a point to the left of the LRPC. At this point, the current inflation rate is greater than the expected inflation rate. So, over time, people revise upward their expected inflation rate and the short-run Phillips curve shifts upward. The long-run Phillips curve does not shift.

The inflation rate is 6 percent a year, the unemployment rate is 4 percent, and the economy is at full employment. The Fed announces that it intends to slow the money growth rate to keep the inflation rate at 3 percent a year for the foreseeable future. People believe the Fed. Explain how unemployment and inflation change in the short run and in the long run. Because people believe the Fed, they immediately adjust their expected inflation rate downward to 3 percent, which shifts the short-run Phillips curve downward. Then, in both the short run and the long run, when the inflation rate falls to 3 percent, the unemployment rate remains at 4 percent.

Use the following information to work Problems 8 to 10. Brazilian inflation and growth get worse Brazil’s central bank has increased its inflation forecast to 9 percent and cut its forecast for real GDP growth, which it now says will be minus 1.1 percent. Source: The Wall Street Journal, June 24, 2015 8. According to Okun’s Law, how would you expect Brazil’s fall in real GDP (negative growth rate) to change the unemployment rate? According to Okun’s Law, the unemployment rate will rise. Okun's Law concludes that for each percentage point that the unemployment rate is

Chapter 31 . The Short-Run Policy Tradeoff

above the natural unemployment rate, real GDP is 2 percent below potential GDP. So if the real GDP growth rate decreases by 1.1 percentage points, then the unemployment rate rises by 1.1/2.0 or 0.55 percent. 9.

Draw two short-run Phillips curves and a long-run Phillips curve for Brazil. On your graph, place two points, one for Brazil in 2014 and one for the central bank’s expectations about the outcome in 2015. Explain any assumptions you make. In Figure 31.10, we assume that the expected inflation rate increases along with the inflation rate, so the short-run Phillips curve shifts upward from SRPC1 to SRPC2. We also assume that the fall in the real GDP growth rate increases unemployment by 0.55 percentage points, as calculated above. The economy moves from point A, with an unemployment rate of 8.45 percent and an inflation rate of 8.5 percent, to point B, with an unemployment rate of 9 percent and an inflation rate of 9 percent.

10. Explain and illustrate with a graph the effects of the central bank of Brazil trying to lower the inflation rate by unexpectedly slowing the money growth rate. Explain how the unemployment rate will change in the short run and in the long run if the central bank persists with a lower money growth rate. Contrast the outcome with that for an expected slowing of money growth. The economy starts at point A. When the central bank unexpectedly lowers the monetary growth rate and thereby the inflation rate, the economy moves down along the short-run Phillips curve SRPC1 to point B. Eventually the expected inflation rate falls, which shifts the short-run Phillips curve downward to SRPC2. The economy moves to point C. If the public expects the lower monetary growth rate and inflation rate, the short-run Phillips curve immediately shifts downward to SRPC2 and the economy moves from point A to point C.

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 Multiple Choice Quiz 1.

The short-run Phillips curve shows that, other things remaining the same, . A. an increase in expected inflation will lower the unemployment rate B. a fall in unemployment will lower the inflation rate C. the inflation rate rises by 1 percent when unemployment falls by 1 percent D. a rise in the inflation rate and a fall in the unemployment rate occur together Answer: D The short-run Phillips curve shows a tradeoff between higher inflation and lower unemployment.

The long-run Phillips curve . A. is a horizontal curve at the expected inflation rate B. is a vertical curve at the natural unemployment rate C. slopes downward as the inflation rate falls D. slopes upward as the unemployment rate falls Answer: B Figure 31.3 in the text illustrates that Answer B is correct.

The short-run Phillips curve intersects the long-run Phillips curve at . A. the expected inflation rate and the current unemployment rate B. the current inflation rate and the natural unemployment rate C. the expected inflation rate and the natural unemployment rate D. the current inflation rate and the current unemployment rate Answer: C Figure 31.4 in the text illustrates that Answer C is correct. 4.

An increase in the expected inflation rate, other things remaining the same, . A. shifts the short-run Phillips curve upward B. creates a movement up along the short-run Phillips curve C. decreases the natural unemployment rate and shifts the long-run Phillips curve leftward D. creates a movement up along the long-run Phillips curve with no change in the short-run Phillips curve Answer: A Figure 31.4 in the text illustrates that Answer A is correct.

Chapter 31 . The Short-Run Policy Tradeoff

A decrease in the natural unemployment rate . A. shifts both the short-run and the long-run Phillips curves leftward B. shifts the short-run Phillips curve leftward but the long-run Phillips curve does not change C. creates a movement along the short-run Phillips curve D. increases the expected inflation rate and shifts the short-run Phillips curve upward Answer: A Figure 31.6 in the text illustrates that Answer A is correct. 6.

Suppose that the unemployment rate exceeds the natural unemployment rate and the Fed increases the money growth rate. If the Fed’s action is . A. unexpected, the unemployment rate falls but the inflation rate rises B. unexpected, the inflation rate doesn’t change but the unemployment rate falls C. expected, the inflation rate rises but the unemployment rate doesn’t change D. expected, the unemployment rate doesn’t change and the inflation rate equals the expected inflation rate Answer: A Because the expected inflation rate does not change, the rise in the inflation rate moves the economy upward along its short-run Phillips curve and leads to a fall in the unemployment rate and a rise in the inflation rate.

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Fiscal Policy ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Suppose that in an economy, investment is $400 billion, saving is $400 billion, tax revenues are $500 billion, exports are $300 billion, and imports are $200 billion. Calculate government expenditure and the government’s budget balance. The circular flow shows that GDP = C + I + G + X − M. The circular flow also shows that Y = C + S + T. Because GDP = Y, these two equalities can be combined to give C + I + G + X − M = C + S + T. Rearranging this equality gives G = S – I + T + M – X. Using this formula shows G = $400 billion − $400 billion + $500 billion + $200 billion − $300 billion, or government expenditure = $400 billion. The government’s budget balance equals T − G, so the budget balance is $500 billion − $400 billion, or a $100 billion budget surplus. 2. Classify the following items as automatic fiscal policy actions, discretionary fiscal policy actions, or neither. • An increase in expenditure on homeland security Discretionary fiscal policy because the spending must be approved by an act of Congress. • An increase in unemployment benefits paid during a recession Automatic fiscal policy because no action of Congress was necessary for this increase to occur. • Decreased expenditures on national defense during peace time Discretionary fiscal policy because the spending change must be approved by an act of Congress. • An increase in Medicaid expenditure brought about by a flu epidemic Automatic fiscal policy because no action of Congress was necessary for this increase to occur.

