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Solutions to
Problems
CHAPTER 1
1. Answers will vary, but should include the notion that each activity takes time away from
the pursuit of other activities (opportunity cost) and that each activity provides benefits
in the form of satisfaction or additional income. One must compare both the costs and
the benefits of each activity. Each activity is limited because as more time is spent on
any one activity, it yields smaller additional benefits, and activities are foregone.
2. Answers will vary. Clearly, a focus of the election was what to do with the surplus in the
federal budget and how to maintain the solvency of Social Security as the baby boomers
moved toward retirement. In addition, the funding of Medicare was mentioned
frequently. At the time of the election, the economy was in the 10th year of an
expansion for which Al Gore wanted credit.
3. (a) Pos.
(b) Norm.
(c) That Chile should not be allowed to join NAFTA is a normative statement. However,
the reasons given are examples of positive economic analysis.
(d) Pos.
(e) Pos.
(f) Norm.
4. Average cost is $1.1719.95  17 . Marginal cost is $0.
5. (a) Shopkeepers would gain by greater access to customers and higher profits. All city
residents would gain, because greater access will generate higher sales and greater
sales tax revenues. Consumers gain due to the opportunity cost of time not spent
waiting in traffic jams.
(b) Losers would include shopkeepers closer to the other, older bridge whose customers
choose to shop closer to the new bridge. Any taxpayers for whom the extra taxes
exceed the added benefit of the new bridge would also lose.
(c) The gains/losses could be measured by adding up the value of all the time saved not
waiting in line. We might say the bridge is efficient if the value of the time saved
were greater than the cost of building the bridge.
1
6. (a) Since gambling is not mandatory, only those who want to will gamble. The state
should allow the market to provide what people want. Tax revenues are in essence
paid voluntarily.
(b) It has been argued that gambling casinos bring with them higher crime and
“undesirable” elements. In addition, gambling can be addictive, and it often leads
some who can least afford it into poverty and bankruptcy. Thus, opponents argue
that wanting to gamble may not be strictly voluntary. Clearly allowing casino
gambling may produce more than just the enjoyment of gambling.
(c) The most frequent argument against casino gambling is that lower income
households tend to gamble away more of their incomes than do higher income
households. Thus, the taxes collected from gambling come predominantly from lower
income households and often from gambling addicts.
7. (a) Tuition (which could have been spent on other things), forgone wages, study time,
etc.
(b) All the money (gas, depreciation of the car, etc.) could have been spent on other
items; time spent en route could have been used for other activities.
(c) A better grade, no headache, perhaps admission to a better grad school, a higherpaying job. He has traded off an investment in human capital (staying in to study)
for present consumption (going to the party).
(d) The other things that $200 could buy.
(e) The $1 million could have been invested in other profit-making ventures or projects
or it simply could have been put into the bank or loaned out to someone else at
interest.
(f) From the standpoint of the store, Alex is free. From Alex’s standpoint he gives up
other uses of time and wages that could be earned elsewhere.
CHAPTER 1 APPENDIX
1. The slopes are as follows: line 1: 5; line 2: –5; line 3: 1; line 4: –1; line 5: slope is 1 as X
goes from 0 to 20, and –1 as X goes from 20 to 40; line 6: –250.
2. Answers will vary.
(a) Negative slope. As price rises, quantity of apples purchased falls.
(b) Positive (and declining) slope. As income rises, taxes rise, but the rise in taxes is
less at higher incomes than at lower incomes.
(c) Negative (and declining) slope. As mortgage rates fall, home sales increase, but the
increase in home sales is more at lower mortgage rates than at higher mortgage
rates.
(d) Negative, then positive slope. As young children get older, they run faster, but as
adults get older (beyond a certain age), they run slower.
(e) Positive slope. Greater sunshine leads to greater corn yield.
(f) Positive, then negative slope. Up to a point, more fertilizer increases corn yield, but
beyond a certain point, adding more fertilizer actually decreases the yield.
3. The slopes are as follows:
(a) –2
(b)  4
CHAPTER 2
(c) 6
(d) 1 500 or –.002
1. Answers will vary, but should include:
(a) The value of alternative uses of time
(b) The value of alternative uses of time including studying
(c) Forgone opportunities to spend the same amount of money
(d) The value of the goods and services that taxpayers would have purchased
(e) The alternative uses to which those resources could have been put by the
government or the value of the goods and services that taxpayers would have
purchased
(f) The forgone salary that you would have earned in a more traditional job
(g) The forgone salary that you would have earned and the value of the alternative uses
of time.
2. Disagree. To be efficient an economy must produce what people want. This means that
in addition to operating on the ppf (resources are fully employed, best technology is
being used) the economy must be operating at the right point on the ppf.
3. (a) For Kristen
potholder is
(b) Anna has a
opportunity
potholder).
W
(c)
the “cost” of a potholder is five wristbands; for Anna the cost of a
six wristbands. Kristen has a comparative advantage in potholders.
comparative advantage in the production of wristbands because the
cost (1/6 potholder) is lower for Anna than it is for Kristen (1/5
W
300
240
0
0
P
P
60
40
Kristen
Anna
(d) Kristen: 150 wristbands and 30 potholders. Anna: 120 wristbands and 20 potholders.
Total wristbands  270 . Total potholders  50 .
(e) 285 wristbands and 51 potholders.
(f) Kristen should completely specialize in potholder production and earn
60  $5.50  $3.30 . Anna should completely specialize in wristband production and
earn 240  $1  $240 . Maximum combined revenue is $570.
4. (a) Depends on her state of mind and income. If she will be paying for college, she may
have to work more later. In a sense, she is trading future work for present
consumption. On the other hand, if she is really stressed out, taking time off may
well make her a more productive student and earn her higher grades later on.
(b) Sacrificing present consumption for the future benefits of losing weight. For most
people, dieting and working out are difficult. The future benefits of feeling well and
being healthy make it worthwhile for many.
(c) Time and money spent today on maintenance can be thought of an investment in the
future—avoiding costly repair bills and/or the inconvenience of breaking down on
the road. (“Pay me now or pay me later.”)
(d) Present time saved vs. risk of an accident or a ticket, which could be costly.
5. (a) Blah
Blah
(b) Blah: fruit
Figistan: timber
(c)
Fruit
Fruit
36,000
12,000
9,000
4,000
4,000 6,000
Timber
9,000 12,000
Timber
(d) Figistan: 800 workers to timber
400 workers to fruit
produces 4000 of each
Blah:
900 workers to timber
300 workers to fruit
produces 9000 of each
(e) Figistan moves all labor to timber and produces 6000 board feet
Blah moves to 150 out of timber into fruit
450 in fruit produces 13,500 baskets; 750 in timber produces 7,500 ft.
Blah trades 4200 baskets to Figistan for 1800 board ft.
Blah ends up with 9300 of each; Figistan ends up with 4200 of each
Both move beyond their individual ppf’s.
Y
6. (a) A straight-line ppf curve intersecting the Y axis
at 1,000 units of luxury goods and intersecting
1,000
the X axis at 500 units of necessity goods. These
are the limits of production if all resources are
(b) used to produce only one good.
Unemployment or underemployment of labor
would put the society inside the ppf. Full
(c) employment would move the society to some
point on the ppf.
0
Answers will vary, but the decision should be
X
500
based on the relative value of necessities and
Necessity
luxuries, and the degree of concern that all
fellow citizens have enough necessities.
(d) If left to the free market, prices would (at least ideally) be determined by market
forces; incomes would be determined by a combination of ability, effort, and
inheritance. It would be up to each individual to find a job and determine how to
spend the income.
7. According to the News Analysis box on page 38 of the text, countries like Poland,
Hungary, and the Czech Republic have been making progress economically, while poorer
countries like Albania, Bulgaria, and Romania have had more of a struggle. Differences
are due to factors such as geography (and in particular, proximity to the West), history
and culture, and government policies.
8. (a) none
(d) (c and e)
(b) (e and f)
(e) (d and e)
(c) (a and e)
(f) (b and e)
9. (a)
50
40
after new technology
30
20
10
0
20
40
60 80 100 120 140 160
Loaves of bread
(b) Yes, increasing cost applies. The opportunity cost of the first 15 million loaves of
bread is 4 ovens, of the next 15 million loaves, 6 ovens; and so on.
(c) Over time, as the number of ovens increases, the capacity to produce bread with the
same quantity of other resources will also increase. Thus, the production
possibilities curve will shift out horizontally to the right. The vertical intercept
(maximum possible oven production) will remain unchanged, but the horizontal
intercept (maximum possible bread production) will increase.
(d) See graph in a above.
(e) Before the new technology, production of 22 ovens left enough resources to produce
45 loaves of bread. After the new technology, production of 30 ovens leaves enough
resources to produce 60 loaves of bread.
CHAPTER 3
1. (a) Title:
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(b)
P
S1
S2
$55
$42
0
D
Q
100-pound barrels of cranberries
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(d)
P
P2
S
P1
0 Q
s
D
Q Qd
Bread
Q
(e)
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(b) It depends on whether demand responds to the lower price and by how much. The
diagram in (a) suggests that if price was lowered by a lot the stadium would be
filled. If demand is “elastic” enough the quantity demanded will increase by more
than the fall in ticket price and revenues will rise. If demand is not responsive
enough, the quantity demanded may not increase enough to offset the fall in ticket
prices, and revenues will fall. The easiest example of the latter would occur if
demand were “perfectly inelastic,” which implies that no one else would come to the
game despite the lower price.
(c) The price system was not allowed to work to ration the Seattle tickets. Some other
rationing device must have been use(d) Perhaps people stood in line or queue(d)
Perhaps there was a lottery. In all likelihood there would be a secondary market for
the tickets (“scalpers”). You could no doubt find them for sale on line at a high price.
3. If the supply of new homes kept pace with
the expanding demand, prices would
remain constant. The supply curve shifts
to the right at the same rate as the
demand curve shifts to the right:
P
S1
S2
P1 = P1
D1
0
D2
Q
4. (a) Disagree. They are complements.
(b) Agree.
(c) Disagree. A rise in income will cause the demand for inferior goods to fall, pushing
prices down.
(d) Disagree. Sure they can. Steak and lobster are both normal goods.
(e) Disagree. Price could go down if the shift of supply is larger than the shift of
demand.
(f) Agree.
P
5. If the price of tobacco is supported by
S2
limiting land used to grow it, then the
S1
supply curve for tobacco shifts to the left.
The anti-smoking publicity works to shift
the demand curve to the left. Both of these
A
B
policies
work
together
to
reduce
D1
consumption of tobacco.
D2
0
6. (a) A simple demand shift;
diagram for both cities.
same
Q2 Q1
Quantity of tobacco
(b) Rightward shift of supply with new
development; leftward shift of demand
with falling incomes; same diagram for
both cities. (Assumes the shifts are equal.)
S
P2
S
P1
D1
D2
Housing quantity
P2
P3
S1
D2
D3
Housing quantity
(c) Trade-up buyers shift demand in the higher-income towns and supply in the lowerincome towns.
S1
S
P2
P1
P1
P2
D1
Housing quantity,
higher income towns
(Boston area)
S2
D2
D
Housing quantity,
lower income towns
(Boston area)
7. (a) This sequence confuses changes in demand (shifts of the demand curve) with
changes in quantity demanded (movements along a demand curve). First, a demand
shift does cause price to rise. As price rises, the quantity supplied increases along
the supply curve, and the quantity demanded declines along the demand curve as the
market moves to reestablish equilibrium. Nothing here suggests that demand shifts
back down, or that prices will fall back to their original levels.
(b) This sequence confuses a change in price (per unit) with a change in total spending
on meat. When price falls, the quantity demanded increases along the demand curve.
Thus, the total amount spent (price  quantity demanded) depends on whether
quantity demanded goes up by more than price per unit falls. Total spending could
increase if demand responds strongly to the lower price.
8. (a) P decreases, Q decreases
P
(b,
d)
P increases, Q increases
P
S
S
P0
P1
P1
A
B
B
A
P0
D1
D0
D1
D0
Q1 Q0
Q0 Q1
Q
(c) P increases, Q decreases
P
S1
Q
(e) P decreases, Q increases
P
S0
S0
P1
P0
S1
P0
B
A
P1
A
B
D
D
Q1 Q0
Q
Q1
Q
Q0
9. The speaker is confusing a demand shift with a movement along the demand curve,
incorrectly using the term “increase in demand” for both. A full, correct statement
would be: “An increase in demand (rightward shift) causes equilibrium price to rise. In
turn, the rise in price causes a decrease in quantity demanded—a movement along the
new demand curve. But this decrease in quantity demanded is smaller than the initial
increase in demand, and so increases in demand do not cancel themselves out.”
10. (a)
Quantity
Demanded
(in 90
Millions)
80
70
60
50
Price
$.50
$1.00
$1.50
$2.00
$2.50
(b) Quantity
demanded
equals
quantity supplied at P  $1.50 , with
quantity = 70 million dozen eggs.
Quantity Supplied
(in Millions)
30
50
70
90
110
(c)
$
5.00
S
1.50
D
0
11. (a)
70
100
Quantity
S0
S1
R0
B
S
R1
A
R1
R0
D1
D
D0
Q0 Q1
Q
Q0 Q1
Subsidies
Vouchers
The demand side strategy (vouchers) results in higher rents.
(b) Critics believe that the supply curve
for low-income housing looks like this:
Q
S
R2
R1
D1
D0
Q
12. (a)
$
15
10
5
(b) Q d  Q s  300  20 P  20 P  100  P  $10 .
Substitute P  $10 into either the demand
or supply equation to get Q  100 .
(c) With P  $15 , producers would want to
supply
pizzas,
but
20 15  100  200
bg
bg
consumers
would
want
to
buy
300  20 15  0 pizzas. There would be an
excess supply of pizzas, which would
bring the price down. As the price
100
200
300
decreased,
quantity
supplied
would
Quantity of pizza
decrease while quantity demanded would
increase until both were equal at a price
of $10 and quantity of 100.
(d) The new market demand for pizzas would be Q d  600  40 P .
(e) Q d  Q s  600  40 P  20 P  100  P  700 60  $11.67 . Substitute P  $11.67 into either
the demand or supply equation to get Q  133 .
0
CHAPTER 4
1. (a)
(b)
(c)
(d)
2. (a) Disagree. Every demand curve hits the quantity axis because of diminishing
marginal utility . . . at a
price of zero, there is a limit to how much one can or wants to consume. The
argument that at some price demand goes to zero explains why all demand curves
hit the price axis.
(b) Disagree. If demand is elastic (great than 1 in absolute value) a price decline will
lead to more spending. Spending is PxQ, and Q goes up by a bigger percentage than
P goes down.
(c) Disagree. Every straight line demand curve is both elastic (to the left of its
midpoint) and inelastic to the right of its midpoint.
3.
P
S
P*
Px
0
Ticket price
D
Q
Excess
demand
The diagram shows that some people are
willing to pay a very high price (even
higher than P*) for the tickets. Some
nonprice rationing system was used to
allocate the tickets to people willing to
pay as little as Px . What a scalper does is
pay those near Px more than they paid for
the tickets and then sells the tickets to
someone nearer or even above P*. Since
both the buyers and sellers engage in the
trade voluntarily, both are better off and
the exchange is efficient.
4. The subsidy does increase the “cost” of planting—there is now an opportunity cost. (By
planting, the farmers will have to give up the subsidy.) The subsidy will clearly lead to
fewer acres of production and higher farm prices. In effect, it shifts the supply curve to
the left.
5. Disagree; this is not hard to explain. The law of demand does say that higher prices
should lead to lower demand, but that refers to a change in the quantity demanded, a
movement along a demand curve. An increase in demand (a rightward shift of the
demand curve) would result in a higher price. Therefore, a sharp increase in the
demand for apartments in New York City is entirely consistent with a sharp increase in
rent, which is the price of those apartments.
6. (a) Wheat market
(b) Hamburger market
P
P
S1
S
S
Ps
P1
Pe
P0
D1
D
Qs Qe
(c) Gasoline market
D0
Q
Q0 Q1
Q
7. (a)
(b)
W
unemployment
= excess supply
—
S
W
D
0
LD
LS
L
8. (a)
(b) With free trade in oil, Americans would pay $30 per barrel. At this price, the U.S.
demand schedule shows that Americans would buy 15 million barrels per day. The
U.S. supply schedule shows that U.S. producers would supply 6 million barrels per
day, with the remainder—9 million barrels—imported from foreign sources.
(c) With a tax of $4 per barrel, Americans would have to pay $34 for imported oil.
Quantity demanded would decrease from 15 million to 13 million barrels. Of this,
American producers would supply 10 million barrels, whereas imports would be cut
back from 9 million to 3 million barrels. The U.S. government would collect a tax of
$4  3 million  $12 million per day.
