Download ECO 110 – Introduction to Economics

ECO 110 – Introduction to Economics
Professor Mike Rizzo
Third COLLECTED Problem Set –SOLUTIONS This is an assignment that
WILL be collected and graded. Once again this assignment is to be
completed by your groups.
Assigned:
Due:
Monday, April 3rd
Monday, April 10th
1. Mankiw, Chapter 4: Problem #8 and Problem #10.
8.
10.
a.
Cigars and chewing tobacco are substitutes for cigarettes, since
a higher price for cigarettes would increase the demand for
cigars and chewing tobacco.
b.
An increase in the tax on cigarettes leads to increased demand
for cigars and chewing tobacco. The result, as shown in Figure
25 for cigars, is a rise in both the equilibrium price and quantity
of cigars and chewing tobacco.
c.
The results in part (b) showed that a tax on cigarettes leads
people to substitute cigars and chewing tobacco for cigarettes
when the tax on cigarettes rises. To reduce total tobacco
usage, policymakers might also want to increase the tax on
cigars and chewing tobacco, or pursue some type of public
education program.
a.
If the price of flour falls, since flour is an ingredient in bagels,
the supply curve for bagels would shift to the right. The result,
shown in Figure 27, would be a fall in the price of bagels and a
rise in the equilibrium quantity of bagels.
Figure 27
Since cream cheese is a complement to bagels, the fall in the
equilibrium price of bagels increases the demand for cream
cheese, as shown in Figure 28. The result is a rise in both the
equilibrium price and quantity of cream cheese. So, a fall in the
price of flour indeed raises both the equilibrium price of cream
cheese and the equilibrium quantity of bagels.
Figure 28
What happens if the price of milk falls? Since milk is an
ingredient in cream cheese, the fall in the price of milk leads to
an increase in the supply of cream cheese. This leads to a
decrease in the price of cream cheese (Figure 29), rather than a
rise in the price of cream cheese. So a fall in the price of milk
could not have been responsible for the pattern observed.
Figure 29
b.
In part (a), we found that a fall in the price of flour led to a rise
in the price of cream cheese and a rise in the equilibrium
quantity of bagels. If the price of flour rose, the opposite would
be true; it would lead to a fall in the price of cream cheese and
a fall in the equilibrium quantity of bagels. Since the question
says the equilibrium price of cream cheese has risen, it could
not have been caused by a rise in the price of flour.
What happens if the price of milk rises? From part (a), we
found that a fall in the price of milk caused a decline in the price
of cream cheese, so a rise in the price of milk would cause a rise
in the price of cream cheese. Since bagels and cream cheese
are complements, the rise in the price of cream cheese would
reduce the demand for bagels, as Figure 30 shows. The result
is a decline in the equilibrium quantity of bagels. So a rise in
the price of milk does cause both a rise in the price of cream
cheese and a decline in the equilibrium quantity of bagels.
Figure 30
2. Mankiw, Chapter 5: Quick quiz on p.109; Problem #6, #8 and #10.
Quick Quiz: If half of all farm crops are destroyed, then market supply will
fall leading to an increase in the price of crops (if the demand for crops is
sufficiently inelastic). For those farmers whose crops were not destroyed by
droughts, this price increase will allow them to make larger profits.
However, it makes little sense to destroy your own crops for two reasons.
First, one small farmer is unlikely to have an impact on crop prices, so even
if destroying product increased profits, it would not do so my much in this
case. Second, by destroying your own crops, if the price for some reason did
rise, you have less to sell, and it is not clear that you would make larger
profits by selling less at a higher price (it depends on the elasticity of
demand for your product). Only if all farmers destroyed their crops
together, for example through a government program, would this plan
work to make farmers better off.
6. Tom's price elasticity of demand is zero, since he wants the same
quantity regardless of the price. Jerry's price elasticity of demand is
one, since he spends the same amount on gas, no matter what the
price, which means his percentage change in quantity is equal to the
percentage change in price.
8.
a.