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• A cut in farm subsidies Discretionary fiscal policy because an act of Congress was required. 3. The U.S. economy is in recession and has a large recessionary gap. Describe what automatic fiscal policy might occur. Describe a fiscal stimulus that could be used that would not increase the budget deficit. One automatic fiscal policy that kicks in results from the point that the recession lowers people’s incomes, so induced taxes decrease. The other automatic stabilizer occurs because lower incomes increase needs-tested spending, such as unemployment benefits and food stamps. Both automatic stabilizers help to stabilize aggregate demand by decreasing the multiplier effect. A fiscal stimulus that could be used and that does not increase the budget deficit is a balanced budget increase in government expenditure and taxes. The balanced budget multiplier shows that when both government expenditure and taxes increase by the same amount, aggregate demand increases. The increase in aggregate demand can help decrease the recessionary gap. Labor market Real wage rate (dollars per hour)

Quantity of labor demanded (thousands of hours)

Quantity of labor supplied (thousands of hours)

10 11 12 13 14 15

6 5 4 3 2 1

2 3 4 5 6 7

Production function Employment Real GDP (thousands (millions of of hours) dollars)

2 3 4 5 6 7

OilPatch is a mineral rich economy in which the government gets most of its tax revenue from oil royalties. But OilPatch has an income tax. The left table above describes the labor market in OilPatch and the right table above describes the economy’s production function. The government introduces an income tax of $2 per hour worked. Use the tables to work Problems 4 to 6. 4. What are the levels of employment and potential GDP in OilPatch, what is the real wage rate paid by employers, and what is the after-tax real wage rate received by workers? The equilibrium quantity of employment is 3,000 hours. Firms pay a before-tax wage rate of $13 an hour (so the quantity of labor firms demand is 3,000 hours). Households receive an after-tax wage rate of $11 an hour (so the quantity of labor households supply is 3,000 hours). Employment of 3,000 means that potential GDP is $11 million.

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Chapter 32 . Fiscal Policy

If OilPatch eliminates its income tax, what then are the levels of employment and potential GDP and what is the real wage rate in OilPatch? If OilPatch removes its income tax, the equilibrium quantity of employment is 4,000 hours. The real wage rate is $12 an hour and potential GDP is $15 million.

If OilPatch doubles its income tax to $4 an hour, what then are the levels of employment and potential GDP? What is the real wage rate paid by employers and the after-tax real wage rate received by workers? If oil patch doubles its income tax to $4 an hour, the equilibrium quantity of employment is 2,000 hours. Firms pay a before-tax wage rate of $14 an hour (so the quantity of labor firms demand is 2,000 hours). Households receive an after-tax wage rate of $10 an hour (so the quantity of labor households supply is 2,000 hours). Employment of 2,000 means that potential GDP is $6 million.

The income tax rate on all forms of income is 40 percent and there is a tax of 10 percent on all consumption expenditure. The nominal interest rate is 7 percent a year and the inflation rate is 5 percent a year. What is the size of the tax wedge on wages and what is the true tax rate on interest? The tax wedge on wages is the sum of the income tax rate and the tax rate on consumption. So the tax wedge is 40 percent + 10 percent, or 50 percent. The tax on interest income is applied to the nominal interest rate. So the after-tax real interest rate equals the nominal interest rate minus the inflation rate (which equals the before-tax real interest rate) minus the tax paid on the interest income. When the inflation rate rises, the nominal interest rate rises. The higher nominal interest rate increases the tax paid on the interest rate, which decreases the after-tax real interest rate and thereby increases the true tax rate on interest income. If the tax rate on all forms of income, including interest income, is 40 percent and the nominal interest rate is 7 percent, then of the 7 percent nominal interest rate, 2.80 percent is paid as taxes. The real interest rate equals the nominal interest rate, 7 percent, minus the inflation rate, 5 percent, so the real interest rate is 2 percent. Of this amount, 2.8 percent must be paid as taxes, so the after-tax real interest rate is 2 percent – 2.8 percent, or –0.8 percent. The tax lowers the real interest rate from 2 percentage points to −0.8 percentage points, which is a fall of 2.8 percentage points for a true tax rate on interest income of 140 percent (from (2.8 ÷ 2.0) × 100). IMF reduces forecast for U.S. growth The IMF expects U.S. economic growth to slow to 2 percent in 2012 and 2.25 in 2013. That’s down from its earlier estimates of 2.15 percent in 2012 and 2.4 in 2013. Christine Lagarde, the IMF’s managing director, said that Congress should “promptly” raise the debt ceiling and adopt strong fiscal policies. © 2023 Pearson Education, Ltd.

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Source: The New York Times, July 3, 2012 8.

Explain the effects of strong fiscal stimulus if it is implemented well. The fiscal stimulus is designed to increase aggregate demand and offset the recessionary gap that existed. Mr. Blanchard suggested that this stimulus was needed soon because the sooner it was implemented, the sooner the recessionary gap would be closed. If it is implemented well, a fiscal stimulus closes the recessionary gap without creating an inflationary gap by being too strong.

Former Canadian Prime Minister Stephen Harper warns that if policy makers adopt too strong a fiscal stimulus, then long-term growth might be jeopardized. Explain what he meant. Mr. Harper was concerned about the supply-side effects of the fiscal stimulus. If the fiscal stimulus consists of government expenditure increases that are large and permanent, then government tax revenues would need to increase to keep the budget deficit from rising and crowding out investment. If investment decreases, then the economic growth rate slows.

10. Read Eye on Fiscal Stimulus on p. 839. How big was the fiscal stimulus package of 2008–2009, how many jobs was it expected to create, and how large was the multiplier implied by that expectation? Did the stimulus work? In February 2009, the total fiscal stimulus package passed by the Congress was $787 billion, though in the first year only about 20 percent of the stimulus, or $160 billion, had been spent. The stimulus was expected to save or create 650,000 jobs by the summer of 2009. Government economists asserted that 650,000 jobs had been saved or created. Accordingly, $160 billion in fiscal stimulus created 650,000 jobs. The implied multiplier was only 0.4, far smaller than the administration predictions that the multiplier was 1.6.

Chapter 32 . Fiscal Policy

 Additional Problems and Applications 1.