(d) American oil consumers are harmed by the tax; they are paying a higher price for
oil. American oil producers are helped by the tax; they receive a higher price for oil,
and this induces them to produce more oil. Foreign oil producers are harmed,
because Americans buy less imported oil. Finally, the U.S. government (and the U.S.
taxpayer generally) benefit from the tax revenue.
9. (a) Using demand and supply data for the United States only, equilibrium price is $36
and equilibrium quantity is 12 million barrels.
(b) With a price ceiling of $34, quantity demanded equals 13 million barrels, while
quantity supplied equals 10 million barrels. There is an excess demand of 3 million
barrels.
(c) Quantity supplied will determine the quantity purchased. In a market system, no one
can be forced to buy or sell more than he or she wants to. Under conditions of excess
demand, suppliers will supply only as much as they want, and some consumer
demand will go unsatisfied.
10. At $8 and 6 million meals: CS = $18 million; PS = $18 million; total = $36 million
At 3 million meals: CS = $13.5 million; PS = $13.5 million; total = $27 million
Deadweight loss = $9 million
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11. (a) Between Points A and B: –3.666. Between Points C and D: –1. Between Points E and
F: –0.273.
(b) Starting at $50, revenues would fall by $4,000, from $10,000 to $6,000. Starting at
$30, revenues would remain constant at $12,000. Starting at $10, revenues would
rise by $4,000, from $6,000 to $10,000.
(c) When demand is elastic (e.g., between Points A and B), a price increase will lead to a
revenue decline. When elasticity is unitary (e.g., between Points C and D), a price
increase will leave revenues unchanged. When demand is inelastic (e.g., between
Points E and F), a price will increase revenue.
12. The key here is that total revenue is equal to P  Q . When price rises (cab fares go up),
quantity demanded goes down, depending on the elasticity of demand. Cab drivers who
were expecting a 10% increase in revenues were expecting no loss of riders. They
expected demand to be perfectly inelastic. But while revenues did not go up 10%, they
did go up. Thus, the increase in price was more than the decrease in riders, thus the
percentage decrease in Q was less than the percentage increase in price: Demand in fact
was inelastic.
13. (a) % change in
(b) % change in
(c) % change in
(d) % change in
14. (a) –1.2
P  50.0% ;
P  23.7% ;
P  97.2% ;
P  28.6% ;
% change in
% change in
% change in
% change in
(b) +10%
Q  28.6%
Q  15.4%
Q  66.7%
Q  28.6%
(c) +15%
Elast.
Elast.
Elast.
Elast.
 .57
 .65
 .69
= -1.0
(d) +12%
(e) +.67
15. (a) No. Because demand is elastic, an increase in price will lead to a larger percentage
decrease in quantity demanded, so revenue P  Q will fall if P is increased.
b g
b g
(b) No. Because demand is inelastic, a decrease in prices will lead to a smaller
percentage increase in quantity, so revenue P  Q will fall if P is cut.
16. (a) %Q  %P  0.2
Thus %P  %Q  0.2  10%  0.2  0.10  0.2  0.50  50% . Price would rise to $2.10.
(b) A price ceiling at $1.40 per gallon would create a shortage of gasoline. The result
might be long lines at gas stations and perhaps a black market in gasoline.
17. (a) Disagree. The top half of the demand curve is elastic.
(b) Disagree. Price would fall but firms would earn more revenue because demand is
elastic over the range of prices shown in the graph.
18.
P
P
S1
S1
S2
S2
P1
P2
P1
P2
D1
D2
D
0
0
Q1 Q2
Q1 Q2
Q
Q
The figure on the left shows that legalization would reduce the cost of supplying drugs
and shift the supply curve to the right. A successful advertising campaign would shift
the demand curve to the left. The unambiguous result would be a lower price of drugs
that would reduce the profitability of production. The relative sizes of the supply shift
and the demand shift would determine whether consumption would rise or fall. If the
advertising campaign failed to shift the demand curve (as in the figure on the right), the
lower price would indeed lead to more consumption. The high cost of drugs to
consumers who may be addicts is the real link to the crime rate.
CHAPTER 5
1. Answers will vary because the question asks for personal choices; however, it is likely
that students may offer some of the following in response:
(a) First of all, you might drive less. Depending on where you live you might substitute
public transit; the bus or subway. The effect on your real income depends on how
much you drive. It could have a significant impact on your real income. In any
event, what is clear is that people on average are worse off and will buy fewer
normal goods and potentially more inferior goods. You may drive home less
frequently. Answers will vary.
(b) Students might consume more of other goods (e.g., movies, clothing) because with
lower tuition they have more money to spend on other things. They may also work
fewer hours, assuming they mostly work to pay tuition. Instead of spending more,
they may also save the money they did not have to spend on tuition.
(c) This represents an increase in income for the next five years; again, students may
spend it on any number of goods, may use that added income to allow them to work
fewer hours, or may save it (resulting increased saving).
(d) Higher interest rate could have a positive or negative impact on saving. First of all
the opportunity cost of spending today is higher. Thus, households would tend to
save more (substitution effect). On the other hand, if you already have a lot of
saving, you will earn a higher return on it, and you will have to save less than you
did when interest rates were lower to achieve the same level of income in your
retirement (income effect). If you have savings, the higher return will give you
more income. If, on the other hand, you are a net borrower, then the interest rates
on your loans may increase, making you worse off. Answers will also vary.
(e) Having to spend more money on food will likely leave students with less money to
spend on other goods (e.g., movies, CDs, etc.), and may mean they have to work
more hours. Students may also draw down savings or just save less as a result of
increased expenditure on food. (This assumes that they do not drastically decrease
the amount of food consumed as a result of the higher price!)
(f) Students may work more hours because of the high wage or may work fewer hours
since they are earning so much more per hour (than minimum wage, for example). If
the result is higher income, students will buy more of any number of goods
(including leisure). They may also be able to save more.
2.
400
350
300
250
200
150
100
50
TU
0
1 2 3 4 5 6 7
Number of cookies
# of Cookies
1
2
3
4
5
6
7
100
90
80
70
60
50
40
30
20
10
0
MU
1 2 3 4 5 6 7
Number of cookies
Marginal
Utility
100
100
75
50
25
10
0
The maximum that he would buy would be 6, because the seventh yields no marginal
utility.
3. (a) She can no longer afford to buy the same combination of things that she bought last
year. Her real income is lower. Something has to give—her budget constraint
changed. So, she must cut back on some things, and her preferences dictate that
concerts and CDs took a hit.
(b) She is worse off—her real income is lower—she will reduce consumption of normal
goods including air trips home; this is the income effect. In addition, the opportunity
cost of a trip home increases from $350 to $600. Thus, Kamika will be pushed to
substitute other goods for air travel. This is the substitution effect.
4. (a)
(b)
Y
20
20
0
(c)
Y
50
0
X
(d)
Y
X
25
Y
40
10
0
(e)
50
0
X
(f)
Y
100
X
28
X
Y
28
14
0
(g)
0
X
28
Y
28
0
5. (a,
c)
X
14
aP  $5 f
(b) 10 lunches at the club, and 5 at Alice’s
cost a total of 10  $5  5  $10  $100 . This
is within the budget constraint.
F
af a f
20
10
0
a
5
10
20 PA  $5
Alice’s restaurant lunches
PA  $10
a
f
f
6. This statement is backwards. An increase in the “after tax” wage will have a positive
effect on the labor supply only if the substitution effect outweighs the income effect.
The substitution effect states that a higher wage makes the opportunity cost of leisure
increase. Thus, people tend to substitute working for leisure. The substitution effect
alone suggests that a higher after tax wage leads to more labor supply. On the other
hand, if the after tax wage goes up, people are better off. Assuming leisure is a normal
good, the higher wage suggests that people will consume more leisure and work less.
7. (a,
(c) Zanzibar is a normal good; Chinese food is
b)
an inferior good. As income rises,
Zanzibar consumption rises but Chinese
food consumption falls.
(d) The entire effect is due to an income
effect. Mei is clearly better off, but the
opportunity
costs
haven’t
changed
because the prices have not changed! The
cost of a Zanzibar trip in terms of meals
sacrificed has not changed.
8. (a) Disagree. If the income effect of a wage change dominates the substitution effect we
know that a wage increase will cause additional consumption of leisure and less
work . . . and that lower wages will cause additional work . . . increased labor
supply. Thus, if our household works more it must have been a wage cut.
(b) Disagree. In product markets, a price cut makes households better off . . . higher real
income. Thus, for normal goods, the income effect leads to MORE consumption of the
good.
9. (a,
c)
(b) As shown on the graph, the household
ends up at Point A, buying 50 X and 25Y .
(d) X is a normal because consumption
increases from 50 to 160. Y is inferior
because consumption decreases from 25
to 20.
A
10. (a)
# Per Month
1
2
3
4
5
6
7
Movies
TU
50
80
100
110
116
121
123
MU
50
30
20
10
6
5
2
MU/$
6.25
3.75
2.50
1.25
.75
.63
.25
# Per Month
1
2
3
4
5
6
7
Books
TU
MU
22
22
42
20
52
10
57
5
60
3
62
2
53
1
MU/$
1.10
1.00
.50
.25
.15
.10
.05
(b) Yes, these figures are consistent with the law of diminishing marginal utility, which
states that as the quantity of a good consumed increases, utility also increases, but
by less and less for each additional unit. In the tables, the TU figures for both books
and movies are increasing, but as more movies or more books are consumed, the MU
diminishes.
(c) Five movies and two books. To maximize utility, the individual should allocate
income toward those goods with the highest marginal utility per dollar. The first
four movies have a higher marginal utility per dollar than the first book, so the
person begins by seeing four movies for $32. The first book has a higher marginal
utility than the fifth movie, so now the person should buy a book, for total
expenditure of $52. Next, the second book, for total spending of $72. And finally, the
fifth movie, for total spending of $80.
(d) See graph below.
(e) If the price of books falls to $10, only the MU $ column for books needs to be
recalculated:
# Per Month
1
2
3
4
5
6
7
Books
TU
22
42
52
57
60
62
63
MU
22
20
10
5
3
2
1
MU/$
2.20
2.00
1.00
50
.30
.20
.10
(f) Now, using the same logic as in (c) above, this individual should purchase six movies
and three books, for a total expenditure of 6 $8  3 $10  $78 .
(g) See graph below.
(h) The decrease in the price of books increases the purchasing power of the individual’s
income. this increase in purchasing power—or income effect—will be used to
purchase more of one or both goods, depending on the individual’s tastes. In this
case, the individual chooses to use his or her “increased income” to buy more of both
goods.
(Note: Another answer to (f) is 5 movies and 4 books. This choice uses up the entire
$80, and it results in the same total utility as 6 movies and 3 books.)
af a f
10
10
8
5
8
A
2
0
5
B
A
2
1 2 3 4 5 6 7 8
Number of books
0
1 2 3 4 5 6 7 8
Number of books
11. The Dutch auction is probably more effective in reducing consumer surplus, because a
bidder—to be sure of getting the good—will have to bid the highest price he or she is
willing to pay for it. By definition, this eliminates all consumer surplus. In a regular
auction, the individual would begin the bidding at a price less than the highest price he
or she is willing to pay. Unless other bidders force the price up to this maximum, he or
she will be able to purchase at a lower price, gaining some consumer surplus.
12. If leisure is a normal good, a large inheritance will be used to purchase more leisure,
reducing the number of hours a person wants to work.
We might be tempted to conclude that taxing away all inheritances would increase
desired working hours, but this is not necessarily the case. We must also consider the
impact such large taxes would have on the desired working hours of those leaving the
bequests. With a 100% tax rate, wealthy individuals would probably decide there is no
point in leaving a bequest at all, therefore decreasing their need to work while they are
alive. The final impact on desired working hours in the economy must take into account
the effects on both bequest leavers and bequest receivers, and could go either way.
CHAPTER 5 APPENDIX
1. The figure to the left violates “more is better” because when an indifference curve has a
positive slope,
you get more of both goods and are indifferent. Indifference curves cannot “curl
upward.” The figure to the right violates “diminishing marginal rate of substitution.”
This shape would imply that MUx MUy increases as you consume more X and less Y. The
opposite is true.
2. I Pxl  100 and I  100 , thus Pxl  $1.00
(Point A on demand curve).
1 Px 2  200 and I  100 , thus Px 2  $.50
(Point B on demand curve).
1 Px 3  300 and I  100 , thus Px 3  $.33
(Point C on demand curve).
3. Agree.
MUx MUy  5  Px Py  9.00 2.00  4.50 then
MUx Px  MUy Py  MUy Py . The MU per
dollar spent on X is greater than the MU
per dollar spent on Y. She should
substitute X for Y to increase utility.
Moving from A down to the right will
increase utility.
P
1.0
1.00
0
.50
.30
.50
.33
0
A
B
C
D
30
140 180
y
Qy
A
0
Qx
x
4. (a) We know that PA A  PN N  100  5 N  10 A  100 .
We also know that MU N MU A  A N  PN PA  5 10  N  2 A . Substituting, we find that
5 2 A   10 A  100  A  5 ; N  10 .
(b) If PN  10 , N  5 and if PN  2 , N  25 .
(c) Answers will vary, but graph should show an indifference curve tangent to a budget
constraint drawn for PA  $10 and PN equal to one of the prices given in the answer
to (b).
CHAPTER 6
1. Total revenue is $50,000 ($10 x 5,000). The opportunity cost of the capital is 10% of
$100,000 annually or $10,000. Total cost, including opportunity costs, is $45,000 for
labor plus $10,000 for capital or $55,000. Profit is TR-TC or $50,000 - $55,000 = $5,000. The firm is suffering a $5,000 loss in economic terms.
2. They are not earning economic profits; they are not considering opportunity costs. The
opportunity cost of capital is 10 percent of $50,000 annually, or $5,000. Because simple
revenue minus cost yields an accounting profit of only $2,000, adding $5,000 in
opportunity cost means the firm is suffering losses of at least $3,000. In addition, they
are not considering the opportunity cost of their own labor.
3. The size of the theater is the fixed factor. Decisions include how to divide up the tickets,
what price to charge, what shows to put on, and what kind of stage sets to use. All are
constrained by the scale of the theater. In the long run you might be able to raise money
and build or acquire a bigger theater. There is no fixed factor in the long run; you can
think big!
4. (a) The marginal product decreases as a single variable factor increases, holding all
other factors constant.
(b) The table does exhibit diminishing returns because the marginal product of labor
falls as labor increases:
L
0
1
2
3
4
5
TP
0
5
9
12
14
15
MP
—
5
4
3
2
1
5. (a) Total costs of each technique are as follows:
Q 1
$9
$12
Tech A
Tech B
Q2
$12
$19
Q3
$24
$26
Q4
$30
$33
Technique A is cheaper at all levels of output.
(b) Labor and capital employed would be as follows:
Q
1
2
3
4
5
L
5
10
14
18
20
K
2
1
5
6
8
(c)
(
c
)
$
40
TC
30
20
10
0
1
2
3
4
5
Q
(d) With the price of labor rising to $3:
Q5
$36
$38
Tech A
Tech B
Q 1
Q2
Q3
Q4
Q5
$19
$16
$32
$25
$52
$34
$66
$43
$76
$50
Labor and capital employed would be as follows:
Q
1
2
3
4
5
L
2
3
4
5
6
K
5
8
11
14
16
$
50
TC
40
30
20
10
0
1
2
3
4
5
Q
6. Clearly the labor-intensive way would be to carry the boxes down the hall and up the
stairs one at a time. She could get a friend or two to help. If the dorm has an elevator
and she can borrow a hand truck, the job would be a piece of cake. She would be using
capital to raise her productivity. To go three miles across campus, a car (capital) or a
truck (more capital) would be nice, although she could carry them one at a time across
campus as well. In the developing world, where capital is scarce, people carry a lot of
stuff. To get the boxes to a new campus, she would probably mail them or send them
UPS. In this case, they would go in a big truck or in an airplane (a whole lot of capital).
7. (a)
(b) Yes, the marginal product drops from 10
units and 5 units after 100 units of labor
have been used.
10
5
0
MPL
100
300
Units of labor
8. The addition of capital (tractors, combines, etc.) and the application of technology
(nitrous fertilizers) raise the productivity of labor, just as the new grill discussed in the
chapter raised the productivity of workers. Capital is also a substitute input for labor.
9. (a) Number of Workers
(Per Week)
0
1
2
3
4
5
6
Number of
Repairs
0
8
20
35
45
52
57
MP L
AP L
—
8
12
15
10
7
5
—
8.00
10.00
11.66
11.25
10.40
9.50
7
60
3
8.57
(b) Between 1 and 3 workers, there are increasing returns to labor ( MPL increases as
more workers are hired). From 3 to 7 workers there are diminishing returns to labor
( MPL decreases as more workers are hired). There is no range of employment where
returns to labor are negative, because MPL is always positive.
(c) Marginal product is greater than average product for the second and the third
worker, and average product rises as these two workers are hired.