With a price elasticity of demand of 0.4, reducing the quantity
demanded of cigarettes by 20 percent requires a 50 percent
increase in price, since 20/50 = 0.4. With the price of cigarettes
currently $2, this would require an increase in the price to $3.33
a pack using the midpoint method (note that ($3.33 - $2)/$2.67
= .50).
b.
The policy will have a larger effect five years from now than it
does one year from now. The elasticity is larger in the long run,
since it may take some time for people to reduce their cigarette
usage. The habit of smoking is hard to break in the short run.
c. Since teenagers don't have as much income as adults, they are
likely to have a higher price elasticity of demand. Also, adults are
more likely to be addicted to cigarettes, making it more difficult to
reduce their quantity demanded in response to a higher price.
10. a. As Figure 2 shows, in both markets, the increase in supply reduces the
equilibrium price and increases the equilibrium quantity.
b.
In the market for pharmaceutical drugs, with inelastic demand,
the increase in supply leads to a relatively large decline in the
price and not much of an increase in quantity.
Figure 2
c.
In the market for computers, with elastic demand, the increase
in supply leads to a relatively large increase in quantity and not
much of a decline in price.
d.
In the market for pharmaceutical drugs, since demand is
inelastic, the percentage increase in quantity will be less than
the percentage decrease in price, so total consumer spending
will decline. In contrast, since demand is elastic in the market
for computers, the percentage increase in quantity will be
greater than the percentage decrease in price, so total
consumer spending will increase.
3. Mankiw, Chapter 6: Problems #2, #6, #7 and #11.
2.
a.
The imposition of a binding price floor in the cheese market is
shown in Figure 3. In the absence of the price floor, the price
would be P1 and the quantity would be Q1. With the floor set at
Pf, which is greater than P1, the quantity demanded is Q2, while
quantity supplied is Q3, so there is a surplus of cheese in the
amount Q3 – Q2.
b.
The farmers’ complaint that their total revenue has declined is
correct if demand is elastic. With elastic demand, the
percentage decline in quantity would exceed the percentage rise
in price, so total revenue would decline.
c.
If the government purchases all the surplus cheese at the price
floor, producers benefit and taxpayers lose. Producers would
produce quantity Q3 of cheese, and their total revenue would
increase substantially. But consumers would buy only quantity
Q2 of cheese, so they are in the same position as before.
Taxpayers lose because they would be financing the purchase of
the surplus cheese through higher taxes.
Figure 3
6.
If the government imposes a $500 tax on luxury cars, the price paid
by consumers will rise less than $500, in general. The burden of any
tax is shared by both producers and consumers⎯the price paid by
consumers rises and the price received by producers falls, with the
difference between the two equal to the amount of the tax. The only
exceptions would be if the supply curve were perfectly elastic or the
demand curve were perfectly inelastic, in which case consumers would
bear the full burden of the tax and the price paid by consumers would
rise by exactly $500.
7.
a.
b.
It doesn’t matter whether the tax is imposed on producers or
consumers⎯the effect will be the same. With no tax, as shown
in Figure 6, the demand curve is D1 and the supply curve is S1.
If the tax is imposed on producers, the supply curve shifts up by
the amount of the tax (50 cents) to S2. Then the equilibrium
quantity is Q2, the price paid by consumers is P2, and the price
received (after taxes are paid) by producers is P2 – 50 cents. If
the tax is instead imposed on consumers, the demand curve
shifts down by the amount of the tax (50 cents) to D2. The
downward shift in the demand curve (when the tax is imposed
on consumers) is exactly the same magnitude as the upward
shift in the supply curve when the tax is imposed on producers.
So again, the equilibrium quantity is Q2, the price paid by
consumers is P2 (including the tax paid to the government), and
the price received by producers is P2 – 50 cents.
Figure 6
The more elastic is the demand curve, the more effective this
tax will be in reducing the quantity of gasoline consumed.
Greater elasticity of demand means that quantity falls more in
response to the rise in the price of gasoline. Figure 7 illustrates
this result. Demand curve D1 represents an elastic demand
curve, while demand curve D2 is more inelastic. To get the
same tax wedge between demand and supply requires a greater
reduction in quantity with demand curve D1 than for demand
curve D2.