Read Eye on Fiscal Stimulus on p. 839. From the peak in 1929 to the Great Depression trough in 1933, government tax revenues fell by 1.9 percent of GDP and government expenditures increased by 0.3 percent. Real GDP fell by 25 percent. Compare and contrast this experience with the fiscal policy that accompanied the 2008-2009 recession. What did fiscal policy do to moderate the last recession that was largely absent during the Great Depression? In the 2008-2009, fiscal policy was used extensively to moderate the recession. During the Great Depression, however, fiscal policy was virtually not used. For instance, during the Great Depression, government expenditure increased by only 0.3 percent of GDP but during the recent recession government expenditure (including both automatic and discretionary expenditure) increased by 5 percent of GDP. Similarly during the Great Depression government tax revenues fell by only 1.9 percent of GDP while during the recent recession tax revenues (both automatic and discretionary) fell by 3.0 percent of GDP. The scale of the fiscal stimulus was much greater during the last recession and this fact might be a point why the recession was much less severe than the Great Depression.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on aggregate demand and real GDP. Government expenditure is autonomous expenditure, so the increase in government expenditure increases autonomous expenditure. As a result, aggregate demand increases. The multiplier effect means that aggregate demand increases by more than the $100 billion increase in government expenditure. Real GDP increases because aggregate demand increases.

Suppose that the U.S. government increases its expenditure on highways and bridges by $100 billion. Explain the effect that this expenditure would have on needs-tested spending and the government’s budget surplus. Needs-tested spending decreases as the economy expands. The budget surplus will fall but by less than the increase in expenditure because the increase in GDP will induce some additional taxes and decrease needstested spending.

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Labor market Real wage rate (dollars per hour)

Quantity of labor demanded (thousands of hours)

Quantity of labor supplied (thousands of hours)

10.00 10.50 11.00 11.50 12.00 12.50

18 15 12 9 6 3

6 9 12 15 18 21

Production function Employment Real GDP (thousands (millions of of hours) dollars)

6 9 12 15 18 21

The first table to the left describes the labor market in LowTaxLand and the second table to the right describes the economy’s production function. LowTaxLand introduces an income tax of $1 per hour worked. Use the tables to work Problems 4 to 6. 4. What are the levels of employment and potential GDP in LowTaxLand, what is the real wage rate paid by employers, and what is the after-tax real wage rate received by workers? Employment equals 9,000 hours. At this level of employment, potential GDP equals $12 million. The before-tax wage rate is $11.50 per hour and the after-tax wage rate is $10.50 per hour. 5.

If LowTaxLand eliminates its income tax, what then are the levels of employment and potential GDP and what is the real wage rate in LowTaxLand? If LowTaxLand eliminates its income tax, employment equals 12,000 hours. At this level of employment, potential GDP equals $16 million. The real wage rate is $11.00 per hour.

If LowTaxLand doubles its income tax to $2 an hour, what then are the levels of employment and potential GDP? What is the real wage rate paid by employers and the after-tax real wage rate received by workers? If LowTaxLand doubles its income tax to $2 an hour, employment equals 6,000 hours. At this level of employment, potential GDP is $7 million. The before-tax wage rate is $12.00 per hour and the after-tax wage rate is $10.00 per hour.

Describe the supply-side effects of a fiscal stimulus and explain how a tax cut will influence potential GDP. A tax cut increases people’s incentives to work and to save. Therefore a tax cut increases employment and investment in new capital. The increase in employment and capital increase potential GDP.

7 12 16 19 21 22

Chapter 32 . Fiscal Policy

Use an aggregate supply–aggregate demand graph to illustrate the effects on real GDP and the price level of a fiscal stimulus when the economy is in recession. The fiscal stimulus increases aggregate demand and shifts the aggregate demand curve rightward, as illustrated in Figure 32.1. The increase in aggregate demand raises the price level, in Figure 32.1 from 110 to 115, and increases real GDP, in Figure 32.1 from $19 trillion to $20 trillion. The recessionary gap is decreased; indeed, in Figure 32.1, the recessionary gap is completely eliminated.

Use the following information to work Problems 9 to 11. CBO expects deficit to grow more than projected Federal deficits are expected to swell to higher levels over the next decade than previously expected. The U.S. budget deficit is expected to average a whopping $1.2 trillion per year between 2020 and 2029. The aging of the U.S. population and growth in health-care spending are the main drivers of the large deficit. Source: CNBC, August 21, 2019 9. Explain why the national debt does not measure the federal government’s true indebtedness. How does the nation’s fiscal imbalance provide a more accurate account of government’s debt? The national debt does not measure the federal government’s true indebtedness because it does not measure the present value of the government’s commitments to pay future benefits minus the present value of the government’s future tax revenues. For example, the government has made promises to pay certain amounts as Social Security benefits in the future and has set tax rates that will collect certain tax revenues in the future. The national debt omits these sorts of future spending and revenues. The fiscal imbalance, however, includes these future commitments because it equals the present value of the government’s future commitments to pay future benefits minus the present value of the government’s future tax

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revenues. Consequently, the fiscal imbalance is a measure of the government’s true indebtedness. 10. If the government decided to slow the growth of debt by cutting transfer payments and raising taxes by the same amount, how would this fiscal policy influence the budget deficit and real GDP? By cutting transfer payments and raising taxes, the government will decrease the budget deficit. Cutting transfer payments and increasing taxes decrease aggregate demand, which decreases real GDP. A higher tax rate also increases the tax wedge, which in turn decreases employment, saving, and investment and thereby decreases potential GDP and aggregate supply. The decrease in aggregate supply also decreases real GDP. The lower budget deficit, however, lowers the real interest rate which increases investment and, through this channel, increases real GDP. This effect on real GDP, though, is smaller than the others, so on net real GDP decreases. 11. How do an aging population and healthcare programs drive spending and the deficit and how do they create fiscal imbalance and generational imbalance? Spending on an aging population is largely spending on Social Security. Social Security and healthcare are major drivers of government spending. Consequently, they are also major drivers of the deficit. In addition, because they represent future government obligations, they also create fiscal imbalance as well as being the prime source of the generational imbalance. For example, the Social Security and Medicare fiscal imbalance is $68 trillion in 2014, about four times U.S. GDP. The current generation and the future generation each pay some of the fiscal imbalance. Presently the current generation will pay 83 percent of the fiscal imbalance and the future generation will pay 17 percent.

Chapter 32 . Fiscal Policy

 Multiple Choice Quiz 1.

The federal government’s major outlay in its budget is and its major source of revenue is . A. debt interest; sales of government bonds B. expenditure on goods and services; taxes on goods and services C. Social Security and other benefits; personal income taxes D. subsidies to farmers; corporate taxes Answer: C Social Security payments are the major part of the government’s transfer payments, which is the largest outlay item. On the revenue side, personal income taxes exceed Social Security taxes in revenue collected. 2.