(d) Marginal product is less than average product for the fourth, fifth, sixth, and
seventh workers. As each of these workers is hired, the average product of labor
declines.
10. (a) Tall buildings—skyscrapers.
(b) Product usually has to move along an assembly line and out into a warehouse. An
assembly line usually takes a lot of space on a single floor. (Can you imagine a
vertical assembly line?)
(c) Offices can be “stacked up.” People can move by stairs or elevators easily.
(d) Accessibility!
(e) The area of land increases with the square of distance from the center: When a city
grows from a radius of 1 mile to a radius of 5 miles, the new area is 25 times as
large as the original Area   R 2 .
e
j
11. (a) Opportunity cost of capital is the interest that could have been earned in another
enterprise or by holding another financial asset.
(b) They represent lost opportunity to obtain income.
(c) $1,000,000 times 10%, or $100,000.
(d) $250,000 less $100,000, or $150,000.
12. (a) The first step is to calculate the cost for each level of output using each of the three
technologies. With capital costing $100 per day, and labor costing $80 per day, the
results are as follows:
Daily
Output
100
150
200
250
Technology
1
860
1,100
1,280
1,540
Technology
2
800
960
1,140
1,400
Technology
3
820
900
1,080
1,340
From the table, we can see that for output of 100, Technology 2 is the cheapest. For
output levels of 150, 200, and 250, Technology 3 is cheapest.
(b) In a low-wage country, where capital costs $100 per day and labor costs only $40
per day, the cost
figures are as follows:
Daily
Output
100
150
200
250
Technology
1
580
700
840
1,020
Technology
2
600
680
820
1,000
Technology
3
660
700
840
1,020
From the table, we can see that for output of 100, Technology 1 is now cheapest. For
output levels of 150, 200, or 250, Technology 2 is now cheapest.
(c) If the firm moves from a high-wage to a low-wage country and continues to produce
200 units per day, it will change from Technology 3 (with six workers) to
Technology 2 (with eight workers). Employment increases by two workers.
CHAPTER 6 APPENDIX
1.
MPL PL  5 2  MPK PK  10 5  2 . The MP per dollar spent on labor is higher than the MP
per dollar spent on capital. The firm should transfer spending from capital to labor,
because each dollar spent on labor (at the margin) yields more output.
2. At A, MPL MPK  PL PK because the slope of the isoquant is greater than the slope of the
isocost. That means that MPL PL  MPK PK ; thus the firm can cut costs by hiring more
labor and less capital.
At B, MPL MPK  PL PK because the slope of the isoquant is less than the slope of the
isocost. That means that MPK PK  MPL PL ; thus the firm can cut costs by hiring more
capital and less labor
3.
Q
100
200
300
TC
100
200
300
L
25
50
75
K
25
50
75
CHAPTER 7
1. The monthly payment and the insurance do not depend on the amount that you drive.
They must be paid even if you do not drive. Thus, the fixed costs are $418.71 per month.
The marginal cost of a mile driven is $1.50 divided by 20, or 7.5 cents, plus 15 cents for
a total of 22.5 cents per mile. The “cost” of a trip to Pittsburgh would be $225. Only the
variable costs of 22.5 cents  1,000 miles are incurred as a result of the trip. Some would
argue that only the interest portion of the monthly payment is a cost because the
principal repayment represents a form of saving because you will fully own the car in
five years.
2.
Q
0
1
2
3
4
5
6
MC
—
5
4
5
6
8
10
The firm will produce four units of output—at five units MC rises above P  MR  d .
TR  $28 , TC  $32 , losses = $4. It will operate in the S R because TR  TVC . It will exit in
the long run.
3. (a)
Q
0
1
2
3
4
5
TVC
0
45
85
120
155
195
AVC
—
45
42.5
40
38.75
39
MC
—
45
40
35
35
40
6
7
8
9
10
240
290
345
405
470
40
41.43
43.13
45
47
45
50
55
60
65
$
500
TVC
$
70
MC
60
400
50
AVC
300
40
200
30
20
100
10
0
2
4
6
8
10 q
0
2
4
6
8
10 q
(b) Yes. Given diminishing returns, MC may fall at first but should eventually rise with
output.
(c) When MC is below AVC , AVC falls; when MC is above AVC , AVC rises. At 3 units of
output, MC  35  AVC  40 , thus AVC falls. At 6 units, MC  45  AVC  40 , thus AVC
rises.
(d) Marginal cost is the added cost of the resources needed to increase output one unit.
The MC of the sixth unit of output, for example, is $45; 2 units of K at $10 each plus
5 units of L at $5 each.
(e) The firm would increase production as long as P  MC . The optimal level of output
would be 8.
4. (a) Disagree. Firms would not increase output if price were below marginal cost because
that would decrease profits.
(b) Disagree. Even if marginal cost is rising with output, average cost will decline if
marginal cost is below average cost. For example, if the marginal cost of a unit of
output is $10 and the next unit costs $11 and yet another costs $12, if the average
were $25, it is still falling as output rises.
(c) Disagree. Fixed cost is constant and must be paid even at zero output.
5. (a)
Q
0
1
2
3
4
5
6
7
8
9
10
TC
$
100
130
150
160
172
185
210
240
280
330
390
TFC
$
100
100
100
100
100
100
100
100
100
100
100
TVC
$
0
30
50
60
72
85
110
140
180
230
290
AVC
$
—
30
25
20
18
17
18.33
20
22.50
25.56
29
ATC
$
—
130
75
53.33
43
37
5
34.29
35
36.66
39
MC
$
—
30
20
10
12
13
25
30
40
50
60
(b)
(c) 7 units
TR  7  $30  $210
$
130
120
100
80
MC
60
40
ATC
AVC
20
0
a
TR  TC  $210  $240  $30 loss of $30
9
(d) units
TR  9  $50  $450
2
4
6
8
f
TR  TC  $450  $330  $120 profits
(e) Because a price of $10 is below the
minimum AVC , the firm should shut down
and incur only fixed costs, for a total loss
of $100.
10 q
MC
ATC AVC  ,
When
is
below
ATC AVC  is decreasing. When MC is
ATC AVC  ,
ATC AVC 
above
is
increasing.
6. (a) Marginal cost is a constant $1 from
one unit of output up to 100 units
because the most efficient machine
will be used. From the 101st unit to
the 300th unit, MC is constant at $2.
From the 301st unit to the 800th unit,
MC is constant at $3.
Total cost is $100 at zero units of
output and rises by $1 per unit up to a
total of $200 at 100 units of output.
From 101 units of output up to 300
units, total cost increases by $2 per
unit up to a total of $600. After that it
rises at $3 per unit to a total of $2,100
(b) at 800 units of output.
At a price of $2.50, the company
should produce 300 books.
TR  750 , TC  $600 , or profit = $150
7.
If P = $3 the optimal q is 200.
At output below 200 P > MC.
At output above 200 P < MC.
$3
MC
$2
$1
0
200
400
600
Quantity
2,100
600
200
100
0
200 400 600 800
Units of output
800
8. (a)
(b)
2
1
.5
0
MP
100 200 300
Units of labor
(c) The profit-maximizing level of output is 100 units. the firm will hire 100 units of
labor.
9. (a) The table gives the marginal product from each day’s efforts: 100, 80, 60, and 40 kg.
(b) Marginal cost of a kg of fish is the change in cost divided by the change in q. During
prime season, each day brings in 100 kg of fish at a cost of 6,000 levs, or
MC  6,000 100  60 levs . During month 7, it’s 6,000 80  MC  75 levs . During month 8
it’s 6,000 60  MC  100 levs . During the rest of the year it’s 6,000 40  150 levs .
(c) Produce as long as price, which is marginal revenue (80 levs), is greater than MC .
Thus, the boat should be in the water fishing during prime season and month 7, but
should not fish during month 8 or during the rest of the year.
10. (a) The land.
(b) The fixed capital—the kitchen and the dining area.
(c) The office, the dental equipment, and, in a way, the dentist’s time (the most he can
work is 24 hours a day).
(d) The land (parking for inventory of cars), showroom and service area, and installed
equipment.
(e) The branch buildings and major equipment like automated teller machines.
11. (a)
Q
0
1
2
3
4
5
6
7
L
0
10
15
18
22
28
36
48
TFC
$200
$200
$200
$200
$200
$200
$200
$200
TVC
TC
$0
$200
$500
$700
$750
$950
$900 $1,100
$1,100 $1,300
$1,400 $1,600
$1,800 $2,000
$2,400 $2,600
AFC
—
$200
$100
$67
$50
$40
$33
$29
AVC
—
$500
$375
$300
$275
$280
$300
$343
ATC
—
$700
$475
$367
$325
$320
$333
$372
MC
—
$500
$250
$150
$200
$300
$400
$600
(b) (student verification)
(c) From 0 to 3 units of output, there are increasing returns to labor and (therefore)
decreasing marginal costs. From 3 to 7 units of output, there are diminishing returns
to labor and (therefore) increasing marginal costs.
(d) AVC is minimized at 4 units of output. ATC is minimized at 5 units of output.
(e) Under perfect competition, MR  $410 , so the firm should produce 6 units of output.
(Note that MR  MC for units 2–6, while MR  MC for the first unit and the seventh.
Thus, the profit-maximizing output could be either 0 units or 6 units, but nothing in
between. A quick check tells us that profits at 0 units would be $200 , and profits at
6 units would be $410 6   $2,000  $460 . The firm should produce 6 units.)
(f) ATC is minimized at 5 units, but profits are maximized at 6 units. The firm is,
indeed, “minimizing costs” in the sense that it is producing any given level of output
at the lowest possible cost. But its goal in choosing among different output levels is
to maximize profits, not to minimize average costs. Because MR  MC for the sixth
unit, producing the sixth unit adds to profits, even though it also raises ATC .
CHAPTER 8
1. (a) Disagree. Constant returns to scale means that the long-run average cost curve is
flat over most of its range.
(b) Disagree. A firm suffering losses will continue to operate as long as total revenue
covers variable cost.
a
f
2. The enterprise is suffering a $20,000 economic loss. TR  $100,000 P  q  $5  20,000 ,
TC  $120,000 . Fixed costs are $30,000 (10% annually on $300,000: the opportunity cost
of capital). That makes TVC  $90,000 TC  TFC  120,000  30,000  . Thus, revenue covers
variable cost, profit on operations is 100,000  90,000  10,000 . The firm should operate in
the short run but exit in the long run.
3. Increasing returns is a reduction in average costs in the long run, when all inputs can be
optimally adjusted. Diminishing returns is an increase in marginal costs in the short
run, when only one input can be varied and others are held fixed.
4. One could make a case that some economies probably exist in all five, but the case is
much stronger in electric power (needs a big power plant or dam) and aircraft
manufacturing (requires a big assembly line and a great deal of cooperation).
Home Building: Home building is usually done by very small independent
contractors, although there are some big tract developers (like Ryan Homes) that
produce tens of thousands of homes each year. They do quantity buying and use massproduced parts.
It is hard to find economies of much significance in software development and
vegetable farming. Although some firms in those industries are large, many are quite
small and quite competitive.
5. The key is to calculate TVC  TC  TFC in each case. Whenever TR  TVC (as in cases A, B,
D, and F), the firm should stay open. When TR  TVC (cases C and E), the firm should
shut down.
6. (a) Disagree. A firm will never sell its output for less than the marginal cost of
producing it, but may indeed sell at less than average total cost, as long as it can
earn an operating profit.
(b) Disagree. The short-run marginal cost curve assumes at least one input is fixed. The
long-run average cost curve allows all inputs to vary. For example, the short-run MC
curve for each fixed level of capital could be U-shaped, and yet the LRAC curve could
be flat (constant returns to scale).
7. To look for economies of scale, you need to calculate average total cost. For the three
farms, ATC is: Smythe $1.12, Faubus $.91, and Mega $.91. This suggests that in moving
from producing 28,000 chickens to producing 55,000 chickens, average cost falls, thus
indicating economies of scale. But in moving from 55,000 to 100,000, average cost
doesn’t change, thus indicating constant returns to scale.
8. (a) Disagree. Constant returns to scale
means that the long-run average cost
curve is flat over most of its range.
(b) Disagree.
Profit-maximizing
firms
earning economic profits will produce
to the right of the minimum point on
the average total cost curve. See the
following diagram:
$
MC ATC
Px
0
q
(c) Disagree. The supply curve of a competitive firm is its marginal cost curve above the
average variable cost curve. At any point above AVC , total revenue is greater than
total variable cost and firms will choose to operate.
(d) Disagree. A firm suffering losses will continue to operate as long as total revenue
covers variable cost.
9. The firm will produce 4 units of output—At 4 units MC rises above P  MR  d . TR  $28 ,
TC  $32 , losses = $4. It will operate in the S R as TR  TVC . It will exit in the long run.
Q
0
1
2
3
4
5
6
MC
—
5
4
5
6
8
10
10. The enterprise is suffering a $1,000 loss. TR  $30,000 , TC  $29,000 , accounting profit =
$1,000. But the opportunity cost of capital is 10% or $2,000. When the $2,000 is added
to cost the result is a $1,000 loss.
11. (a) Output
0
1
2
3
4
5
6
7
8
9
10
(b)
Price
$50
$70
$100
$130
$170
TFC
$300
$300
$300
$300
$300
$300
$300
$300
$300
$300
$300
TVC
$0
$100
$150
$210
$290
$400
$540
$720
$950
$1,240
$1,600
TC
$300
$400
$450
$510
$590
$700
$840
$1,020
$1,250
$1,540
$1,900
Quantity
Supplied
0 (shut down)
0 (shut down) or
3
4
5
6
AVC
—
$100.00
$75.00
$70.00
$72.50
$80.00
$90.00
$102.90
$118.80
$137.80
$160.00
Profit
$300
$300
$190
$50
$180
ATC
—
$400.00
$225.00
$170.00
$147.50
$140.00
$140.00
$145.70
$156.30
$171.10
$190.00
MC
—
$100
$50
$60
$80
$110
$140
$180
$230
$290
$360
$220
$280
$350
(c)
Price
$50
$70
$100
$130
$170
$220
$280
$350
7
8
9
Market Quantity
Supplied
0
Between 0 and 300
400
500
600
700
800
900
$520
$990
$1,610
Market Quantity Demanded
$1,000
900
800
700
600
500
400
300
(d) Fill in the blanks: From the market supply and demand schedules given, the
equilibrium market price for this good is $170 and the equilibrium market quantity
is 600. Each firm will produce a quantity of 6 and earn a profit equal to $180.
(e) The equilibrium in this market is not a long-run equilibrium. because firms are
making profits, entry will occur. Entry will increase quantity supplied, and this will
decrease equilibrium price until each firm is making zero profit.
12. (a,
b)
(c) In the short run, demand shifts from D to D  , and price rises to P1 . Firms are making
profits, and they raise output to 18.
In the long run, 100 new firms enter the industry. Supply shifts from S to S  , and
price falls back to $7.
CHAPTER 8 APPENDIX
1. Disagree. Input prices can rise as the result of an expansion of an industry causing the
LRAC to shift upward. This is one reason why the LR industry supply curve has a
positive slope in an increasing cost industry.
2. See the story in the text and Figure 8A.2 for an increasing-cost industry.
3.
P
Cloth industry
S0
$10
SN
A'
P2
A
B
DN
0
D0
Q
At Point A, the representative firm is
earning normal profits. When demand
D0
DN ,
increases
from
to
price
temporarily rises to P2 . Existing firms in
the industry will expand their production
as they realize above-normal profits. The
representative firm is in short-run
equilibrium, which corresponds to Point
A  for the industry picture. New firms
enter shift the supply curve to S N , which
pushes price back to $10. At a price of $10
the representative firm is earning normal
profits again, corresponding to Point B.
Because input prices do not increase as
firms bid for more inputs, the long-run
supply curve is flat at $10. Points A and B
lie on the long-run industry supply curve.
CHAPTER 9
1. Clearly, there has been a shift in the demand for labor. When demand increases, it
creates a shortage, or excess demand, and causes wages to rise. One probable source of
the shift in demand that has occurred is an increase in productivity. As the productivity
of workers increases, MRP increases shifting the demand curve for labor to the right. Of
course, the expansion of the U.S. economy during the 1990s had many complex sources
including the recovery from recession in 1990 and 1991, low inflation, low interest
rates, and strong economic growth.
K  10
q  10 ,
2. (a)
(b, When
and
TVC'
650
c)
L  40  TVC  $70 .
600
When q  30 , K  30 and
500
L  120  TVC  $210 .
When q  50 , K  50 and
400
TVC
L  200  TVC  $350 .
(d)
300
If capital costs $3 and labor costs $4 per
200
unit, then process 3 becomes cheapest,
with a cost of $13 per widget.
100
When q  10 , K  30 and
L  10  TVC  $130 .