Figure 7
10.
c.
The consumers of gasoline are hurt by the tax because they get
less gasoline at a higher price.
d.
Workers in the oil industry are hurt by the tax as well. With a
lower quantity of gasoline being produced, some workers may
lose their jobs. With a lower price received by producers, wages
of workers might decline.
a.
Programs aimed at making the public aware of the dangers of
smoking reduce the demand for cigarettes, shown in Figure 13
as a shift from demand curve D1 to D2. The price support
program increases the price of tobacco, which is the main
ingredient in cigarettes. As a result, the supply of cigarettes
shifts to the left, from S1 to S2. The effect of both programs is
to reduce the quantity of cigarette consumption from Q1 to Q2.
Figure 13
b.
The combined effect of the two programs on the price of
cigarettes is ambiguous. The education campaign reduces
demand for cigarettes, which tends to reduce the price. The
tobacco price supports raise the cost of production of cigarettes,
which tends to increase the price.
c.
The taxation of cigarettes further reduces cigarette
consumption, since it increases the price to consumers. As
shown in the figure, the quantity falls to Q3.
4. Mankiw, Chapter 7: Problems #6, #8, #9, #10
6.
a.
The effect of falling production costs in the market for stereos
results in a shift to the right in the supply curve, as shown in
Figure 11. As a result, the equilibrium price of stereos declines
and the equilibrium quantity increases.
b.
The decline in the price of stereos increases consumer surplus
from area A to A + B + C + D, an increase in the amount B + C
+ D. Prior to the shift in supply, producer surplus was areas B
+ E (the area above the supply curve and below the price).
After the shift in supply, producer surplus is areas E + F + G.
So producer surplus changes by the amount F + G – B, which
may be positive or negative. The increase in quantity increases
producer surplus, while the decline in the price reduces producer
surplus. Since consumer surplus rises by B + C + D and
producer surplus rises by F + G – B, total surplus rises by C + D
+ F + G.
c.
If the supply of stereos is very elastic, then the shift of the
supply curve benefits consumers most. To take the most
dramatic case, suppose the supply curve were horizontal, as
shown in Figure 12. Then there is no producer surplus at all.
Consumers capture all the benefits of falling production costs,
with consumer surplus rising from area A to area A + B.
Figure 11
Figure 12
8.
a.
The effect of falling production costs in the market for
computers results in a shift to the right in the supply curve, as
shown in Figure 14. As a result, the equilibrium price of
computers declines and the equilibrium quantity increases. The
decline in the price of computers increases consumer surplus
from area A to A + B + C + D, an increase in the amount B + C
+ D.
Figure 14
Prior to the shift in supply, producer surplus was areas B + E
(the area above the supply curve and below the price). After
the shift in supply, producer surplus is areas E + F + G. So
producer surplus changes by the amount F + G – B, which may
be positive or negative. The increase in quantity increases
producer surplus, while the decline in the price reduces producer
surplus. Since consumer surplus rises by B + C + D and
producer surplus rises by F + G – B, total surplus rises by C + D
+ F + G.
Figure 15
b.
Since adding machines are substitutes for computers, the
decline in the price of computers means that people substitute
computers for adding machines, shifting the demand for adding
machines to the left, as shown in Figure 15. The result is a
decline in both the equilibrium price and equilibrium quantity of
adding machines. Consumer surplus in the adding-machine
market changes from area A + B to A + C, a net change of C –
B. Producer surplus changes from area C + D + E to area E, a
net loss of C + D. Adding machine producers are sad about
technological advance in computers because their producer
surplus declines.
c.
Since software and computers are complements, the decline in
the price and increase in the quantity of computers means that
the demand for software increases, shifting the demand for
software to the right, as shown in Figure 16. The result is an
increase in both the price and quantity of software. Consumer
surplus in the software market changes from B + C to A + B, a
net change of A – C. Producer surplus changes from E to C + D
+ E, an increase of C + D, so software producers should be
happy about the technological progress in computers.
d.