U.S. national debt when the federal government’s . A. increases; outlays exceed tax revenue B. decreases; outlays exceed tax revenue C. increases; tax revenue rises faster than outlays D. decreases; tax revenue rises faster than outlays Answer: A The national debt increases whenever the government’s outlays exceeds its tax revenues.

Discretionary fiscal policy to stimulate the economy includes . A. lowering the tax rate paid by households with middle incomes B. raising the tax on gasoline C. the fall in tax revenue as the economy goes into recession D. the rise in tax revenue collected from businesses as their profits increase Answer: A Answer A is discretionary fiscal policy because it requires an act of Congress. It is an expansionary policy because it is designed to increase consumption expenditure and hence aggregate demand.

Automatic fiscal policy . A. requires an action of the government B. is weak unless the government cuts its outlays to reduce the deficit C. operates as the economy moves along its business cycle D. reduces the deficit as the economy goes into recession Answer: C Answer C is essentially the definition of automatic fiscal policy.

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Needs-tested spending is fiscal policy because it . A. automatic; increases in recession and decreases in expansion B. discretionary; increases when tax revenue increases C. automatic; increases when the government’s budget deficit falls D. discretionary; is determined by economic hardship Answer: A Needs tested spending automatically increases in recessions and decreases in expansions without need for any government action. 6.

A government expenditure multiplier . A. equals 1 B. is less than the tax multiplier C. exceeds 1 D. equals the tax multiplier Answer: C The expenditure tax multiplier exceeds 1 because an increase in government expenditure induces additional increases in expenditure.

When the government lowers the income tax rate, . A. employment increases and potential GDP increases B. employment does not change but labor productivity falls C. labor productivity rises and employment decreases D. both labor productivity and potential GDP increase Answer: A Lowering the income tax rate increases the supply of labor, thereby raising both employment and potential GDP.

A tax cut increases . A. aggregate demand but has no effect on aggregate supply B. aggregate demand because it increases disposable income and increases aggregate supply because it is an incentive to supply more labor C. aggregate demand because it increases consumption expenditure and decreases aggregate supply because labor productivity falls D. aggregate supply but has no effect on aggregate demand Answer: B A tax cut increases both aggregate demand and aggregate supply.

Chapter

Monetary Policy ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications 1.

Bernanke raises alarm on spending Fed Chairman Ben Bernanke warned that government spending and budget deficits threaten financial stability and might be setting the scene for the next crisis. Source: The Globe and Mail, June 4, 2009 How might a large increase in government spending and the government’s budget deficit threaten financial stability and make the Fed’s job harder? A large budget deficit means that the government must sell a large quantity of debt, thereby drastically increasing the demand for loanable funds. The increase in the demand for loanable funds could lead to a massive rise in the interest rate on the debt. The quantity of the government’s debt might be too large and the resulting interest rate might be so high that the value of the outstanding debt plunges. This situation would create financial instability, much as when as financial firms faced insolvency. The demand for (safe) reserves would soar and banks would decrease th eir (risky) lending, leading to a downturn in the economy. To help restore stability, the Fed would need to increase the quantity of reserves to avoid creating a depression out of a recession. As the Fed would be concentrating on financial instability, its tasks of keeping the inflation rate low and maintaining full employment would become much harder.

Use the following information to work Problems 2 to 4. Suppose that the U.S. economy is at full employment when strong economic growth in Asia increases the demand for U.S.-produced goods and services. 2.

Explain how the U.S. price level and real GDP will change in the short run. The increase in Asian demand for U.S.-produced goods and services will increase net exports and therefore increase aggregate expenditur e and aggregate demand. The increase in aggregate demand will lead to in creases in the U.S. price level and real GDP. © 2023 Pearson Education, Ltd.

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Explain how the U.S. price level and real GDP will change in the long run if the Fed takes monetary policy actions that are consistent with its objectives as set out in the Federal Reserve Act of 2000. If the Fed takes the monetary policy action consistent with its objectives, it will raise the federal funds rate to offset the increase in aggregate demand. If the Fed’s actions perfectly offset aggregate demand, then neither the price level nor real GDP change. Even if the actions are not perfect, the Fed will moderate the rise in the price level and real GDP.

Explain whether the Fed faces a tradeoff in the short run. The Fed does not face a tradeoff. Its actions move both real GDP (and hence employment) and the price level back to their desired levels.

What is the Fed’s “dual mandate” for the conduct of monetary policy? What are the means to achieving the goals of the dual mandate? The Fed has two goals for its monetary policy. These two goals —the Fed’s dual mandate—are to achieve a stable price level, that is, keep the infla tion rate low and predictable, and to achieve maximum employment, that is, keep real GDP close to potential GDP. To achieve these goals the Fed has been instructed to maintain growth in the monetary and credit aggregates that are consistent with the economy’s production potential. In oth er words, the Fed has been instructed to keep the growth of the quantity of money in line with the growth in potential GDP.

What is financial stability? What actions has the Fed taken since 2007 in pursuit of financial stability? Use a graph to illustrate the effects of the Fed’s actions. Financial stability is the situation in which the nation’s financial markets and institutions are working normally to allocate capital and risk. The financial crisis that started in 2007 has caused the Fed to focus more than normal on financial stability. With the crisis in the nation’s financial markets, banks faced significantly more risk than normal and responded by drastically increasing their demand for (safe) reserves. In Figure 33.1, the demand curve for reserves shifted right from RD0 to RD1 . In the absence of Fed action, the federal funds rate would have skyrocketed from 5 percent to 9 percent. But the Fed engaged in quantitative easing by increasing the supply of reserves from RS0 to RS1 . The Fed’s actions drove

Chapter 33 . Monetary Policy

the federal funds rate to 0 percent and helped maintain financial stability by giving banks reserves with which they could make loans. Use the following information to work Problems 7 to 9. Figure 33.2 shows the aggregate demand curve, AD, and the short-run aggregate supply curve, AS, in the economy of Artica. Potential GDP is $300 billion. 7.

What are the price level and real GDP? Does Artica have an unemployment problem or an inflation problem? Why? The price level is 130 and real GDP is $200 billion. Artica has an unemployment problem because real GDP is less than potential GDP.

What do you predict will happen if the central bank takes no monetary policy actions? What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action? If the central bank takes no action, then in the long run the money wage rate falls. Aggregate supply increases so that the AS curve shifts rightward. In the long run, the economy returns to potential GDP of $300 billion and the price level falls to 120. If the central bank undertakes a policy action, the central bank should lower the federal funds interest rate and thereby increase aggregate demand. If the central bank did so and was totally accurate, then real GDP would return to potential GDP of $300 billion and the price level would rise to 140.