0
10 20 30 40 50 q
When q  30 , K  90 and
Process 1 costs $7 per widget. Process
L  30  TVC  $390 .
2 costs $8, and Process 3 costs $10.
When q  50 , K  150 and
Process 1 is cheapest.
L  50  TVC  $650 .
3. The sectors of the economy that expanded the most in recent years have been those
employing more highly skilled and educated workers. Workers in those industries are
likely to have high marginal products  MP and thus high marginal revenue products
 MRP . The rise in wages at the upper end of the income distribution is more than likely
the result of an increase in the number of firms demanding high-skilled workers and the
increase in productivity of those workers. The stagnation and decline of wages in the
unskilled labor market is more than likely the result of a decrease in the number of
firms hiring such workers as well as foreign competition in the markets for those
products keeping prices low and dragging down marginal revenue product. Recall that
marginal revenue product is equal to MP  P , where P is equal to the price of the
product.
4.
Workers
0
1
2
3
4
5
6
Bushels
0
40
70
90
100
105
102
MP
—
40
30
20
10
5
3
MRP
—
$80
$60
$40
$20
$10
–$6
The firm should hire workers as long as MRP  W . When W  $30 , the firm should hire
three workers. If W increases to $50, the firm should cut back to only two workers,
because the MRP of the third worker ($40) is now less than the cost of hiring him/her
($50).
5. (a)
(b)
MPL
MRPL
1.0
$6
.5
$3
0
100
200
L
300
0
100
200
300
L
(c) Note that this is the same problem as problem #5 in chapter 7 viewed from another
prospective. A profit-maximizing firm would produce as long as MRPL is greater than
the wage rate. the firm depicted above will hire 100 workers and produce 100 units
of output.
6. (a) Demand curve for construction
workers shifts leftward; wave
decreases; employment decreases.
(b, Demand curve for construction workers
c) shifts
rightward;
wage
increases;
employment increases.
r
r
S
S
W2
W1
W1
W2
D'
D
D
D'
L2 L1
Number of workers
L1 L2
Number of workers
7. Answers will vary depending on the location of the school.
8. Investment tax credits reduce the cost of capital relative to the cost of labor. To the
extent that capital is a substitute for labor, these credits can lead to layoffs and slower
employment growth.
9. At $6.35, the marginal revenue product of bringing a field to production was sufficient
to cover the $25,000 cost at all but field 4. The marginal value of field 4 is
3,000  $6.35  $19,050 . He would plant only three fields. At $4.50, only two fields would
produce enough potatoes to cover costs. The MRP of field 3 is now only $22,500
$4.50  5,000 . The lower price of potatoes will directly lower the demand for workers on
Doug’s farm and will likely decrease the value of his land.
a
f
10. You would weigh the benefits with the costs. The costs are $40 per week, but the
benefits depend on the value of the roommates’ time and the displeasure that each gets
from mowing. It also depends on their incomes and wealth. There could easily be
disagreement. Also, depending on their individual opportunities, one or both of the
other two roommates might offer to do the mowing in exchange for money.
11. (a) Number of Number of Shirts
MP L
MRP L
Workers produced per day
TR
0
0
—
$0
—
1
30
30
$90
$90
2
80
50
$240
$150
3
110
30
$330
$90
4
135
25
$405
$75
5
155
20
$465
$60
6
170
15
$510
$45
7
180
10
$540
$30
8
185
5
$555
$15
(b) (1) TR 170   $3  170  $510 and TR 180   $3  180  $540 ,  MR from selling the output
produced by the seventh worker  $540  $510  $30
(2) MRP7  $3  10  $30
(c) The firm should hire workers as long as MRPL  W , subject to the shutdown
condition. In this case, if the firm stays open, it should hire six workers. (If labor is
the only variable cost, then the firm should indeed stay open, because in this case
TR  TVC .)
(d) Now the firm should hire only five workers, because the MRP of the sixth worker is
only $45, which is less than the wage.
(e) The new technology will double both MPL and MRPL at each number of workers.
Now, at a wage of $50, the firm should hire seven workers (because the MRP of the
seventh worker will be $60, but the MRP of the eighth worker will be only $30).
a
f
12. (a) Even though the ratios MRPL PL and MRPK PK are equal, we still have MRPL  PL and
MRPK  PK .
(b) The firm could increase profits by either purchasing more capital or hiring more
workers. Either action would add more to revenue than it would add to cost.
CHAPTER 10
1. All are except (b), (f), and (h).
2. (a) Disagree strongly. Savings is defined as household income minus consumption
spending. It is that portion of income set aside for future consumption. Investment is
new purchases of capital, plant, equipment, and inventory. Savings in the simple
model is done by households and investment is done by firms. What is often
confusing is the fact that saving is the source of resources used to finance
investment spending.
(b) Disagree. It is important to remember that when a household buys a share of stock
or a bond, it is not investing in the economic sense of the word. Only when new
capital is produced does investment take place. If a new firm sells shares to
households and uses the proceeds to buy new machinery, the purchase of the new
machinery is investment.
(c) Disagree. Higher interest rates encourage saving but discourage investment. Interest
rates determine in part the cost of investment. If the capital investment is financed
with borrowing, higher interest rates increase the cost directly. If capital investment
is financed with internal funds by a firm, higher interest rates increase the
opportunity cost of the investment.
3. No. The total capital cost of the station is $1 million. With revenues of $420,000 and
costs of $360,000, profit is just $60,000, which is a 6% yield on an investment of $1
million. If I can get 7.5% by investing in perfectly safe government securities, why buy
a gas station?
4.
Quando Company should invest in all
projects that have a rate of return greater
than the interest rate. Therefore, it should
invest a total of $48,820,600.
r
20
16
12
8
4
0
Total investment (Singapore dollars)
5. As discussed in the chapter, most capital investment is financed with borrowing. Lower
interest rates mean lower borrowing costs and a lower cost of capital. This should
stimulate capital spending and employment.
6. Total profits are taxed; what is left is split between dividends paid out to owners and
retained earnings held internally for investment.
7. Savings can be borrowed by business firms, which can purchase new technology, engage
in research to develop new technology, expand existing plants, or build new plants.
Savings can be borrowed from banks or by a firm issuing bonds. Other channels include
the stock market and venture capital funds. Savings can be borrowed by individuals,
who can invest in human capital (college education, professional school, technical
training) or purchase newly constructed houses.
Investment is what enables a nation’s average standard of living to grow. With more
capital, labor is more productive, output is greater, and real incomes rise. But
investment requires that productive resources be diverted from consumer goods. Thus,
investment requires a sacrifice of current consumption.
8. Answers will vary. Interest rates differ because of the terms of the loan (how long
before the loan is due) and the risk associated with the loan. Longer term interest rates
may reflect expectations about future short-term rates. The federal government is
considered a safe borrower and pays low interest rates.
9. Households supply the funds (saving), which are used by business firms to purchase
capital equipment.
10. Stockholders have put up $100,000 and receive dividends of $30,000. With an interest
rate of 10%, $10,000 of this is the normal rate of return. The other $20,000 is profit,
earned by the stockholders.
11. Physical capital would include the buildings, laboratories, photocopying equipment,
chalkboards, desk, and chairs. Intangible capital would include human capital (the
education and training possessed by professors, administrators, and staff) and the
reputation of the institution.
The value of the physical capital stock could be measured by estimating how much it
could sell for on the open market. The value of intangible capital is much more difficult
to assess.
Other parts of the answer will vary depending on the school, but some examples
might be building new dormitories, athletic centers, or libraries and their impact the
school’s reputation and therefore admissions and tuition revenue, alumni giving, and
the ability to secure grants from private and government sources.
12. Disagree. Lower interest rates actually make households invest more (in human capital,
durable goods, etc.), but might make them save less.
13. Answers will vary, but students should refer to assessing how good an investment the
purchase of the building would be. They will likely refer to how much of the space is
rented and how much is vacant, and what the rent is per square foot. Taxes and other
costs would also be relevant. The expectations that matter would also be about the
demand for the space and its price, and would be shaped by economic trends affecting
vacancy rates.
CHAPTER 10 APPENDIX
1.
You would not be willing to pay $1,900 because you can get the same $2,000 by
depositing $2,000
divided by 1.1 or $1,818.18 in a 10% account for a year. If you figure on $181.82 in
interest, the
$1818.18 becomes $2,000 after a year. Thus, $1818.18 is the maximum that you
would be willing to\
pay. For $2,000 after 2 years, your maximum offer would be $1652.89 or $2,000
2
divided by (1.1) .
2. The PDV of the inheritance is $10,000 1.065 10  $5,327.26 . You should accept your
brother’s offer.
3. Disagree. The bridge cannot be justified on efficiency grounds, because simply investing
the $25,000,000 in the financial markets would generate a stream of income worth
more to citizens than the benefits from the bridge. However, at substantially lower
interest rates, the PDV of the benefits would be higher and might exceed $25,000,000.
In that case, the bridge should be built.
4.
@8%
@10%
A
$1,000
$924
B
$1,000
$903
C
$1,052
$1,000
D
$1,092
$1,000
E
$1,258
$1,208
At 8% interest, flow E is worth a current expense of $1,235, because its PDV of $1,258
would exceed the expense. At an interest rate of 10% the PDV of $1,208 is less than the
current expense, so the investment should not be undertaken.
5. (a) $3,000 1.05   $2,857.14 .
2
(b) $3,000 1.05   $2,721.09 .
2
3
(c) $1,000 1.05   $1,000 1.05   $1,000 1.05   $2,723.24 .
.   $2,727.27
6. (a) $3,000 110
. 2  $2,479.34
(b) $3,000 110
.   $1,000 110
. 2  $1,000 110
. 3  $909.09  $826.45  $751.32  $2,486.86
(c) $1,000 110
7. (a) False
(b) True
CHAPTER 11
1.
P
S1
LRAC1
P1
P1
S2
P2
D1
LRAC2
P2
D2
Q
q
Supply shifts right from lower costs and entry of new firms. Demand shifts right and
consumers increase quantity demanded. LRAC shifts down.
2. Disagree. Even if shareholders are made worse off, the breakup could be a potential
Pareto improvement. The term “efficient change” is often used to describe changes in
which some are made better off and others worse off but in which those who gain
receive benefits that are greater than the costs imposed on those who lose. The theory
of the court is that consumers will gain more than shareholders lose, making the
breakup efficient.
3. Certainly the demand for labor will drop. This will put downward pressure on wages.
As people lose their jobs income falls, and those who see lower wages or who are laid
off consume less. There will be less borrowing in financial markets. The housing
market insane Jose will experience a decline in demand and possibly falling process.
Firms that were servicing the high tech sector with banking or legal services find
themselves in a slump. There are dozens of other connections that can be made.
4. (a) First, calculate MP and P  MP :
Workers
0
1
2
3
4
5
6
7
Loaves of Bread
0
15
30
42
52
60
66
70
MP
—
15
15
12
10
8
6
4
P  MP
—
210
210
168
140
112
84
56
At a wage of 119 koruna per hour, 4 workers should be hired. the fifth worker would
produce less value in an hour (112 koruna) than his/her wage.
(b) When the price of bread rises to 20 koruna, the last column must be recalculated.
Workers
0
1
2
3
4
5
6
7
P  MP
—
300
300
240
200
160
120
80
Now, 6 workers should be hired.
(c) If the wage rises to 125 koruna per hour, assuming bread still costs 20 koruna, only
5 workers should be hired. (If bread still costs 14 koruna, as in the first example,
only 4 workers would be hired.)
(d) Yes, the allocation of labor would be efficient because each firm would hire labor
until the wage was equal to the value of the marginal product of output. If all firms
paid the same wage, they would all have the same marginal product of labor, and no
reallocation of labor could increase total output.
5. There will likely be trade between Country A and Country B. Country A will produce
only corn and no soybeans, and Country B will produce only soybeans and no corn.
Country A will then trade some of its corn for soybeans from Country B (at the same
time, Country B is therefore trading some of its soybeans for corn from Country A). This
is Pareto efficient because each good is being produced by its more efficient producer,
and both countries are likely to have more or both goods with trade than without it.
6. (a) Disagree. The enjoyment of housing can be limited to those who pay for it.
Therefore, the private market will supply it.
(b) Disagree. Monopolies produce too little product and charge an artificially high price.
(c) Agree. It is difficult for consumers to evaluate the skills of a doctor or to judge the
advice a doctor gives them.
7. All are examples of potentially Pareto efficient changes.
(a) Both parties are better off; no one else is worse off.
(b) Monopolist is hurt but gains to consumers are greater— enough to compensate
losers.
(c) If we assume that the taxes were being used wisely, this still might be an efficient
change. Let’s assume that the revenues are made up by a new tax that does not
distort consumer choices. The argument here is that taxes produce extra or excess
burdens when they distort consumer choices. As the result of the repeal, some
people buy sweaters, gaining utility over what they were buying before.
(d) Simple elimination of waste is clearly efficient.
8. The cost of chicken is likely to go up. Substitutes for chicken include fish, turkey, and
perhaps pork and beef. In each of these markets, the demand curve will shift rightward,
and both equilibrium price and equilibrium quantity will rise. Complements might
include rice and canned and packaged chicken gravy. The demand curves for these goods
would shift leftward, causing both equilibrium price and quantity to decrease. In the
market for farmland, we might see more acreage devoted to substitutes when the
anchovies disappear, because the demand for substitutes will increase, as will their
equilibrium prices.
9. (a-b) The coin toss is more “equitable,” because both parties have the same chance of
winning, regardless of their incomes. But with the coin toss, there is no guarantee that
the party who values the ticket most would get it. Selling the ticket to the higher bidder
is more “efficient,” because whoever places the higher money value on the ticket will
get it, but it is less equitable, because it favors those with higher incomes.
10. Demand for G shifts left (from D0 to D1 ), driving down the price of G from P0 to P1 and
creating losses in the short run for firms in G. Demand for S shifts to the right, causing
the price of S to rise from P0 to P1 and creating short-run profits for firms in S. In the
long run, firms exit G, shifting the supply curve left (from S 0 to S 1 ), driving the price of
G back up to P0 and eliminating the losses. At the same time firms will enter S, shifting
the supply curve to the right (from S 0 to S 1 ) and driving price back down to P0 eliminate
profits. In the long run, employment will expand in S and shrink in G.
P
Sectors
S1
Representative firms
S0
MC
ATC
P0
P1
Losses
D1
G2 G1 G0
P
S0
D0
G
S1
g1 g0
MC
P1
P0
g
ATC
Profits
D0
S0 S1 S2
D1
S
S0 S1
S
11. (a) Pareto efficient. Both you and the street vendor benefit.
(b) Pareto efficient. You are better off (you don’t die) and the vagabond is better off (by
$10,000). Given your circumstances, this is a voluntary exchange.
(c) Not Pareto efficient. Not a voluntary exchange, and you are worse off.
(d) Not Pareto efficient. You and the cab driver are better off, but you are also adding to
traffic congestion that will make other rush-hour travelers worse off.
12. (a) Imperfect information—you don’t know enough about cars to recognize whether or
not you need the repair.
(b) Public good—there is no way to limit enjoyment of the park to those who pay, so the
market will not provide it.
(c) Negative externality—there is a byproduct to this activity that affects (harms)
parties outside the transaction of buying the album.
(d) Imperfect competition—these firms are not acting like pricetakers. Their decision to
raise price above marginal cost will restrict output (ticket sales) below the efficient
level.
13. The allocation of labor is inefficient. Because each factory is hiring the profit
maximizing number of workers (where W  PX  MPL ), the value of the marginal product
of labor in factory A is $10, whereas that in factory B is only $6. If workers were moved
from factory B to factory A, the value of total output would rise.
CHAPTER 12
1. (a) Disagree. Monopoly sets MC  MR , but then charges a price higher than MR . This is
because a monopolist faces a downward-sloping demand curve. To sell more output,
it must lower its price.
(b) Disagree. Demand still constrains monopoly. There are always substitutes (however
distant) for a monopoly’s output. A rise in price causes a decrease in sales, and may
or may not decrease total revenue. But there is only one price that will maximize a
monopoly’s profits.
(c) Agree. Demand elasticity is equal to 1 at the midpoint of the demand curve, and the
marginal revenue curve bisects the quantity axis at that same level of output.
2. A competitive firm can sell all the output it wants without having any impact on market
price. For each additional unit sold its revenue will rise by the market price. Hence, MR
is the same at all levels of output.
Each time a monopolist increases output by one unit, it must lower the price to sell
it. The additional revenue the monopolist receives is actually less than the price,
because consumers who were already buying the output get a price break too. MR is
thus lower than price, and as output increases, both price and MR decline.
3. (a) 2000 price is P1 ; output is Q1 .
(b) TR  P2 AQ 2 0 ; TC  CBQ 2 0 ; Total profit
= P2 ABC .