Yes, this analysis helps explain why Bill Gates is one the world’s
richest men, since his company produces a lot of software that
is a complement with computers and there has been
tremendous technological advance in computers.
9.
a.
Figure 16
Figure 17 illustrates the demand for medical care. If each
procedure has a price of $100, quantity demanded will be Q1
procedures.
Figure 17
b.
If consumers pay only $20 per procedure, the quantity
demanded will be Q2 procedures. Since the cost to society is
$100, the number of procedures performed is too large to
maximize total surplus. The quantity that maximizes total
surplus is Q1 procedures, which is less than Q2.
c.
The use of medical care is excessive in the sense that
consumers get procedures whose value is less than the cost of
producing them. As a result, the economy’s total surplus is
reduced.
10.
d.
To prevent this excessive use, the consumer must bear the
marginal cost of the procedure. But this would require
eliminating insurance. Another possibility would be that the
insurance company, which pays most of the marginal cost of the
procedure ($80, in this case) could decide whether the
procedure should be performed. But the insurance company
does not get the benefits of the procedure, so its decisions may
not reflect the value to the consumer.
a.
Figure 18 illustrates the effect of the drought. The supply curve
shifts to the left, leading to a rise in the equilibrium price from
P1 to P2 and a decline in the equilibrium quantity from Q1 to Q2.
Figure 18
b.
If the price of water is not allowed to change, there will be a
shortage of water, with the shortage shown on the figure as the
difference between Q1 and Q3.
c.
The system for allocating water is inefficient because it no
longer allocates water to those who value it most highly. Some
people who value water at more than its cost of production will
be unable to obtain it, so society’s total surplus is not
maximized.
The allocation system seems unfair as well. Water is allocated
simply on past usage, rewarding past wastefulness. If a family’s
demand for water increases, say because of an increase in
family size, the policy doesn’t allow them to obtain more water.
Poor families, who probably used water mostly for necessary
uses like drinking, would suffer more than wealthier families
who would have to cut back only on luxury uses of water like
operating backyard fountains and pools. However, the policy
also keeps the price of water lower, which benefits poor
families, since otherwise more of their family budget would have
to go for water.
d.
If the city allowed the price of water to rise to its equilibrium
price P2, the allocation would be more efficient. Quantity
supplied would equal quantity demanded and there would be no
shortage. Total surplus would be maximized.
Whether the market allocation would be more or less fair than
the proportionate reduction in water under the old policy is
difficult to say, but it is likely to be fair. Notice that the quantity
supplied would be higher (Q2) in this case than under the water
restrictions (Q3), so there is less reduction in water usage. To
make the market solution even more fair, the government could
provide increased tax relief or welfare payments for poor
families who suffer from paying the higher water prices.
5. Suppose the city of Danville decides that it needs to crack down on the
consumption of unhealthy foods, so in all of its infinite wisdom, it
decides to ban the production and consumption of pizza. Please
describe what would happen to the market for pizza after this ban has
enacted. Do you think the ban would have its desired impact on
health outcomes in Danville? Can you think of any economic actors
that would be winners in response to such a policy change? If so,
might this suggest to you why this law might have been passed in the
first place?
First note that making something illegal does not put an end to the supply
and demand process. After this law passes, it is likely that the supply of
pizza becomes more inelastic (rotates inward) and that demand is relatively
unaffected (I would consider answers that claim pizza demand will fall a little
bit). This change would end up producing a higher equilibrium price and
lower equilibrium quantity of pizza sold. What other market impacts would
their be? Well, since it becomes more profitable to make pizza, but it is
illegal, we’d see a black market in pizza emerging and those that produced
the pizza would not only be those that made really good pizza, but also those
that are really good at evading the law. Since the quantity of pizza sold
would fall a bit, you might think health outcomes would improve. However,
two unintended consequences are likely to occur. First, the level of crime is
likely to increase, making Danville less healthy (i.e. safe). Second, since the
risk of getting caught selling a pizza is higher, producers might begin to
make “more potent” pizza. That is, they might start offering extra cheese as
the base ingredient. They might add specialty meats and veggies and
cheeses. And, while the number of pizzas consumed might be lower, each
pizza that is consumed may well be less healthy than what prevailed before
the ban – making “Danville” less healthy than before the law.