Suppose that a drought decreases potential GDP in Artica to $250 billion. Explain what happens if the central bank lowers the federal funds rate. Do you recommend that the central bank lower the interest rate? Why? The central bank should lower the interest rate. If the central bank lowers the federal funds rate, aggregate demand increases. The price level rises. Real GDP increases and moves closer to potential GDP. Lowering the interest rate can move real GDP back to potential GDP. But if the central bank does not realize that potential GDP has decreased to $250 billion, it might lower the interest rate by too much and increase real GDP well beyond potential GDP. In that case inflation would result.

10. Fed cuts interest rates again but future drops this year are in doubt Fed policymakers cut rates but were divided about their future path. A majority projected no more cuts in the foreseeable future with the

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unemployment rate expected to remain at a very low 3.7% this year and next, and inflation to stay at about 1.5% this year and rise to 1.9% in 2020. Source: Los Angeles Times, September 18, 2019 What are some of the problems that could arise if the Fed cuts interest rates too soon by too much or too late by too little? When the Fed lowers the interest rate, the lower interest rate leads to an increase in aggregate demand and more rapid growth in real GDP. If the Fed lowers the interest rate by too much or for too long, the rapid growth in aggregate demand will open an inflationary gap. In this situa tion, inflation will rise more than otherwise and could rise above the desired level. However, if the Fed lowers the interest rate by too little or for not long enough, growth in aggregate demand will slow and unemployment will be higher than otherwise. 11. Read Eye on the Fed in a Crisis on p. 860. What are the key differences in monetary policy between the Great Depression and the slow recovery from the 2008–2009 recession? The major difference in the Fed’s behavior between the Great Depression and the 2008-2009 recession was the vast increase in reserves in 2008 -2009 and the following increase in the quantity of money. In the Great Depression, the Fed allowed the quantity of money to decrease by 35 percent; in the 2008-2009 recession, the Fed engineered an increase in the quantity of money of 37.5 percent.

Chapter 33 . Monetary Policy

 Additional Problems and Applications 1.

Read Eye on the Fed in a Crisis on p. 860. In which episode, the Great Depression or the 2008–2009 recession, did the banks’ desired reserve ratio and the currency drain ratio increase by the larger amount and the money multiplier fall by the larger amount? Banks’ desired reserve ratio increased by much more in the 2008-2009 recession than during the Great Depression. The currency drain ratio in creased by more during the Great Depression. The fall in the money multiplier was much larger during the 2008-2009 recession.

Compare and contrast the Fed’s monetary policy response to the surge in desired reserves and currency holdings in the Great Depression and the 2008–2009 recession. The Fed in the 2008-2009 recession attempted to avert the collapse in lending that occurred during the Great Depression by making its monetary policy much more accommodative than during the Great Depression. That is, the Fed met the increased demand for reserves in 2008 -2009 by vastly increasing the quantity of reserves while in the Great Depression the Fed did very little. During the Great Depression M2 decreased by more than 30 percent while during the recent recession M2 grew by 8 percent.

Use the following information to work Problems 3 to 5. The U.S. economy is at full employment when the world price of oil begins to rise sharply. Short-run aggregate supply decreases. 3.

Explain how the U.S. price level and real GDP will change in the short run. The increase in the price of oil decreases aggregate supply so that the price level rises and real GDP decreases.

Explain how the U.S. price level and real GDP will change in the long run if the Fed takes monetary policy actions that are consistent with its objectives as set out in the Federal Reserve Act of 2000. The Fed faces a quandary. It is charged with keeping stable prices and maximum employment. If the Fed raises the federal funds rate, it will decrease aggregate demand and thereby offset the rise in the price level. But this policy also decreases real GDP, which worsens the effect of the oil price hike on employment. However, if the Fed lowers the federal funds rate, it will increase aggregate demand and thereby offset the fall in real GDP (and employment). But this policy also increases the price level, which worsens the effect of the oil price hike on inflation.

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Does the Fed face a tradeoff in the short run? Explain why or why not. The Fed definitely faces a tradeoff. With the change in aggregate supply, the Fed can either stabilize the price level or real GDP (and employment) but not both.

Use the following information to work Problems 6 to 9. Figure 33.3 shows the aggregate demand curve, AD, and the short-run aggregate supply curve, AS, in the economy of Freezone. Potential GDP is $300 billion. 6.

What are the price level and real GDP? Does Freezone have an unemployment problem or an inflation problem? Why? The price level is 110 and real GDP is $400 billion. Freezone has an inflation problem because real GDP exceeds potential GDP.

What do you predict will happen in Freezone if the central bank takes no monetary policy actions? What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action? If the central bank takes no action, then in the long run the money wage rate rises. Aggregate supply decreases so that the AS curve shifts leftward. In the long run, the economy returns to potential GDP of $300 billion and the price level rises to 120. If the central bank undertakes a policy action, the central bank should raise the federal funds rate and thereby decrease aggregate demand. If the central bank did so and was totally accurate, then real GDP would return to potential GDP of $300 billion and the price level would fall to 100.

What happens in Freezone if the central bank lowers the federal funds rate? Do you recommend that the central bank lower the interest rate? Why? If the central bank lowers the federal funds rate, aggregate demand in creases. The price level rises. Real GDP increases and moves farther away from potential GDP. Lowering the interest rate moves real GDP farther away from potential GDP and so is an incorrect policy to pursue.

What happens in Freezone if the central bank conducts an open market sale of securities? How will the interest rate change? Do you recommend that the central bank conduct an open market sale of securities? Why? If the central bank conducts an open market sale of securities, the federal funds interest rate rises. With the rise in the federal funds rate, aggregate