(c) Point E is the perfectly competitive
outcome; Point A is the monopoly
outcome. Under monopoly, price is
higher P2 and output is lower Q 2 .
af
A
P2
C
P1
B
MC
E
MR
bg
0
Q2
AC
D
Q1
(d) The memo should mention that under the monopoly, the price is higher and output
lower than it was under perfect competition. Further, the price is higher than
marginal cost. This is not efficient because some potential customers who are not
buying actually place more value on additional units of the good than it would cost
to produce them. Breaking up the monopoly into several small firms (its original
competitive structure) would bring the price and quantity back to the efficient level,
where P  MC .
4.
Interval
0–5
5–10
10–15
15–20
20–25
25–30
30–35
35–40
Marginal Revenue
+90
+70
+50
+30
+10
–10
–30
–50
TR at 0 is zero; TR at 5 is 450; 450  5 = 90.
Produce as long as MR  MC ; thus if MC  $20 , optimal output = 20 units.
Profits are TR  $1,200 20  $60 minus TC  $100 FC  400 VC 20  $20  $500 .
Thus profit = $700.
When MC  $40 , optimal output = 15 units, TR  $1,050 15  $70 ,
TC  $100 FC  600 VC 15  $40 . And, finally, profit  $350 $1,050  $700 .
a
a
f
f
a
a
a
f
f
f
5. (a) Q *  10 ,000
(b) P*  $4
(c) TR  $4  10,000  $40,000
(d) TC  ATC  Q  $5  10,000  $50,000
(e) profit = TR  TC  $10,000 (a loss of $10,000)
6. (a,
b)
P
20
15
10
5.50
1
0
(c) Profit-maximizing output is 900; profitmaximizing price is $5.50.
(d) Efficient price would be $1, where the
demand curve intersects the marginal cost
curve. At this price, Q  1,800 .
(e) Long-run output would be zero, because
losses would cause the monopoly to exit
(f)
the industry.
MR
D
ATC
Alternatively, regulators could require the
MC
monopoly to charge a price equal to
500 1,000 1,500 2,000 Q
marginal cost and then subsidize the
900
1,800
monopoly’s loss.
Quantity
7.
CHAPTER 13
1. (a) and (d) are probably oligopolies dominated by a few firms: (b), (c), and (e) are
clearly monopolistically competitive because there is lots of product differentiation,
many firms, and lots of entry and exit.
2. (a) Monopolistic competition: free entry, lots of firms, product differentiation, close
substitutability.
(b) As new establishments open, demand curves for existing firms shift left. Price of
admission falls and profits drop to zero at the tangency of demand and ATC (see
Figure 13.3).
3. (a) Disagree. There are no barriers to entry in monopolistic competition, and economic
profits are eliminated in the long run.
(b) Disagree. Oligopoly is an industry in which there are some firms that can control
price or influence price because of their size. Dominant firm price leadership is an
oligopoly model.
(c) Disagree. Price does not equal MC in the short or long run in monopolistically
competitive industries.
4. Bands are as good of an example of monopolistic competition as there is. Firms are
small and have
some, but not much market power. Better bands are more expensive than lesser-known
bands. The
average local band is not getting rich, but earning enough to get by. There is likely to be
close to zero
economic profit. Clearly there is product differentiation as each group tries to attract
fans and CD buyers.
They advertise and try to improve. Booking agents often serve as barriers to the entry
of new bands.
5. (a) A good example was AT&T when it held a dominant position in the U.S.
telecommunications market. At the same time it had little competition in the United
States, other countries had big, powerful telecommunications firms producing
equipment (telephones, etc.) and services for the world market. World competition
was fierce.
(b) The key is the availability of substitutes. A monopoly is a firm producing a product
for which there is no close substitute. When they were just another band, clubs could
hire a cheap band and consumers didn’t know the difference or care. With their
success, there became fewer substitutes in the minds of consumers.
6. (a-d) Shipbuilding and wine production: not contestable. Both require large investments
of land and capital that cannot easily be moved to another location or another industry.
Trucking is contestable because it’s easy to move trucks to new locations. Housecleaning
services are contestable because it requires a very small initial investment.
7. Both A’s and B’s potential losses are minimized by cheating. To minimize the maximum
loss, A should cheat, because it yields higher profit regardless of what B does. The same
is true for B. If A cheats, so will B, and if B cheats, so will A. Most likely outcome: Both
will cheat.
(a-c) With either
or
MC  $100,000
MC  $85,000 , 800 homes will maximize
profits, and a price of $120,000 will be
charged.
8.
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
0
–$20,000
–$40,000
D
400
L
Number of houses
MR
800 1,200 1,600 2,000
9. (a) 30 units.
(b) P  $14 .
(c) TR  30  $14  $420 .
TC  $9  30  $270 .
Profit  $420  $270  $150 .
(d) In the long run, entry will shift the demand and marginal revenue curves leftward
until normal profit is earned at the profit-maximizing output level. This occurs when
the demand curve is tangent to the ATC curve.
10. (a) Both have dominant strategies in Game 1—charge the low price. Neither has a
dominant strategy in Game 2.
(b) You might try tit for tat (match the competitor’s move) to signal the opposite that if
she prices high, you might do so also.
(c) If you are risk averse, you would probably swerve to guarantee a gain of 3. This
minimizes your losses from the worst thing that can happen to you (a maximum
strategy).
CHAPTER 14
1. The statement is correct. Figure 14.3 in the text shows that when the penalty is equal to
the marginal damage cost, the price paid by consumers will increase until it equals
marginal social costs. A tax in excess of marginal damage cost will cause price to exceed
marginal social cost—an inefficient result.
2. The automobile causes a number of externalities including pollution and congestion.
Many advocate tolls as a way to force drivers to weigh these external costs in their
decision to drive.
3. (a) With private goods, we each get to choose what quantity of each good we want. If I
don’t like a good, I don’t buy it. But with public goods, we all get the same level of
output. We all breathe better air if it is cleaned up, and we all get the same amount
of national defense. When public goods are produced locally we have more choice
(see discussion of the Tiebout hypothesis).
(b) Representative democracy is not guaranteed to produce the socially optimal mix of
public goods. Some problems are logrolling, a poorly informed electorate, poor
incentives for people to become informed and vote, and the fact that votes are
limited to bundles of public goods. Also, Arrow’s theorem implies that there is no
consistent, nonarbitrary way to agree on what the socially optimal mix is. The voting
paradox is an example of why majority voting does not provide a consistent social
choice mechanism.
(c) An example might be a bureaucrat who is motivated just to increase the power,
prestige, and budget of her bureau. This might lead to bloated bureaucracies. Clearly
there has been great pressure in recent years to keep politicians and bureaucrats
honest. The press plays an enormous role.
4. Answers should mention that although both education and health care are basically
private goods (exclusion is possible), each can be thought of as a mixed good that is, a
good that delivers public benefits as well. Healthy and educated members of society
make society better: less poverty, less crime, lower taxes, smarter voting. Public health
is also a concern. In health care, physicians have all the information, and demand is
basically supply determined. Health insurance also suffers moral hazard and adverse
selection problems.
5. (a) Elementary and secondary education: Private aspects—substantial benefits accrue to
the individual, and those who do not pay could, in theory, be excluded from
receiving them. Also rivalry, in that there is a limited number of students one
teacher can effectively teach. Public aspects—there are substantial benefits to the
public at large (more informed voting, more socialized behavior). It is impossible to
limit these benefits to those who pay.
(b) Higher education: Same as in (a), but here even more of the benefits accrue to the
individual, and the costs are often borne by those who benefit.
(c) Medical care: Private aspects—most of the benefits of good health are enjoyed by the
individual, and in theory we could exclude those who won’t or can’t pay. Also, high
degree of rivalry. Public aspects—substantial public benefits when communicable
diseases are reduced or public health is improved.
(d) Air-traffic control: Private aspects—there is certainly rivalry, as shown by the
congested skies over urban airports and the ulcers suffered by overworked airtraffic controllers. Public aspects—all air traffic in a given area must be controlled
from a single set of controllers. Competing firms would not be able to supply this
service effectively. Also, substantial benefits to the public at large, which are
nonexcludable (e.g., reduced probability of a plane crashing into one’s home).
6. (a) This might work in the small numbers case, but here large numbers of people are
involved, and the “free rider problem” and the “drop in the bucket problem” are
likely to get in the way of the efficient outcome.
(b) Compensation may be fair, but there are some worries about efficiency. First is
Coase’s contention that compensation might interfere with the damaged party’s
incentive to avoid the damage. Compensation for past damages will also overcharge
the polluter and potentially put him out of business. For efficiency, the charge must
be equal to “marginal damage cost.”
(c) This works perfectly in the case where the damages are very high. For example,
suppose that the factory was dumping highly radioactive waste! But if the pollution
damage was small relative to the benefits of production on the current site, it is
inefficient to stop it cold. Also, there may be ways of reducing certain effluents if the
tax were set correctly.
(d) This one is efficient assuming that the marginal damages can be measured
accurately. You might argue that it is not equitable, but by not compensating the
damaged parties, they still have the incentive to avoid the damage if it is the least
expensive way of dealing with the problem.
7. (a) People disagree about this. there are private aspects of housing for the poor:
excludability and rivalry. There may also be substantial benefits for society at large
when everyone has a place to sleep at night.
(b) Disagree. An unregulated market economy tends to underproduce public goods,
because nonexcludability and the free-rider problem prevent the private sector from
charging for these goods.
8. Rewrite the demand curves as:
PXA  5  .05QXA and PXB  10  .1QXB .
Since X is a public good, QXA  QXB  QX .
Summing vertically, PX  PXA  PXB  5  .05 Q X
10  .1Q X  15  .15 Q X . Setting price equal
to marginal cost yields 6  15 .15 Q X and
Q X  60 . Plugging Q X  60 into each
demand equation we find that A should be
charged $2 per unit and B should be
charged $4 per unit.
PX
15
MC
6
60
100
QX
9. Most economists would argue that the patent system is, on balance, a good thing. True,
patent holders—as monopolies—charge a higher-than-efficient price for the technology.
But without such monopolies, the new technologies would not have been developed in
the first place. Still, government involvement in research may be justified on several
grounds. It might be better to have the government fund the research and make the
results widely available than to encourage research via patents that impart monopoly
control over new ideas. Also, patents may not be sufficient to keep new technology from
being imitated once developed. In this case, the private sector has little incentive to
develop the new technology.
10. False. First, the statement ignores the difficulty of negotiations when large numbers of
individuals are involved. Second, externalities involve equity as well as efficiency
problems. (Examples used will vary.)
11. (a) Imperfect information: impossible to verify who is faking. Also, moral hazard: less
reason to avoid injury due to benefits received.
(b) Adverse selection: disproportionate number of damaged computers will be sold.
(c) Imperfect information: difficult to know how well a company’s system will work
until after it is in place. Hard to evaluate competing bids.
(d) Adverse selection: The worst drivers will buy more insurance, forcing up rates and
causing better drivers to choose between subsidizing bad drivers or doing without
insurance. Also, moral hazard: less reason to avoid collisions if insurance company
will bear the costs.
12. Answers will vary, but should mention public goods, externalities and imperfect market
structure at a minimum. Could bring in ‘public choice’ as an issue.
CHAPTER 15
1. If we assume that most people work a 40 hour week and 52 weeks per year, at $5.15 an
hour, someone would earn $10,712.00 a year, or $892.67 per month. Less taxes, if the
tax rate is 10%, that means a “take-home” amount of $803.40 a month. Other parts of
the answer (like the cost of rent) will vary based on location. Hypothetical budgets
should allow for utilities, clothes, and other necessities.
2. Answers will vary.
3. The Gini coefficients for African-Americans exceeds that for whites. The Gini coefficient
for 1995 exceeds that for 1980. A higher Gini coefficient is one possible signal of greater
income inequality. Note that the differences in the Gini coefficients are uninformative
as to differences in the average income of the two groups.
Lorenz curve for whites
100
Lorenz curve for 1980
100
80
60
53.7
40
51.5
30.7
14.9
20
3.2
4.6
20
Lorenz curve for
African-Americans
26.8
11.7
40 60
80 100
% of households
80
60
Lorenz curve
for 1995
58.5
40
53.2
34.2
16.7
20
4.2
5.1
20
29.9
14.2
40 60
80 100
% of households
4. The biggest reason was that the economy was expanding at a rapid pace during this
period. Millions of new jobs had to be filled; employment and labor force participation
increased dramatically. In addition, welfare reform was passed and federal law made
benefits temporary. In addition, real benefit levels have been falling steadily for years,
making the opportunity cost of leisure significantly higher. In other words, the trade-off
between work and welfare shifted toward work. The new welfare bill also provided
more money for child care and medical insurance. There are many other possible
explanations.
5. Capital is an input into the production process that is produced and produces benefits
over time. Clearly education is produced, and it in turn is used to produce other things.
The return comes to educated people in the form of higher wages and benefits as well as
higher utility from job satisfaction. Parents may enjoy psychic rewards if their children
are successful as well. You would need to calculate the full costs of the education
including the opportunity cost—forgone wages during time spent in school. The money
returns can be estimated by looking at wages paid in various professionals and job
categories. College-educated workers do much better than those without a college
degree.
6. Computer programming requires a great deal of skill and training. Those who get such
jobs have a lot of human capital. Working in a gas station or a car wash does not require
great skill. Logging and heavy construction require some skills and are dangerous
occupations requiring employers to pay compensation differentials to attract workers.
7. Answers will vary.
8. Disagree. The statement ignores different working conditions, differing vacations, and
differing time available for other income opportunities (writing books, consulting). Also
choices reveal preferences for various jobs. Academic jobs must yield more utility to
some or no one would be an academic.
9. Answers will vary. Cost-of-living differences would imply that they should be different.
The concept of “horizontal equity” (equal treatment of equals), would argue for similar
benefits after adjusting for cost-of-living differences. On the other hand, it may well be
true that people tend to move to higher-benefit areas and away from low-benefit areas.
This could result in concentrations of poverty, such as in the urban north. There is
mixed evidence on the last point.
10. Social security, Medicare, private pensions, and the availability of secure vehicles for
saving (like FDIC-protected bank accounts) have all contributed to the reduction of
poverty among the elderly.
11. If labor markets work the way the competitive ideal suggests, pay is linked to
productivity. Recall that the demand for labor reflects the marginal productivity of
workers in each market. A worker in one labor market is paid more than workers in
another because the value of his/her product is greater there. Wages reflect the relative
scarcity of various skills as well. Differentials provide incentives for people to invest in
the kinds of human capital that are needed.
On the other hand, discrimination by race or gender may crowd certain occupations
or result in patterns of inequality that cannot be explained by productivity alone.
12. Answers will vary.
CHAPTER 16
2.
Average Tax Rate (%)
1. All the arguments from the chapter that favor consumption taxation or income taxation
(see “best base” discussion). Income tax is a doable tax on savings. Taxing
consumption taxes what we “remove from the common pot,” not what we leave in.
Clearly, saving leads to growth (supply of capital), which should be encouraged. For
retaining an income tax, one could argue that income is a better measure of “ability to
pay”. A VAT or a national sales tax would be regressive, but Arney’s proposal is for a
more progressive “consumption” tax.
Income ($1,000’s)
The tax is progressive because the first $25,000 is taxed at a marginal rate of zero. As
income rises, the part subject to the 0% rate shrinks as a percentage of total income and
the part subject to the 25% marginal rate rises as a percentage of total income.
Income
Minus
standard
deduction
35,000
4,750
50,000
9,500
90,000
4,750
110,000
9,500
Minus
exemptions
Taxable
Income
Income tax
Average Rate
Marginal tax
rate
3,050
12,200
3,050
12,200
27,200
28,300
82,200
88,300
3,730
10.6%
15%
3,545
7.1%
15%
17,762
19.7%
28%
15,695
14.3%
25%
3.
4. Answers will vary.
5. Taxes are ultimately paid by households. The corporate tax falls most heavily on
owners of capital. The proposed change would shift the tax burden from labor to
capital, and might slow down the rate of capital accumulation and economic growth.
6. Disagree. Excess burdens come about because of distortions in behavior. If a good has a
low demand elasticity, the tax will have a relatively small effect on quantity demanded,
and the excess burden will be relatively small.
7. (a) Disagree. The labor supply elasticity for most of the work force is close to zero.
Therefore, the drop
in the payroll tax, which increases the net wage, is unlikely to cause a significant
increase in labor supply.
(b) Disagree. Monopolies cannot pass any tax on profits on to consumers. The profit
maximizing price
and quantity remain unaffected by the text.
(c) Disagree. First, some non-neutral taxes correct for pre-existing externalities.
Second, equity
consideration may make as non-neutral tax desirable, even though it results in an
excess burden.