It is easy to see who the winners would be. Those that have a comparative
advantage in crime and those in law enforcement that are able to grant
favors or look away in exchange for a kickback of the now illegal businesses.
Second, and less malignant, is that non-pizza producers stand to benefit a
great deal. Health food stores, supermarkets, Mexican restaurants, etc. all
stand to benefit from pizza being banned – and as usually happens in the
real world – these groups might have lobbied the government of Danville for
the pizza banning on the grounds of “health concerns” for the citizens of
Danville but the health they really are concerned about is their own bottom
lines.
6. The Alfred Dunhill store in London features classic motorcycles, model
planes and a humidor, while an Armani store in Milan has video games
in the basement. Many high end stores are spending large sums of
money sponsoring men’s nights by sponsoring pizza, beer and TV
nights at their stores. These efforts cost money and reduce the overall
amount of foot traffic in a store. So, why do you suppose high-end
retailers choose to do this?
If the demand for the products in the store is sufficiently inelastic, then
Dunhill might want to sell more high priced items but in lower quantities than
more lower priced items in higher quantities. By offering these enticements
to men, they are likely raising the image of the store, and making it more
comfortable for them to spend more money on any one purchase than if they
were running through a mall with their spouses and just “browsed” in the
Dunhill store.
7. Based on what you learned about the market process, briefly evaluate
the claim by many Marxists that competitive forces corrupt the
fairness of resource allocation in a capitalist system. Is what you
learned about the nature of market competition consistent with the
Marxist doctrine that entrepreneurs are oppressors and consumers and
workers are oppressed? Why or why not?
I’ll leave this as a self-evaluative exercise. This aspect of capitalism is yet
another one that is misunderstood by Marxists. Recall that the type of
competition espoused by the free-market system is that between demanders
themselves and that between suppliers themselves. The essence of a market
economy is that buyers compete with buyers to gain the favor of sellers and
that sellers compete with sellers to gain the favor of buyers. To understand
what is exploitive and unfair, consider the following PS questions.
8. Price controls are meant to prevent money prices from rationing scarce
residential space and are often meant to keep the wealthy from
obtaining more than the poor. Why do you suppose that most of New
York City’s rent controlled apartments are occupied by relatively
wealthy people?
Wealthy people seem to have an advantage in discovering and using the new
discriminatory rationing criteria that come unto play when money prices are
not allowed to perform the task of allocating scarce goods. Approximately
the same people get the goods. But the suppliers of the goods no longer get
the same rewards. That’s why deterioration sets in soon after rent controls
are imposed. Suppose that a person with a very low income who is paying
$400 a month for a rent-controlled apartment in Greenwich Village knows
that others are willing to pay $2500 to rent that apartment. Don’t you think
a deal will be made that will put a wealthier person in that unit while making
the occupant a lot less poor than he was while living there?
9. Centre College recently completed renovations and additions to its
athletic complex, Sutcliffe Hall. In Sutcliffe there is a faculty-staff
locker room that contains approximately 50 lockers. It has been
observed that well over 100 people use that locker room when they
are working out. Initially, all of these lockers were intended to be
temporary (i.e. you use them while at the gym and then take
everything home with you when you leave). Many people have
expressed a desire for permanent lockers.
i. Since locker space is a scarce resource, using what you
have learned in economics, how would you recommend
that Centre College allocate these lockers to the people
that want to use them?
I’d recommend Centre charge a fee or auction off the lockers.
ii. An economist here at Centre (yes, an ACTUAL economist)
publicly declared that lockers should be allocated via a
lottery or by a measure of frequency of use of Sutcliffe
Hall. Evaluate these two mechanisms from an economic
perspective.