Chapter 33 . Monetary Policy

demand decreases. The price level falls. Real GDP decreases and moves closer to potential GDP. Because real GDP moves closer to potential GDP, it is reasonable to recommend that the central bank conduct an open market sale of securities. 10. Suppose that inflation is rising toward 5 percent a year, and the Fed, Congress, and the White House are discussing ways of containing inflation without damaging employment and output. The President wants to cut aggregate demand but to do so in a way that will give the best chance of keeping investment high to encourage long -term economic growth. Explain the Fed’s best action for meeting the President’s objectives. The Fed really cannot meet both the President’s objectives. On the one hand, to keep investment high, the policy must lower, or at the least, not raise the real interest rate. So the President’s goal is to decrease aggregate demand and lower (or not raise) the real interest rate. The rise in the federal funds rate means that the real interest rate rises. The rise in the real interest rate decreases aggregate demand, which is what the President wants. But it also decreases investment, which is incompatible with the President’s other goal. On the other hand, cutting the funds rate means that the real interest rate falls. The fall in the real interest rate increases investment, which is what the President wants. But it also increases aggregate demand, which is incompatible with the President’s other goal. Use the following information to work Problems 11 and 12. Many ways to blow up an economy Excessive stimulus could bring inflation in the United States in the long term, but for now, inflation is falling. Bond interest rates reflect inflation expectations that are within the Fed’s long-term target levels. Source: Australian Financial Review, May 9, 2009 11. Explain why inflation was falling in 2009 and how excessive stimulus could bring inflation in the long term. Inflation was falling in 2009 because the financial crisis and recession of 2008 and 2009 decreased aggregate demand. The decrease in aggregate demand lowered the price level (from what it otherwise would have been), which decreased the inflation rate. Excessive stimulation implies that aggregate demand begins to increase more rapidly. If aggregate demand starts to grow too rapidly, then the price level will start to rise rapidly and inflation will return.

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12. What does it mean to say that inflation expectations are within the Fed’s target levels? Though not precisely specified, the Fed apparently has an implicit target for the inflation rate, somewhere near a core inflation rate of 2 percent per year. If expected inflation is near the Fed’s target for the inflation rate, then the inflation expectations are “within the Fed’s target levels.” Expected inflation at this level will not contribute to higher inflation, so the Fed does not need to further alter its policy to reduce expected inflation .

Chapter 33 . Monetary Policy

 Multiple Choice Quiz 1.

The Fed’s “dual mandate” is to achieve . A. a government budget surplus and low interest rates B. low inflation and maximum employment C. a stable quantity of money and stable prices D. zero unemployment and a stable means of payment

Answer: B 2.

The Fed’s dual mandate reflects its major goals.

The Fed’s operational goals include

A. a core inflation rate of 2 percent a year and an output gap as small as possible B. an economic growth rate of 3 percent a year and an unemployment rate equal to the natural unemployment rate C. a strong U.S. dollar on foreign exchange markets and a positive output gap D. maximum growth of stock prices and a low core inflation rate Answer: A

Answer A accurately describes the Fed’s operational goals for its dual mandate to achieve stable prices and maximum unemployment.

The Fed’s monetary policy instrument is the A. inflation rate B. federal funds rate

C. long-term interest rate D. monetary base Answer: B The Fed uses the federal funds rate as its monetary policy instrument. 4.

The Fed fights inflation by

A. lowering the federal funds rate, which lowers interest rates and decreases aggregate demand B. raising the federal funds rate, which raises interest rates and decreases aggregate demand C. decreasing the monetary base, which raises the interest rate and increases saving D. lowering the long-term real interest rate, which increases investment and spurs economic growth Answer: B

By raising the federal funds rate, the Fed ultimately decreases aggregate demand, which slows the inflation rate.

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To fight unemployment and close a recessionary gap, the Fed . A. stimulates aggregate demand by lowering the federal funds rate, which increases the quantity of money B. stimulates aggregate supply by lowering the federal funds rate, which increases potential GDP C. increase employment, which increases real GDP D. increases bank reserves, which banks use to make new loans to businesses, which increases aggregate supply

Answer: A

By lowering the federal funds rate, the Fed ultimately increases aggregate demand, which increases real GDP and lowers unemployment.

The Fed’s choice of monetary policy strategy is

A. discretionary monetary policy B. the k-percent rule for money growth C. adjusting the federal funds rate to best fulfill its dual mandate D. setting the foreign exchange rate of the dollar Answer: C The Fed changes the federal funds rate to hit its target federal funds rate, the federal funds rate it believes will enable it to meet its dual mandate of price stability and maximum em ployment. 7.

A monetary policy rule is cause .

to discretionary monetary policy be-

A. superior; discretion limits what the Fed can do in a financial crisis B. inferior; a rule makes it harder for people to forecast the inflation rate C. superior; a rule keeps inflation expectations anchored D. equivalent; the Fed uses its discretion to set the rule Answer: C

By stabilizing inflation expectations, the Fed helps keep the financial markets and labor markets working well by ena bling people to make safer long-term commitments.

International Finance ANSWERS TO CHAPTER CHECKPOINTS

 Problems and Applications The table gives some data that describe the economy of Antarctica in 2050: Item

(billions of dollars)

Imports Exports of goods and services Net interest Net transfers Foreign investment in Antarctica Antarctica’s investment abroad

150 50 10 35 125 55

Use the table to answer Problems 1 and 2. 1.

Calculate Antarctica’s current account balance, capital and financial account balance, and the increase in Antarctica’s official reserves. For the current account balance, use the definition that CAB = NX + Net interest and transfers from abroad. CAB = $100 billion + (–$10 billion) + $35 billion = $75 billion. The capital and financial account balance equals foreign investment in Antarctica minus Antarctica’s investment abroad, which is $125 billion  $55 billion = $70 billion. Use the formula current account + capital account + official settlements account = 0. So, ($75 billion) + ($70 billion) +(official settlements account) = 0, The official settlements account balance is $5 billion. Antarctica’s official reserves decreased by $5 billion.

Is Antarctica a debtor nation or a creditor nation? Are its international assets increasing or decreasing? Is Antarctica borrowing to finance investment or consumption? Explain. Antarctica is a debtor nation because its net interest payment is negative.

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Antarctica’s net international assets are decreasing because foreign investment in Antarctica is increasing more than is Antarctica’s investment abroad. The value of Antarctica’s imports is $100 billion Antarctica dollars more than the value of its exports. So Antarctica is borrowing these funds. But we have no information about what Antarctica is doing with these funds so we cannot tell if Antarctica is borrowing for consumption or investment. For instance, if Antarctica has no private investment and government spending is not on capital goods, then Antarctica is borrowing for consumption. 3.

U.S. trade deficit grows The Commerce Department report said that exports of goods and services were $187.1 billion, while imports were $232.1 billion. Source: The New York Times, July 3, 2013 Explain how the United States pays for its net export deficit. The United States pays for its net exports deficit by borrowing from abroad. Therefore, the United States is a net borrower and has been so since 1983.