8. If one thinks of the social security tax as payment for future entitlements, it would be
correct to list it as part of employee compensation. However, Congress could always
change the law so that those “entitlements” aren’t received, and faculty may prefer to
receive cash rather than future benefits; to this extent, the full value of the payroll tax
should not be counted as compensation. Also, it must be pointed out that the imposition
of the tax does not raise overall employee compensation. If it really is just another form
of compensation, wages will simply fall by the amount of the tax. To the extent that it
is a tax because workers prefer to be compensated in a different way, if the supply of
labor is inelastic workers will bear the burden of the tax and their compensation will be
reduced.
9. Individual commodities have a large elasticity of demand than broad groups of
commodities or consumption goods as a whole. The greater the elasticity, the more
distorting the tax. In addition, developing countered are usually commodity-exploring
countries. The taxes would make their exports less competitive and harm domestic
export industries.
10. If the cost of one’s car is proportional to one’s income, then the tax would be
proportional. If high-income people spend a smaller (larger) percentage of their income
on cars, then the tax would be regressive (progressive). The tax would distort by
discouraging automotive ownership (especially ownership of expensive cars) but might
also correct for existing externalities (congestion, air pollution, noise).
11. Use Figure 16.7 as a guide: the excess burden is the area of the triangle ABC. The area
of a triangle is ½ the base times the height. In this case, the height is .10 x $15 or $1.50
in tax T per unit. The base is 2 million (12 million minus 10 million). The area (excess
burden) is thus $1.5 million. Total tax collected is $1.50 x 10 million = $15 million. The
excess burden is 10% of the tax collected.
CHAPTER 17
1. Inflation is an increase in the overall price level, which should reflect the prices of
everything traded in the economy. In the simple economy described in the question, you
might be tempted to look at the average price of the three goods to see how the overall
price level has changed. On January 1, 1998 the average price was
whereas
at
the
end
of
the
year
it
was
$2.50  $3.00  1.50 3  $2.33 ,
b
g
b$5.00  $2.00  1.50g3  $2.83 .
From this you can conclude that on average prices are
higher. This is a simple version of a price index. A better measure would include
information about the relative importance of each of the three goods in consumer’s
budgets (you could then construct a weighted average as your price index).
2. The unemployed are those who are not working for pay or profit but who have made
specific efforts to find a job during the week of the employment survey. In simple terms
it is the excess of labor supplied over labor demanded in the market. The labor demand
curve measures the quantity of labor (workers or hours) demanded by firms at each
possible wage rate. Firms’ demand for labor is derived from the demand for products.
Firms will hire workers as long as the product of their labor sells for a price high
enough to produce a profit. Thus, the ”productivity” of workers is critical. Labor supply
reflects the choices made by households to work and how much to work. The alternative
to working is leisure or “home production.” Home production can include child rearing,
subsistence farming, or other unpaid work. The value of leisure and home production is
the opportunity cost of working.
SL
W
DL
0
Q
Quantity of labor
3. Although lower unemployment is certainly “good” for the economy, an unemployment
rate that is too low means that labor markets are “tight” and that there is upward
pressure on wages. Higher wages represent higher costs for firms, and are therefore
likely to lead to higher prices. Thus very low rates of unemployment lead economists
like Mr. Greenspan to be concerned about higher prices (or inflation, another
macroeconomic policy concern).
4. The productivity of workers must be increasing. If we are producing more output with
fewer workers, output per worker is rising.
5. Answers will vary depending on the state(s) in which students live.
6. Macro looks at aggregates in the total economy, while micro looks at individual markets
and individual economic agents. It is often helpful (and more accurate) to base
macroeconomic theories on the behavior of the individuals who make up the
macroeconomy.
7. To stimulate expansion, the government could spend more or lower tax rates. Here,
higher taxes reduce consumer spending, while the government itself spends less; thus,
total spending, or aggregate demand, drops. In times of slow economic growth, most
people would expect the government to adopt an “expansionary fiscal policy” of cutting
taxes and raising spending instead of this contractionary policy.
8. Wars result in high levels of government spending, which helps to increase total
spending in the economy.
9. Wrong. Incomes have actually risen faster than prices, so that the purchasing power of
the average citizen has increased. Prices may now be higher in dollar amounts, but
compared to people’s earnings, some goods may in fact be cheaper than they were in the
1940s.
10. When demand shifts to the right in a market, prices tend to rise. Higher interest rates
make buying a car or a home more expensive to those who must borrow to finance those
items. Thus, high interest rates tend to shift demand curves back to the left, taking
pressure off prices.
CHAPTER 18
1. (a) Gross private investment  net private investment  depreciation  100 + 50 = 150
(b) Net exports  exports  imports  60  50  10
(c) GDP  personal consumption  gross private investment  government purchases
 net exports  250  150  75  10  485.
(d) GNP  GDP  receipts of factor income from the rest of the world
485
= 484
 payments of factor income to the rest of the world  485
 4+45 – 5
484
(e) Net national product  GNP  depreciation  484  50  434
(f) National income  NNP  (indirect taxes  subsidies)  434
 –20(20
 5 +5)
419
434
=
419


(g) Personal income  national income  corporate profits  dividends  social insurance payments
personal interest income  transfer payments
 419  45  4   35  35  15  393
(h) Disposable income  personal income  personal taxes  393  60  333
b g
2. Every payment made by a buyer becomes revenue for the seller which is paid to
someone or held by the seller as profit. Thus, the dollar value of the purchases of new
goods and services in a year must be equal to the dollar value of the income generated
in that year.
3. Nominal GNP rises when real output rises and when prices rise. Between 1973 and 1975
the data shows that prices rose a lot. Thus, GNP rose faster than real GNP. Real GNP is
simply GNP adjusted for inflation. Conditions in 1974 and 195 were quite bad. The data
shows substantial inflation and declining real GNP. The economy is in recession and
there is substantial inflation at the same time, a condition called “stagflation.”
4. With fixed-weight indexes, the percentage change in the index from year to year
depends on the weights chosen and thus on the base year.
Goods whose output decreases (or increases slowly) because of slowly- or backwardshifting supply curves will have their relative prices increase. If we use the old prices as
weights, we will tend to understate the importance of this decrease. Likewise, if we use
the new prices as weights, we overstate the importance of the production decline.
Fixed-weight price indexes that use old quantities as weights are generally taken as
overestimates of the increase in the price level, because these indexes ignore
consumers’ opportunities to find substitutes for goods whose relative prices rise. Those
that use current-year quantities as weights are taken to underestimate changes in the
price level because they implicitly assume that the substitutes people chose for the
goods whose relative prices rose are considered just as good as the “real thing.”
The use of fixed-weight indexes poses special problems when used to make
measurements over long periods of time, because the use of, say, 1950 weights for the
1995 economy is not desirable.
The BEA’s new approach does two things: First, it takes the (geometric) average of
fixed-weight indexes, to deal with the overestimation and underestimation issues.
Second, it “updates” the base years for the fixed-weight indexes every time it makes a
new calculation, to ensure that the weights remain appropriate. That is, the indexes
whose average it takes are those whose base years are the previous year and the current
year.
5. Double counting occurs when intermediate goods are counted directly in calculating
GDP. This means these intermediate goods will be counted more than once because they
are also counted as part of the value of the final product. Total sales includes sales of
intermediate goods that firms sell to each other. GDP includes only the sale of final
goods and services.
6. You can’t tell how much inflation is forecast. If you knew the forecast for “nominal”
GDP (for GDP in current dollars) in addition to the forecast for real GDP, you could
figure out how much of the forecast change was due to inflation. The 2005 per capita
GDP: $35,614; 2062 per capita GDP; $36,457. Forecast for real GDP: + 3.23 percent.
Forecast for per capita real GDP: + 2.37 percent.
7. This is a current events question; answers will vary.
8. Consumption as measured by retail sales is just part of GDP. Using the expenditure
approach, real GDP is made up of consumption plus investment plus net exports plus
government purchases. If the sum of I, G, and (X – M) grows more rapidly than C, real
GDP will rise more rapidly than retail sales.
9. (a) not counted—financial transaction
(b) counted—investment spending
(c) not counted—financial transaction
(d) not counted—financial transfer
(e) counted—consumption spending
(f) not counted—used goods (unless you are in the book-rental business, and declare
your income to the government.
(g) not counted—transfer payment
(h) counted—investment spending
(i) counted—consumption (the cheese is part of the value of the final good)
(j) not counted—nonmarket activity
(k) not counted—illegal goods
10. The pizza is entirely consumed in the year it was produced, while the car will last many
years. To correct for this, we could count just the value of the services provided by the
car each year. For example, if the car lasts 5 years, then 20 percent of its value could be
counted in each year’s GDP.
11. Consumption, investment, and government spending (C, I, and G) include expenditures
on goods produced both domestically and by foreigners, and so C  I  G overstates
domestic production. Imports have to be subtracted out to obtain the correct figure.
12. There is no right or wrong answer here. But counting environmental damage requires a
dollar estimate of this damage, about which there will be little consensus.
CHAPTER 19
1. Answers will vary, but should indicate that a depression is a prolonged and deep
recession. The precise definitions of prolonged and deep are debatable; answers should
include data on the unemployment rate and real GDP and indicate the time frame over
which those measures were recorded.
2. Full employment is another term for the natural rate of unemployment. The idea behind
this terminology is that if the only unemployment in the economy is the unemployment
that comes about as the result of the normal working of the labor market, then there is
no “unnecessary” unemployment. Labor is being “fully” utilized because the only
unemployment that exists is the natural consequence of an efficiently working market.
Thus the economy can be at full employment with a 4.1 percent unemployment rate,
provided that the 4.1 percent unemployment is frictional and structural only.
3. 6.0%. 5.8%. Employment increased by 300,000. The labor supply increased by
700,000; 300,000 were employed but 400,000 of them were unemployed.
4. This is structural unemployment, which can sometimes exist for long periods, especially
when workers must learn new skills to find jobs. The social costs of this unemployment
might be greater than the costs of retraining these workers, providing some justification
for government assistance.
5. Answers will vary depending on the state(s) in which students live.
6. Yes, inflation would still be a problem. There are other costs of inflation besides the
redistribution of income that occurs when incomes are not indexed. One example is the
waste of time and resources spent coping with inflation. See the section on
“Administrative Costs and Inefficiencies” under the heading “Costs of Inflation.”
7. The CPI is intended to measure the cost of living—the price of a typical market basket.
This is the figure that tells us how well off in real terms a given wage or pension makes
someone. It is used by the government in setting social security payments, by unions in
bargaining over wages, by workers in evaluating their incomes, by economists in
studying the standard of living, and as the basis of wage and pension indexation. The
PPI measures the prices of the bundles of goods that firms buy, or the prices of
intermediate goods and raw materials. Since these items are not directly consumed,
PPIs are not a good measure of the cost of living, but they can be used to predict the
increase in the price of consumer goods.
8.
Bundle price
Index
% change
2000
$400
1.00
2001
$531.25
1.328
32.8
2002
$550
1.375
3.54
Yes. There was a modest increase in the price level between 2001 and 2002.
9. (a-b) Yes, both statements can be true. The labor force of Tappania may have grown
faster than the number of employed, implying an increase in the number of people who
are looking for work but not working, and an increase in the unemployment rate.
10. Clearly in the long run output can only grow if the quantity of inputs grows or the
productivity of those inputs increases. The capacity at any point in time is given by the
available capital stock (plant and equipment) and the available labor force. Ultimately
the labor force is limited by the working age population. Since there are always firms
going out of business and new firms being born, there are always people looking for
work. Economists often look at the unemployment rate and the “capacity utilization
rate” as indicators of how close we are to capacity. When demand exceeds the capacity
constraints in an economy, the result is usually an increase in the price level or
inflation.
11. This is a current events question, so answers will vary.
12. In the short run, this can easily happen if more of the labor force becomes employed . . .
the unemployment rate falls . . . or more of the existing capital stock is used . . .
capacity utilization rises. In the long run it can happen if technological advance
increases factor productivity . . . each unit of labor and capital produces more output
over time.
13. The only way the unemployment rate can rise if employment is increasing is through
labor force growth.
CHAPTER 20
1. (a-b) The increase in inventory, if not planned, should lead to a drop in GDP. In fact,
rising inventory is a key indicator of an approaching downturn in GDP. If investment
spending were to pick up, that would lead to an increase in GDP, all else equal. What
actually happens will depend on the relative strength of these two phenomena, and upon
other things that could happen to stimulate or serve as a drag on growth.
2. MPC: marginal propensity to consume; the fraction of additional income that is spent on
consumption. Multiplier: the concept that a sustained increase in one component of
aggregate expenditure (like I) could lead to an increase in the equilibrium level of
income that is a multiple of the initial increase in expenditure. In a simple economy the
multiplier is equal to 1/MPS or 1 1  MPC . Actual investment: the actual amount of
b
g
investment that takes place; it includes items such as unplanned changes in inventories.
Planned investment: those additions to the capital stock and inventory that are planned
by firms. Actual investment and planned investment are equal only in equilibrium; at
levels of output below equilibrium actual investment will be less than planned
investment and at levels of output above equilibrium actual investment will be greater
than planned investment. Aggregate expenditure: the total amount of economy spends in
a given period. Real GDP: the value of gross domestic product corrected for the effect of
higher prices. Planned aggregate expenditure determines the equilibrium level of real
GDP. Aggregate output: the total quantity of goods and service produced (or supplied) in
an economy in a given period. Aggregate income: the total income received by all factors
of production in a given period. Aggregate output and aggregate income are the same
(just seen from two different points of view).
3. We know that C .75 Y  150 billion. C  I  150  75  225 billion. Thus, C  I  Y . . .
aggregate spending is greater than aggregate output. Inventories will fall and in the
coming months Y (real GDP) will rise. GDP will stop rising when C  I  Y . That is when
.75 Y  75  Y or 75 .25 Y or Y = 300 billion Yuck dollars.
4. Answers will depend on future events.
5. (a)
Aggregate
Planned
Output/Income Consumption Investment Saving
2,000
2,100
300
–100
2,500
2,500
300
0
3,000
2,900
300
+100
3,500
3,300
300
+200
4,000
3,700
300
+300
4,500
4,100
300
+400
5,000
4,500
300
+500
5,500
4,900
300
+600
Unplanned
Inventory
–400
–300
–200
–100
0
+100
+200
+300
Equilibrium Output Y *  4,000 . When Y  4,000 , inventories are lower than desired
(unplanned investment is negative). Firms will increase production to increase their
inventories, causing aggregate output/income to rise. When Y  4,000 , the opposite
will happen, causing output/income to fall.
(b) Over all ranges MPC  4 5  .80 and MPS  1 5  .20 . The multiplier is 1 MPS  1 .20  5 .
(c) If I increases by 200 to 500, Y* goes up by 5  200  1,000 . Thus, the new equilibrium
level of output (income) is 5,000. Yes, the two are consistent.
6. Think of the adjustment that occurs when, with the economy at the equilibrium level of
output, an increase in planned investment occurs. Inventories are drawn down, and
output increases. If firms increase output by the amount of the increase in planned
investment, equilibrium will not be reestablished. The increased output (income) will
also increase consumption. Thus there will have been an increase in Y of I , but an
increase in aggregate expenditure of more than I . Y must increase further to establish
equilibrium. The multiplier is finite because a fraction of income is saved. Thus, as Y
grows, S grows; so we will eventually reach a level of Y at which the new planned
investment just offsets the leakage into savings. This will be a new equilibrium. At this
point, S  1 . Because S  MPS  Y , we can solve for Y :
Y 
1
 I .
MPS
.
7. (a) MPC = .8; MPS = .2.
(b)
(c) Y  1 MPS I .
Multiplier  1 MPS  1 .2  5 . In this case,
with the multiplier equal to 5 and an
increase
in
investment
of
10,
Equilibrium
Y
Y  (5)(10)  50.
increases from 1,500 to 1,550.
b
g
AE
Equilibrium at
Y  1,500
C+I
300
45°
0
(d) S  Y  C  Y 200 .8 Y 
 200 .2Y
The equilibrium must be the same in
both graphs because Y  C  I and S  I
are the same condition. To see this,
Y CS
remember that
always.
CS
Substitute
for Y in the
equilibrium condition Y  C  I to
obtain C  S  C  I , which simplifies to
S  I.
500
1,000 1,500
Quantity
Y
S, I
S
I  100
100
0
500
1,000
1,500
Y
8. Y  600 , C  500 , S  I  100 ; Y  680 , C  580 , S  I  100 . Wealth accumulation increases
Y.
If the stock market gets overvalued, it inflates GDP on the way up and could deflate it on
the way down adding to cyclicality.
9. No. AE is planned aggregate expenditure. If you add unplanned changes in inventory to
it, the sum equals aggregate output (income).
CHAPTER 21
1. The debt starts at 1 million lavs at the end of year one and grows to 10 million lavs at
the end of year ten. In year ten the interest on the debt will be 5% of the 10 million lav;
500,000 lavs. Thus, government spending will be 10,500,000 lavs and taxes will be
9,000,000 lavs.