While may seem fair, neither of these mechanisms ensure that those people
that value locker use the most will have access to the lockers. Even under a
frequency requirement, it is not clear that those people that come to the gym
every day value lockers more than those that come 3 days a week. What if I
bicycle to work every day – it becomes far less convenient for me to travel
with my gym equipment than for someone that takes a car. Furthermore,
there is no reason to believe that a secondary market for lockers will not
arise – enriching those that were fortunate enough to snag a locker, costing
Centre the opportunity to charge for a locker, and ending up costing those
that end up with lockers much more than would have been the case under a
straight price system.
iii. Now, evaluate these two mechanisms from a moral
perspective (in other words, is it really true that these
methods are more fair than what your proposed solution
would be?).
Who decides what is fair? What is fair in this case? It is certainly the case
that the auction system is far less corruptible than alternative allocation
schemes. While these schemes may result in some lucky people who were
unable to afford lockers now being able to get them, it is hard to see how
this is any more fair than a price mechanism (particularly since a secondary
market is likely to emerge).
10.Why do you think that today in the United States the largest
denominated bill is $500? The $1,000, $5,000 and $10,000 bills no
longer circulate as money.’
Oops. I think largest bill is now only $100. In any case, smaller
denomination bills raise the transactions costs for criminals. Before, perhaps
ten million dollars could fit into a briefcase when it was made up of $1,000
notes. With $100 notes, it would now take ten briefcases of money to fulfill a
10 million dollar criminal deal. Not only does this increase transaction costs,
but it also increases the chances of getting caught. This is why large
denomination bills were abolished. Here are pictures of old US Currency and
links to a web page describing them
(http://www.moneyfactory.gov/document.cfm/18/118
). Wikipedia also has a very good entry on currency at
http://en.wikipedia.org/wiki/Large_denomination_bills_in_U.S._currency
11.Would you be in favor of price-gouging legislation in the aftermath of a
natural disaster? Why or why not?
Read this article for an example of why it might not make sense to support
price gouging legislation: http://www.mises.org/fullstory.aspx?control=1593
Questions on “Are We Scaring Ourselves to Death?”
12.How is it that well-intentioned public policies designed to reduce risk
often make people LESS safe?
Think of the unintended consequences of these policies. For example, air
bag requirements lower the cost of driving aggressively and make roads less
safe for pedestrians. Think of programs to remove asbestos actually putting
more asbestos in the air. Think of all of the money spent to alleviate one
type of risk at the expense of other risks.
For these next three ques, I’ll leave the answers for you to discuss
among yourselves.
13.What might explain why the perception that crime is worsening is
more widely held than the knowledge that crime has actually remained
constant or is falling? In other words, who benefits from these
perceptions being widely held?
14.To think about – is freedom worth some risk? Should you be “allowed”
to take the risk of riding a bicycle without wearing a helmet?
15.Why would Congress create regulatory agencies that try to reduce risk
to an impossible standard of zero? To think about - How come it is so
difficult to convince them that they are committing statistical murder?
To think about further – would you rather the FDA keep potentially
lifesaving drugs off the market for years (sometimes decades) or have
them brought to market but with the risk that “someone” might be
hurt by them?
16.Explain the difference between positive economics and normative
economics.
Positive economics is the study of the theory and predictions of the theory of
economics. In some sense, it is a study of the conditions and outcomes of
the world around us as it currently exists. Normative economics is the
analysis of “what should be” – it entails a value judgment and different
people could look at the same positive economic model and apply a different
normative claim to it. Positive economics is focused on questions of
efficiency (the size of the pie) while normative economics is focused on
questions of equity and desirability.
17.The magic of economics can be appreciated by the extraordinary
degree of social coordination required to allocate scarce resources to
competing uses. In a market economy, what is the mechanism that
binds each agent together to promote this coordination? How does
this mechanism work to ensure that Rizzo gets his coffee at Speedway
every morning (in might help you to think about whether the
Columbian coffee farmer, or the truck driver, or the coffee wholesaler
care about me)?
The mechanism is the price system. And it requires no a priori knowledge
about people’s desires or abilities; it requires no additional steps to
incentivize producers and consumers; it requires no central planning board to
ensure that social welfare is being maximized.