The U.S. dollar depreciates. Explain which of the following events could have caused the depreciation and why. • The Fed intervened in the foreign exchange market. Did the Fed buy or sell U.S. dollars? If the Fed intervenes in the foreign exchange market by selling dollars, it increases the supply of dollars and the exchange rate depreciates. However, if the Fed intervenes in the foreign exchange market by buying dollars, it decreases the supply of dollars and the exchange rate appreciates. • People began to expect that the U.S. dollar would depreciate. If people expect the dollar to depreciate, the demand for dollars decreases and the supply increases, which leads to an immediate depreciation of the U.S. dollar exchange rate. • The U.S. interest rate differential increased. If the U.S. interest rate differential increases, the demand for U.S. dollars increases and the supply decreases, and the exchange rate appreciates.

Chapter 34 . International Finance

• Foreign investment in the United States increased. If foreign investment in the United States increases, foreigners need U.S. dollars to make the investment. The demand for dollars increases, and the exchange rate appreciates. Suppose that the inflation rate is lower in Japan than it is in the United States, and that the difference in the inflation rates persists for some years. Use this information to work Problems 5 to 7. 5. Will the U.S. dollar appreciate or depreciate against the yen and will purchasing power parity be violated? Why or why not? The dollar will depreciate. Purchasing power parity might be violated for a while, but ultimately it is purchasing power parity that depreciates the dollar and appreciates the yen. 6.

Will U.S. interest rates be higher or lower than Japanese interest rates and will interest rate parity hold? Why or why not? The U.S. interest rate will be higher than the Japanese interest rate. The higher U.S. interest rate will compensate people who buy U.S. assets for the depreciation of the U.S. dollar. Interest rate parity will continue to hold regardless of any difference in the inflation rates. The exchange rate changes so that interest rate parity always holds

Explain how the expected future exchange rate will change. The inflation difference will influence the expected future exchange rate. Because the U.S. dollar eventually will fall in value, the expected future U.S. exchange rate will be lower than otherwise.

Suppose that the U.K. pound is trading at 1.82 U.S. dollars per U.K. pound and at this exchange rate purchasing power parity holds. The U.S. interest rate is 2 percent a year and the U.K. interest rate is 1.0 percent a year. What is the U.S. interest rate differential? What is the U.K. pound expected to be worth in terms of U.S. dollars one year from now? The U.S. interest rate differential equals 2 percent minus 1 percent, or 1 percent per year. For interest rate parity to hold, the U.K. pound must be expected to appreciate 1 percent over the year, so next year it is expected to be 1.01 × 1.82 U.S. dollars per U.K. pound, or 1.838 U.S. dollars per U.K. pound.

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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. CPI inflation was reported to be generally as expected, but not strong enough to justify expectations for an aggressive interest rate rise by Australia’s central bank next week. Source: Reuters, October 28, 2009 Explain why the expected rise of the Australian interest rate with no change in the U.S. interest rate lowered the current value of the Australian dollar against the U.S. dollar. Participants in the foreign exchange market had expected the Australian interest rate to rise. When that occurred in the future, the Australian dollar was expected to appreciate. The expected future appreciation of the Australian dollar increased the current demand for Australian dollars and decreased the current supply. However, when participants in the foreign exchange market revised their expectations about the future interest rate downwards, the Australian dollar was no longer expected to appreciate in the future. This change in expectations decreased the current demand for the Australian dollar and increased the current supply, which then lowered the current Australian exchange rate.

10. Read Eye on the Dollar on p. 897. When and why did the dollar rise against the euro and when and why did it fall? The dollar rose in 2014 and 2015. During that time, the dollar was expected to appreciate, that is, rise in value relative to the euro. The expected appreciation increased the demand for dollars and decreased the supply of dollars. The demand curve for U.S. dollars shifted rightward, the supply curve of U.S. dollars shifted leftward; consequently the U.S. exchange rate rose. The dollar fell between 2001 and 2008. Between those years, U.S. economic growth fell beneath economic growth in Europe, interest rates in Europe exceeded those in the United States, and the dollar was expected to depreciate. The negative U.S. interest rate differential and expected depreciation decreased the demand for dollars and increased the supply of dollars. The demand curve for U.S. dollars shifted leftward, the supply curve of U.S. dollars shifted rightward; consequently the U.S. exchange rate fell.

Chapter 34 . International Finance

 Additional Problems and Applications 1.

Read Eye on the Dollar on p. 897. If the European Central Bank starts to raise its policy interest rate before the Fed starts to raise the federal funds rate target, what do you predict will happen to the dollar/euro exchange rate? Illustrate your answer with an appropriate graphical analysis. If the European Central Bank starts to raise its interest rate before the Fed raises U.S. interest rates, the U.S. interest rate differential will shrink. The fall in the U.S. interest rate differential decreases the demand for U.S. dollars and increases the supply of U.S. dollars. As Figure 34.1 illustrates, the demand curve for U.S. dollars shifts leftward from D0 to D1 and the supply curve of U.S. dollars shifts rightward from S0 to S1. These changes lower the U.S. exchange rate, in the figure from 0.90 euros per dollar to 0.70 euros per dollar.

The table gives some data that describe the economy of Atlantis in 2020: Item

(billions of dollars)

Government expenditure Saving Increase in official reserves of Atlantis Net foreign investment in Atlantis Net taxes Investment

200 100 5 50 150 125

Calculate the current account balance, the capital and financial account balance, the government sector balance, and the private sector balance. The current account balance equals the sum of the private sector balance, saving minus investment, plus the government sector balance, net taxes minus government expenditures. In this case, the current account balance equals ($100 billion  $125 billion) + ($150 billion  $200), which is $75 billion. The capital and financial account balance plus the current account balance plus the official settlements account equals zero. So the capital account balance equals  ($75 billion)  ($5 billion), which is $80 billion.

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The government budget balance is equal to net taxes minus government expenditures, which is $150 billion  $200 billion, or $50 billion. The private sector balance is equal to saving minus investment, which is $100 billion  $125 billion, or $25 billion. 3.

The U.S. dollar appreciates, and U.S. official reserves increase. Explain which of the following events might have caused these changes to occur and why. • The Fed intervened in the foreign exchange market and sold U.S. dollars. If the Fed intervenes in the foreign exchange market by selling dollars, it increases the supply of dollars and the exchange rate depreciates. In this case, official holdings of foreign currency increase. •

The Fed conducted an open market operation and sold U.S. bonds. If the Fed sells bonds in an open market operation, the interest rate rises. The demand for dollars increases and the exchange rate rises. The U.S. dollar appreciates but there is no change in the nation’s official holdings of foreign currency.

•

People began to expect that the U.S. dollar would appreciate. If people expect the dollar to appreciate, the demand for dollars increases and the supply decreases, which leads to an appreciation of the U.S. dollar exchange rate. There is no direct effect on official holdings of foreign currency.