2. Answers will vary.
3. Y  1,000 ; C  750 ; S  50 ; Y  1,060 ; C  810 ; S  70 .
Pro: Higher GDP, higher employment, and saving.
Con: If the economy is running at or near full employment, it could overheat and cause
inflation as you will see later.
4. (a) Disagree. During periods of budget surplus government debt shrinks. The debt grows
only if expenditures exceed taxes.
(b) Disagree. A tax cut will increase the equilibrium level of GDP whether the budget is
in surplus or deficit. The only exception might be if the economy were at full
employment.
(c) Disagree. The expenditure multiplier is always greater than the tax multiplier if MPC
is < 1.
If MPC < MPS, the tax multiplier is < 1. If the MPS .90 , the expenditure multiplier is
1.11 and the tax multiplier, MPC MPS is 0.11.
b g
5. Saving is that part of annual disposable income not spent: S  Y  T  C . Investment is
the value of planned purchases of plant, equipment and inventory by business firms.
Equilibrium occurs when C  I  G  AE  Y . This can only occur if leakages from the
circular flow, S and T, are exactly matched by injections of demand, I and G. That is, at
equilibrium, S  T  I  G . If S  I and G  T , it follows that S  T  I  G .
Leakages exceed injections, aggregate spending must be lower than aggregate output,
inventories will rise and Y will fall. In other words when C  S  T  Y  C  I  G ,
inventories rise and Y falls: Newt will experience a recession. If, however, G > T and
S  I, S  T  I  G . Injections exceed leakages, aggregate expenditure exceeds aggregate
output, inventories will fall and Y will rise.
6. (a) Y  1,000 , Y d  800 , C  600 , S  200 , I  100 , G  200 .
Because total spending  C  I  G  600  100  200  900 is less than total output of
1,000, one would predict that inventories will pile up, and firms will decide to
reduce output.
(b) Y would settle at 600. At this level of output, we would have C  300 , I  100 , and
G  200 so that Y  C  I  G  600 .
(c) Cutting government purchases would make the fall in output worse! In particular, a
cut of 25 would cause equilibrium Y to decline by 25 1 MPS  25 4  100 . This would
b
gb gbg
mean Y would decline to 500.
7. The statement is true if one only cares about the budget deficit. But there are also
political controversies about the efficiency and appropriate size of the government
sector that would lead some to favor the tax cut even though it raises the deficit by
more.
8. (a) Equilibrium with government requires that output = spending, or that Y  C  I  G .
Since we know that Y  C  S  T by definition, then equilibrium also requires that
I  G  S  T . To see if Y  200 is an equilibrium, add C  I  G to obtain
160  30  0  190 . This is not an equilibrium, because spending (190) is less than
output (200). Alternatively, saving + taxes  40  0  40 , while investment +
government spending = 30  0  30 . Thus, S  T is not equal to I  G . (Notice that
there is no autonomous consumption.) In the coming months, we can expect output
(Y) to decline and workers to be laid off. Equilibrium Y  150 . At Y  150 ,
C  I  G  0.8 150  30  0  150 .
(b) Set G  10 with taxes = 0 . In this case, we would have Y  C  I  G or
200  160  30  10 . (Note: There are other combinations of G and T that will bring
equilibrium Y to 200, such as G  26 and T  20 .)
bg
(c) Set G  20 with taxes = 0 . In this case, we would have Y  C  I  G or
250  200  30  20 . Other combinations that would accomplish the same result
include G  60 and T  50 or G  44 , and T  30 .
(d) Yes, Y  C  I  G 200  160  40  0  . Also, S  T  I  G 40  0  40  0 .
(e) We can get the answer directly from the multiplier:
Y  G 1 MPS  30 5   150
The new level of Y is therefore 200  150  350 . C will be equal to .8 350  280 , while
a
f
bgb g
a
bgb g
S  .2 350  70 .
(f) Once again, we can get the answer directly from the tax multiplier:
Y  T  MPC MPS  30 4   120
Y falls by 120. The new level of Y is therefore 200  120  80 . Disposable income is
80  30  50 , so C  .8 50  40 , while S  .2 50  10 . The change in Y is larger when
f
bg
bg
government spending changes by 30 than when taxes change by 30. This reflects the
fact that the government spending multiplier is larger than the tax multiplier. A
change in government spending affects output directly, while a change in taxes
affects output indirectly, by a smaller amount, because households will reduce their
spending by only a fraction of the tax change.
9. If G goes up and T does not, the equilibrium level of Y rises. C  I  G  Y , inventories
fall, and Y increases! In 1946 gross federal debt was 127.5% of GDP. Recent data put the
figure at just under 35 percent.
10. There would be no automatic stabilizers. (At least none that have been presented in the
text thus far. In future chapters, we will see that interest rate changes and price level
changes also act as automatic stabilizers.)
There would be no distinction between the actual and full-employment deficit,
because changes in income would have no impact on the budget deficit.
11. (a) Govt. spending multiplier  1 .4  2.5 .
b g
b g
(b) Govt. spending multiplier  1 1.9  10 .
b g
(c) Govt. spending multiplier  1 1.5  2 . (d) Tax multiplier  .75 1.75  3 .
b g
(e) Tax multiplier  .9 1.9  9 .
b
g
(f) MPC must be .833. Tax multiplier  .833 1.833  5.0 .
b
g
(g) MPC must be .666. Government spending multiplier  1 1.666  3.0 .
(h) Output will increase by $100 billion (use the balanced-budget multiplier, which has a
value of 1).
CHAPTER 21 APPENDIX B
1.
Y  C  I  G  85 .5 Y  T   85  60  85 .5 Y  40 .25 Y   85  60
 85 .5 Y .5 40 .5 .25 Y   85  60  85 .5 Y  20 .125 Y  85  60
.625 Y  250
Y  250 .625  400
Taxes  40 .25 400  60 . The budget deficit is G  T  60  60  0 .
b g
CHAPTER 22
1. (a)
The debt increases by 5 million Rags in total; the privately held dept
increases by only 4.5 million Rags because the Central Bank bought 500,000 Rags
worth.
(b) The treasury sale has no effect on the money supply; the Treasury goes to the public
to borrow money that it immediately spends.
(c) When Central Bank buys in the open market it pays with new high-powered money
that becomes a part of the banking system’s reserves; it pays essentially with newly
printed money. The money multiplier is 1/RR or 1/0.2 or 5. Thus, the money supply
expands by 5 X 500,000 or 2.5 million Rags.
2. Paying down the debt by buying bonds with tax receipts has no impact on the supply of
money. Money that comes to the Treasury in tax payments is immediately returned to
the economy as the bonds are paid for by the Treasury. The result is that there is no
change in reserves. When the Fed buys bonds in open market operations, it uses what is
essentially printed money. The whole point is to expand reserves and thus the money
supply.
3. Cash: Asset—Bank has it on hand.
Demand Deposits: Liability—claims by depositors can be withdrawn at any time.
Savings deposits: Liability—same logic.
Reserves: Assets—They are in the vault as cash or on deposit with the Fed.
Loans: Assets—They represent claims of the bank on borrowers.
Deposits at the Fed: Assets—They can be withdrawn at any time; they are owned by the
bank.
4. Decrease the reserve ratio: that would immediately free up reserves (create excess
reserves) system wide. Banks could lend more expanding the money supply.
Decrease the discount rate: encouraging banks to borrow reserves and lend more
money, expanding the money supply.
Buy government bonds. The Bank of Japan pays with cash or by increasing deposits
in banks’ accounts. This increases reserves in the system and expands the money supply.
5. Reducing the reserve requirement means that reserves of 6.24 million hurls can support
62.4 million in total deposits. The money supply could increase by as much as 10.4
million hurls. The Central Bank could counter with open market sales of bonds,
withdrawing reserves from the economy.
6. If banks are loaned up and the money supply is $1,148 billion, the 10 percent reserve
requirement would imply $114.8 billion in reserves. If the reserve requirement were
raised to 11 percent, $114.8 billion is 11 percent of $1,044 billion. Raising the reserve
requirement to 11 percent would reduce the money supply by $104 billion.
7. If the army is unaware of the king’s scheme, the plan will work temporarily, but it will
also lead to an increase in the money supply, with all of the macroeconomic effects that
will be studied in the next few chapters. (It will be shown that this plan will cause
inflation.) If the army is aware of the king’s scheme, there will be immediate inflation.
The army would demand that the king pay them ten percent more coins for their wages.
8. M2 includes everything in M1, plus savings accounts, money market accounts, and some
other categories. A shift of funds between, say, savings accounts and checking accounts
will affect M1 but not M2, because both savings accounts and checking accounts are part
of M2.
9. (a) Agree. The two sentences are correct. When the Fed sells bonds, the proceeds do not
go back into circulation. Rather, the proceeds are withdrawn from the economy,
reducing the quantity of reserves in the system and reducing the supply of money.
Fed open market operations change the money supply.
(b) Disagree. The expenditure (fiscal) multiplier is equal to 1/MPS. The expenditure
multiplier and the money multiplier are very different. The expenditure multiplier
gives the change in equilibrium output (income) that would result from a sustained
change in some component of aggregate expenditure. The money multiplier gives the
change in the stock of money in circulation resulting from a change in reserves. The
money multiplier is equal to 1/(required reserve ratio). It has nothing to do with the
MPS.
10. Money injected through open market operations results in a multiple expansion of the
money supply only if it leads to loans, and loans can be made only if the new money
ends up in banks as reserves. If the Fed buys a bond from James Q. Public, who
immediately deposits the proceeds into a dollar-denominated Swiss bank account, the
U.S. money supply won’t expand at all. If the money ends up in his pockets or in his
mattress, the expansion of the money supply will stop right there. If he had deposited
the proceeds in a U.S. bank, excess reserves would have been created, stimulating
lending and further money creation.
b
g
11. (a) The bank is required to hold .1 $3,500  $350 in reserves.
(b) Excess reserves  $500  $350  $150 .
(c) Assuming that money lent out by the bank gets deposited in this same bank, the bank
can lend out an additional $150 1 .1  $1,500 .
bg
(d) New T-account:
Assets
Reserves $300
Loans
$3,000
Liabilities
Deposits $3,300
Required reserves are now $330. The bank has deficit reserves of $30. The bank will
need to reduce its loans and increase its reserve by at least $30. This would result in
reserves of $300, loans of $2,700, and deposits of $3,000.
CHAPTER 23
1. (a) Disagree. A rise in Y increases the demand for money as more transactions take
place, but the supply of money is unaffected.
(b) Disagree. Ceteris paribus, a rise in P means that each transaction is more expensive
and households and firms need to hold more money, not less.
(c) Disagree, again. When the Fed buys bonds, it expands the money supply. The supply
curve shifts to the right. When we experience a recession (Y falls) the demand for
money falls, shifting the demand curve to the left. Both tend to push interest rates
lower.
2. A decline in P would shift the money curve to the left since transactions would require
less money. If the Fed held the money stock constant, interest rates would fall.
3. If households believe that interest rates will rise, why should they lend money now?
They will desire to hold more of their wealth as money for the time being, betting that
they can get a higher interest rate if they wait. If they buy bonds now, they risk a
capital loss (a decrease in the value of their assets), because bond prices fall when
interest rates rise. When households hold money to speculate in this way, we call their
motive for holding money the “speculation motive.”
4. This is what Keynes called a “liquidity trap.” Expanding money supply would not push
interest rates lower. The public would essentially hold as much money as we inject into
the system. Since, as you will see, monetary policy works through lowering or raising
interest rates, it will not work to stimulate the economy if the money demand curve is
flat.
5. (a)
r
(b)
Ms
r2
r2
r1
r1
Md
0
6. (a)
Ms
M 1d
M 1d
M 0d
0
M
M
r
M 0s M 1s
r
M
(b)
M s'
r0
Md
M d'
r1
0
(c)
Ms
r
Md
Ms
r
(d)
M s'
r0
Ms
M s'
r0
M d'
Md
0
r
Ms
Md
r
r1
0
Md
Ms
Md
r
(e)
7. A recession is a decline in real GDP. When
output falls, there is less economic
activity and fewer transactions. Fewer
transactions means that (ceteris paribus)
money demand will fall. This will cause a
leftward shift in the M d curve, which
results in a lower equilibrium interest
rate (assuming that the money supply
remains fixed).
r
Ms
r1
0
Md
r2
1
Md
M
8. Ceteris paribus, an expansionary fiscal policy at a time when the Fed want to hold the
rate of growth of the money supply steady will drive up interest rates. First, the added
expenditure will push up the growth of real GDP. The increased spending and GDP
would increase the demand for money, M d . If the Fed holds the line, M d  M s and rates
will rise. At the same time these policies hit taxpayers, the Asia crisis of 1998 hit the
U.S. economy and slowed down the growth of real GDP as exports to Asia fell. By early
1998, the Fed was even thinking of expanding M s to push r down to restore GDP growth.
r
r
Ms
M 1s M 2s
r1
r1
r
1
Md
0
Md
Expansionary fiscal
policy; Fed holds
1
Md
r2
2
Md
M
0
Slowdown from Asia
crisis; Fed expands
M
The equilibrium is at r .5 or 50 percent,
which is found as the intersection of the
.75
B
money demand and money supply curves.
Alternatively, we can solve for r
d
M2
algebraically
by
setting
Md  M s:
.50
A
10,000  10,000 r  5,000  10,000
s
 r  5,000 10,000  .5 .
(c)
M
.30
With Y  7,500 , the intersection occurs at
r .75 .
d
Algebraically,10,000  10,000r  7,500  10,000
.10
M1
(d)  r  7,500 10,000 .75 or 75 percent. The
0
5,000 10,000 15,000
money demand curve shifts right.
Money
17,500
We need a money supply equal to what
money demand would be when r .5 .
M d  10 ,000 10,000 .5   7,500  12,500 .
Increase the money supply by $2,500, to
$12,500.
(e) One possibility is that the price level has fallen, shifting the money demand curve
back to its original position.
9. (a,
b)
CHAPTER 23 APPENDIX A
1. Rates in 1980 were much higher due to higher inflation and higher expected inflation.
The higher interest rates in 1980 were due to a higher “inflation premium” based on
this expected inflation.
In 1980, most debt holders believed that the inflation rate would decrease in the
future. Long-term debt thus had a lower inflation premium than short-term debt. In
1993, the situation was reversed: inflation was unusually low, but many debt holders
were wary of higher inflation rates in the future. Thus, it was long-term debt in this
case that carried the higher inflation premium.
CHAPTER 23 APPENDIX B
1. (a) Peabody should hold the amount of money that maximizes the “net profit” from
holding money, balancing the convenience of money against the opportunity cost of
foregone interest.
(b) At r  10% per month:
Number
of
Switches
0
1
2
3
4
Average
Holding
Average
Bond
$750
375
250
187.5
150
0
37.5
500
562.5
600
Interes
t
Earned
0
37.5
50
56.25
60
Cost of
Switch
Net
Profit
0
4
8
12
16
0
33.5
42
44.25
44
The optimal number of switches is 3, with average money holdings of $187.50.
(c) At r  15% per month:
Number
of
Switches
1
2
3
4
5
Average
Holding
$750
375
250
187.5
150
12.5
Average
Bond
0
37.5
500
562.5
600
625
Interes
t
Earned
0
56.2
75
84.37
90
93.75
Cost of
Switch
Net
Profit
0
4
8
12
16
20
0
52.25
67
72.37
74
73.75
The optimal number of switches is 4, with average money holdings of $150.
An increase in the interest rate to 20% would lead to a further increase in the
optimal number of switches, and a further decrease in average money holdings.
(d) The demand for money curve slopes downward because at higher interest rates,
holding money entails a higher opportunity cost (foregone interest). Individuals will
try to economize on money holdings at higher interest rates.
CHAPTER 24
1. The bank hoped that the rate cut, brought about by an increase in the money supply,
would increase investment spending (I). This would cause C+I+G>Y, inventories would
fall and GDP (Y) would rise. Y increasing would set off a multiplier with C rising.
2. A cut in T increases disposable income Y d . C rises as a result as does S. C  I  G is thus
bigger than Y, inventories fall and Y rises. There would be a multiplier. By assuming no
change in interest rates, there would be no direct effect on C, I or G from the debt
reduction. (Note: There could be a portfolio effect. The supply of bonds decreases,
households try to shift from money to bonds, and bond prices rise driving r lower.
However, we assumed the Fed holds rates constant which it could do by reducing the
supply of money.) Because the tax cut is more expansionary, Y will rise, driving up the
demand for money. To get the economy to slow r will have to rise more than it would
have under the debt reduction story.
bg
3. Taxes (T) rise, causing disposable income Y d to fall. When Y d falls, C falls, causing
AE  Y . When AE  Y , inventories rise and firms cut back on output/income: Y falls and
unemployment rises. If I were the central bank and I wanted to counteract these effects,
I might lower interest rates to try to stimulate investment with expansionary money
policy.