•

The U.S. interest rate differential narrowed. If the U.S. interest rate differential narrows, the demand for U.S. dollars decreases and the supply increases. The U.S. dollar depreciates. There is no direct effect on official holdings of foreign currency.

Which of the following events might have caused the euro to appreciate and why? • The European Central Bank sold euros in the foreign exchange market. If the ECB intervenes in the foreign exchange market by selling euros, the supply of euros increases. When the supply of euros increases, the euro depreciates. •

The Fed intervened in the foreign exchange market and bought U.S. dollars. If the Fed intervenes in the foreign exchange market by buying dollars, it is selling euros, which increases the supply of euros. When the supply of euros increases, the euro depreciates.

•

The EU interest rate differential increased. If the EU interest rate differential increases, the demand for euros increases, the supply decreases, and the euro appreciates.

Chapter 34 . International Finance

•

Profits increased in Europe, and U.S. investment in Europe surged. If foreign investment in Europe increases, foreigners, such as U.S. citizens, need euros to make their investments. The demand for euros increases, and the euro appreciates.

Use the following information to work Problems 5 and 6. Suppose that the euro keeps appreciating against the U.S. dollar. The Fed decides to stop the euro from appreciating (stop the U.S. dollar from depreciating) and intervenes in the foreign exchange market. 5. What actions might the Fed take in the foreign exchange market? Could these actions persist in the long run? Would the Fed’s actions prevent interest rate parity from being achieved? Why or why not? The Fed can buy U.S. dollars and sell euros. The Fed increases the demand for U.S. dollars and increases the supply of euros. The Fed cannot take these actions forever because eventually the Fed would run out of euros to sell. The Fed’s actions would not keep interest rate parity from being achieved. If the Fed is able to influence the exchange rate, interest rates in the nations would adjust so that, adjusted for risk, interest rate parity holds. 6.

Are there any other actions that the Fed could take to raise the foreign exchange value of the dollar? Explain your answer. The Fed can make an open market sale of bonds. An open market sale decreases the quantity of money. At least in the short run, when the quantity of money decreases the interest rate rises so that the U.S. dollar exchange rate would rise.

Use the following information to work Problems 7 and 8. In July 2011, the exchange rate between the U.S. dollar and the Brazilian real was 1.6 real per dollar. In the same month, the price of a Big Max was 9.36 real in Sao Paulo and $4.00 in New York. Brazil’s interest rate was 12 percent per year and the U.S. interest rate was 1 percent per year. Source: Pacific Exchange Rate Service and The Economist 7. Does purchasing power parity (PPP) hold between Brazil and the United States? If not, does PPP predict that the real will appreciate or depreciate against the U.S. dollar? The price of the Big Mac converted to U.S. dollars equals 9.36 real ÷ 1.6 real per dollar, which is $5.85. Purchasing power parity does not hold because a dollar buys more in New York than in Brazil. PPP predicts that Brazil’s exchange rate will depreciate (alternatively phrased, the U.S. exchange rate will appreciate). 8.

Does interest rate parity hold between Brazil and the United States? If interest rate parity does hold, what is the expected rate of appreciation or depreciation of the Brazilian real against the U.S. dollar? If the Fed raised

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the interest rate while the Brazilian interest rate remained at 12 percent a year, how would the expected appreciation or depreciation of the real change? 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 11 percent a year. If the Fed raised the U.S. interest rate, interest rate parity will continue to hold. Because the U.S. interest rate is now higher, the expected depreciation of the real is less. (The higher U.S. interest rate means that the U.S. interest rate differential increases. The demand for dollars in-creases and the supply decreases, so the dollar immediately appreciates—which means the real immediately depreciates. From this immediately lower real/dollar exchange rate, the expected depreciation in the future is lower.)

Chapter 34 . International Finance

 Multiple Choice Quiz 1.

The current account balance equals . A. exports minus imports plus net interest and net transfers B. net exports plus net foreign investment in the United States C. capital and financial account balance minus the official settlements account balance D. net exports plus the official settlements balance Answer: A Answer A is the definition of the current account balance. 2.

China’s official reserves have ballooned, fueled by strong foreign investment and large trade surpluses. China is a net and a nation. A. lender; debtor B. borrower; debtor C. lender; creditor D. borrower; creditor Answer: C China is using its large trade surpluses to lend to other nations. 3.

Net exports equal the . A. private sector balance plus the government sector balance B. private sector balance minus the government sector balance C. government sector balance minus the private sector balance D. private sector balance plus the government’s budget deficit Answer: A Table 34.3 shows that answer A is correct and contains recent U.S. data.

A net exports deficit will become a surplus if . A. the government budget deficit is turned into a surplus and the private sector has a surplus B. the private sector surplus adjusts to equal the government sector deficit C. private saving and government saving exceed private investment D. the country appreciates its currency Answer: A If both the government sector and the private sector have surpluses, the country lends these surpluses abroad and has a net exports surplus.

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The quantity of U.S. dollars demanded in the foreign exchange market increases if . A. the value of U.S. imports increases B. traders expect the future exchange rate to rise C. the U.S. interest rate rises relative to those in other countries D. the U.S. dollar depreciates against other currencies Answer: D The depreciation of the U.S. dollar increases the quantity of U.S. dollars demanded and results in a movement downward along the demand curve for U.S. dollars. 6.

The supply of U.S. dollars in the foreign exchange market increases if . A. the value of U.S. imports increases B. the U.S. interest rate differential decreases C. the U.S. dollar depreciates against other currencies D. the U.S. dollar is expected to appreciate against other currencies in the future Answer: B The decrease in the U.S. interest rate differential leads U.S. investors to demand more foreign assets, which increases the supply of U.S. dollars.

Purchasing power parity between euros and U.S. dollars . A. holds if the price of a good is the same number of euros or dollars B. means that the value of the euro and the dollar are equal C. always holds because exchange rates adjust automatically D. implies that international trade is competitive Answer: B The value of the currencies being equal means that these monies buy the same amounts of goods and services. 8.

The free floating yuan-U.S. dollar exchange rate will rise if in the foreign exchange market. A. the Fed agrees not to sell U.S. dollars B. the People’s Bank of China buys U.S. dollars C. the People’s Bank sells U.S. dollars that it holds on reserve D. the Fed does not buy yuan Answer: B If the People’s Bank of China did not buy U.S. dollars, the yuan would appreciate. By purchasing U.S. dollars, the People’s Bank of China can keep the exchange rate stationary.

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