4. (a) If investment depended in no way on interest rates, planned investment in Figure
12.2 would be represented as a vertical line.
(b) A change in interest rates would cause no change in planned aggregate expenditure
because planned investment would not change. (One could argue that consumption
spending might change, but we have not yet discussed the impact of interest rates on
consumption spending.)
(c) Fiscal policy would become more effective than monetary policy. Fiscal policy
directly influences aggregate output by changing government spending or
consumption, and would still be effective. (Indeed, it would be more effective, since
in this case there would be no crowding out.) Monetary policy depends on the
responsiveness of investment to changes in interest rates to influence aggregate
output, and would become completely ineffective.
5. (a) Because these two policies have opposite effects on aggregate spending, the result is
ambiguous. The tax cut raises Y d and thus C. C  I  G  Y . Inventories fall and Y
rises. At the same time, if M s is cut by the Fed, r rises. Higher r leads planned
investment (I) to fall. Lower I implies C  I  G  Y inventories rise and Y falls. The
only thing certain is that r will rise because the tax cut leads to an increase in M d .
(b) In 1998, the tax cuts cause disposable income to rise. When Y d rises, C increases and
C  I  G  Y . Inventories contract, causing Y to rise. Higher Y causes money demand
M d to rise. If M s is fixed, that will cause r to rise. In 1999–2000 the story is
reversed. The expenditure cuts kick in, causing G to fall. C  I  G  Y , inventories
rise, Y falls. That causes money demand to fall and with M s constant, r will fall.
(c) The tax increase reduced disposable income and thus consumption. C  I  G  Y , so
inventories build and output falls. A lower Y means lower money demand. At the
same time that the Fed is increasing the money supply, interest rates will fall
sharply, causing I to rise, perhaps offsetting the effects of the initial tax increase on
Y. (Final result: ambiguous Y, lower r.)
(d) The drop in consumption cuts aggregate expenditure: C  I  G  Y , so inventories rise
and Y falls. As Y falls, money demand drops. If the Fed holds M s constant, r will fall.
Here again, the lower r may stimulate I, causing I to rise, partially offsetting the
initial decline in Y. (Final result: lower Y, lower r.)
(e) The Fed expands the money supply. M s  M d , so r falls. Normally, the lower r might
be expected to cause I to rise, but gloomy expectations and no need for new plant
and equipment keep I low. Thus the link to the goods market is broken, and the
monetary policy doesn’t have much impact. (Final result: lower r, little or no change
in Y.)
6. (a) Increased investment spending would cause an increase in output (income), which
would increase money demand and drive up the interest rate. The Fed could be
expected to respond with an increase in the money supply to hold down the interest
rate. Output, consumption, saving, and investment spending would increase. The
interest rate would remain constant.
(b) The money supply would decrease, causing an increase in the interest rate. The Fed
would respond with an increase in the money supply, bringing the interest rate back
down to its original level. In the end, there would be no change in output,
consumption, saving, investment, or money demand.
7. (a) The decline in investment would be a reduction in aggregate expenditure, causing
equilibrium output (income) to decrease in the goods market. In the money market,
the drop in income would decrease the demand for money (shift the M d curve to the
left), causing the interest rate to fall and investment spending to rise back up
somewhat. But the net effect would be a decline in output (income) and the interest
rate.
(b) Option 3 is the most expansionary, because the increase in the money supply works
to offset the crowding-out effect. Option 2 would come next, but would involve some
crowding out. Option 1 would be at least expansionary, because the tax increase
would decrease consumption spending. (Option 1 relies on the balanced-budget
multiplier, which has a value of 1. Option 2 relies on the government spending
multiplier, which is larger than 1.)
8. Investment may not respond positively to low interest rates during a recession because
decreased production may have left the firm’s existing capital underutilized. In this
case, there would be no incentive to buy new plant and equipment. Investment may not
respond negatively to high interest rates during a boom because the increased consumer
demand arising from increased income may make expansion profitable despite the
higher cost of borrowing.
CHAPTER 24 APPENDIX
1. (a)
(b)
LM
r
r
LM 1
LM 2
r2
r1
r1
IS 2
IS 1
IS 1 IS 2
Y1
Y2
Output
Y1 Y2
Output
(c)
r
(d)
LM 1
LM 2
r
LM 2
LM 1
r2
r1
r1
r2
IS 2
Y1
Output
IS 1
IS 1
IS 2
Y1 Y2
Output
(For part (c) and (d), output can either increase or decrease, depending on the relative
shifts of the two curves.)
CHAPTER 25
1. Both monetary expansion to push (and
hold)
down
interest
rates
and
expansionary fiscal policy (G up and T
down) shift AD to the right. Because the
price level did not rise but Y did, we know
we are on the flat part of the AS curve.
P
AS
AD
AD'
y
2. The cost of doing business would fall, causing the AS curve to shift down to the right.
The price level would fall and cost reductions shift firm supply curves to the right. The
decline in P would cause money demand to drop (shift to the left) putting downward
pressure on interest rates. Lower interest rates stimulate increased I and C, inventories
contract and Y rises . . . real GDP increases.
3. This is not a good explanation for the downward slope of the AD curve. The curve
actually slopes down because an increase in the price level causes the demand for
money to rise, driving up the interest rate and discouraging investment, which causes
aggregate income to fall. The higher interest rate may also discourage consumption and
the higher price level may lower the value of some types of wealth. The AD curve is not
like a market demand curve.
4. (a)
(b)
AS
AS
P2
P2
P1
P1
AD2
AD2
AD1
AD1
Y1
Y2
Output
Y1 Y2
Output
GDP will rise considerably; prices will
rise only a little.
The price level will rise considerably;
equilibrium GDP will rise only a little.
AS 2 AS 1
(c)
(d)
AS
P2
P1
AD2
AD1
Y1
Output
The price level will rise considerably.
Equilibrium GDP may fall, but by less
than it would if the Fed did not
accommodate.
P1
AD
Y1
Output
Neither the price level nor output would
change. The fiscal and monetary policies
have opposing effects on the AD curve. If
they are of equal strength, there will be
no shift in the curve.
5. (a) AD shifts to the
equilibrium beyond
right pushing
Y p (potential
GDP). The price level rises. Costs rise
causing the AS curve to shift upwards.
The Fed belatedly contracts driving r
up shifting the AD curve back down,
down, pushing Y* back to Y p at a
AS 2
AS 1
P2
P1
higher level of P.
AD2
AD3
AD1
YP Y *
(b) Aggregate supply shifts right and AD
shifts to the right but not as far
causing the price level to fall.
AS 2
AS 1
P1
P2
AD2
AD1
Y1 Y2
6. (a) Expansionary fiscal policy shifts the AD curve to the right if the Fed expands the
money supply to accommodate the expansion and prevent crowding out. With high
employment and low capacity utilization there is little danger of inflation.
(b) Contractionary monetary policy shifts the AD curve to the left.
r
AE
P
M s2 M s1
AS
AE1
r2
P1
AE2
r1
P2
Md
M
45°
Y2 Y1
AD1
AD2
Y
Y
P
Y2
Y
7. (a) If the short-run aggregate supply and
aggregate demand curves intersect to
the right of YP, wages and other input
prices will rise, causing aggregate
supply to shift left. If at the same time
there is an increase in the money
supply, aggregate demand will shift
right. The expansionary monetary
policy increases the rise in the price
level that will occur in the long run as
the economy adjusts back to full
employment at Point B.
(b) If the short-run aggregate supply and
aggregate demand curves intersect to
the right of YP, wages and other input
prices will rise, causing aggregate
supply to shift left. If at the same time
a decrease in government spending
and in the money supply occurs,
aggregate demand will shift left. If the
shift in aggregate demand is great
enough, the price level will not have to
rise during the adjustment process.
AS 2
AS 1
LRAS
P1
AD1
AD2
YP
Y*
(c) The increase in oil prices pushes the
aggregate supply curve up. Without
Fed accommodation, the higher price
level would raise interest rates and
GDP would drop below Yp – a
recession. But the Fed accommodates
the rise in price level, shifting the AD
curve to the right and holding GDP at
Yp.
8. The actual physical capacity of existing plants represents the maximum output level the
economy could produce in the short run. It is where the short-run AS curve becomes
vertical. Potential GDP is the maximum output the economy could maintain in the long
run without exacerbating inflation. It is less than full-capacity output because the
bottlenecks and labor shortages that would exist at full-capacity output would cause
wages and input prices to rise, leading to worsening inflation.
9. Expansionary monetary policy is likely to have a greater effect in country B. Because
production costs adjust automatically to price increases in country A, the AS curve will
be vertical. A rightward shift in the AD curve would cause an increase in prices without
increasing output because costs increase at the same time as prices. In country B, input
prices lag behind output prices, so the short-run AS curve is not vertical. In the short
run, a rightward shift in the AD curve will cause an increase in output.
Country A
Country B
AS
AS
P2
P2
P1
P1
AD2
AD1
AD2
AD1
Output
Y 1 Y2
Output
CHAPTER 26
1. An improved trade-off between inflation and unemployment could be the result of a
leftward shift in the Phillips Curve. This could be the result of increased productivity, a
more efficient labor market, falling world prices, or other supply-side factors. The
tradeoff would be worsened by decreases in productivity and increases in resource
prices (like the increased price of oil at the end of 2000 and beginning of 2001).
2. Answers will vary.
3. Answers will vary depending on what occurs.
4. (a) If the minimum wage is 9 slugs per hour, then:
Q D  100  5 9  55 million workers; Q S  10 9  20  70 million workers.
The excess supply of labor (number of unemployed) would be 70  55  15 million
workers. The unemployment rate would be 15 70 .214 or 21.4%.
(b) With no minimum wage, the equilibrium wage is found by setting labor demand
equal to labor supply:
100  5W  10W  20  120  15W  W  8 slugs per hour.
Equilibrium employment is found by substituting W  8 into either the labor-demand
or labor-supply equation:
Q D  100  5 8  60 million workers; Q S  10 8  20  60 million workers.
bg
bg
bg
bg
The labor force shrinks from 70 million to 60 million workers. Total employment
rises from 55 million
to 60 million workers. The unemployment rate shrinks from 21.4% to zero. (The
model assumes no
frictional unemployment.)
(c) The labor market might not adjust so quickly due to wage rigidity, which has a
number of possible causes, including implicit and explicit contracts, worker
concerns over their relative wages, and firms’ concerns over the decline in
productivity that might follow a wage cut.
5. (a) This policy would decrease frictional unemployment by helping employers and
workers find each other. The time spent in job hunting would be reduced.
(b) This policy would decrease structural unemployment by making it profitable to hire
workers who would otherwise not be productive enough to employ. (To some extent,
however, teenage workers might be substituted for existing workers, thus lessening
the impact on unemployment.)
(c) This policy would reduce structural unemployment by providing workers with skills
needed in new or expanding industries.
(d) This policy would reduce structural and cyclical unemployment by providing jobs for
people who would otherwise be unemployed. The program would cause a direct
increase in the demand for labor. A worry might be that to pay them, taxes must be
collected, thus reducing demand in the private sector and eliminating some private
sector jobs.
(e) Reduces frictional unemployment by aiding workers in their job hunt.
(f) If the President is convincing, wage and price hikes would be moderated. The effect
on unemployment would depend on which of the two—wages or prices—is affected
more. If wage growth is affected more than price growth, then real labor costs
would decrease and the demand for labor would increase, thus reducing
unemployment. The reduction would be in all forms of unemployment—structural,
cyclical, and frictional.
6. The wage increase may be inefficient to compensate for rising prices.
increase is less than the tax rate of inflation, real wages fall.
If a wage
7. (a) The effect of a higher wage tax on household labor force behavior is ambiguous.
Workers may respond to the decrease in after-tax wage by consuming more leisure,
which now has a lower opportunity cost, so that labor supply will fall. However,
workers are worse off. Since leisure is normal good, consumption of it might fall and
thus labor supply might rise. At the same time, lower Social Security benefits might
force the elderly back into the workforce. With higher benefits, come elderly may
stay out of the workforce or be able to continue their retirement.
(b) Improved child care reduces the opportunity cost of working. It is likely to attract
more parents to the work force, increasing the labor force and labor supply. It would
also reduce the demand for labor by increasing the full costs of hiring a worker.
Over the short run, during which some wage rigidity is likely, the effect of an
increase in labor supply and a decrease in labor demand would be an increase in the
unemployment rate.
(c) Increased immigration will increase labor supply at a given wage rate without a
corresponding increase in jobs. With short-run wage rigidity, unemployment will
rise.
(d) Labor supply (and the labor force) should increase as more workers begin to seek
even low-paid work to support themselves. With short-run wage rigidity,
unemployment will rise.
(e) Increased investment might increase or decrease labor demand, depending on
whether the new capital is more complementary to or substitutable for labor. There
would be no immediate impact on labor supply. The effect on employment and
unemployment would be ambiguous.
8.
9. Answers will vary.
10. The trade-offs would likely not be identical, largely because of differences in
institutions in the two countries. For example, Japan had a tradition of “lifetime”
employment for male workers in the country’s largest industries. As a result there are
fewer layoffs in Japan and it probably has a lower natural rate of unemployment than
does the United States.
11. Answers will vary.
CHAPTER 27
1. The Fed began cutting interest rates in June of 2000 when the Fed Funds Rate was
6.5%. Rates were cut steadily through mid 2003 when The Fed Funds Rate hit 1%. The
federal budget was in surplus in 2001 as a whole when the surplus was $40 billion
according to the Bureau of Economic Analysis. In 2002 the deficit was $354 billion.
There seems to be a bigger response lag for fiscal policy.
2. Fine tuning refers to the use of monetary and fiscal policy to steer the economy along a
continuous growth path without inflation or unemployment. When economic growth
accelerated in 1999, the Fed began to worry about inflation. In fact, beginning in the
summer of 1999 and continuing for a full year, the Fed slowly acted to raise short-term
interest rates in order to slow the economy down. As growth slows, the Fed could be
expected to cut rates.
3. When the economy contracts, both taxable income and corporate profits fall, causing a
decrease in tax revenues. In addition, some government expenditure categories, such as
unemployment insurance benefits, tend to rise. With decreased tax revenues and
increased government expenditures, the government deficit typically rises when the
economy contracts.
a
f
4. (a) Y  C  I  G  100  .8 Y d  60  80  100  .8 Y  150  .25 Y  60  80
 100  .8 Y  120  .2Y  60  80  360  .6 Y
Y  360 .4  900
D  G  T  80  150  .25 900   5
(b) With G  75
Y  C  I  G  100  .8 Y d  60  75  100  .8 Y  150  .25 Y  60  75
 100  .8 Y  120  .2Y  60  75  355  .6 Y
Y  355 .4  887.5
D  G  T  75  150  .25 887.5   3.125
The deficit is not zero because the cut in government spending shifts the AD curve to
the left, decreasing aggregate output and causing a drop in the net tax revenue.
Although the original cut in government spending would seem to eliminate the
deficit, the resulting drop in GDP tends to raise the deficit, so the net effect is a
deficit that is smaller, but not zero.
(c) The deficit response index (DRI) is the amount by which the deficit changes in
response to a one-dollar change in GDP. In this example, the deficit changed for two
reasons. The decrease in G had a direct effect of decreasing the deficit by $5 billion.
The decrease in GDP of 12.5 billion caused the deficit to increase by .25 12.5  $13.125
a
f
b g
billion due to the loss in tax revenue. This latter effect is what is measured by the
DRI. DRI  3.125 12.5  .25 .
To find the required change in G to eliminate the deficit, note that in this
example  deficit  G  T  G  .25 GDP . We also know that GDP  2.5 G .
bg
Combining these two equations give us  deficit  G  .25 2.5 G  .375 G . We need
deficit to equal –5, so 5  .375 G  or G  5 .375  13.33 . Government spending
b
g
must be cut by $13.33 billion.
(d) With I  55
Y  C  I  G  100  8 Y d  55  80  100  .8 Y  150  .25 Y
 100  .8 Y  120  .2Y  55  80  355  .6 Y
Y  355 .4  887.5
D  G  T  80  150  .25 887.5   8.125
a
f  55  80
Following the methodology of part (c), we need deficit to equal –8.125, so
8.125  .375 G or G   8.125 .375  21.67 .
b
g
5. Beginning in the summer of 1999, the Fed raised short-term interest rates. While
growth began to slow in early 1999, it was the third quarter of 1999 when growth
slowed significantly to under three percent. At the end of 2000 it appeared that the
Fed’s decision to slow the economy was a good one. Only time will tell whether the
decision to tighten credit was a good thing in the long run.
6. States that must have balanced budgets are unable to use spending and taxing to offset
local economic shocks. Moreover, an adverse shock that sends the state budget into
deficit requires the state to raise taxes or cut spending, which will cut local spending
and exacerbate the impact of the shock. The effect is therefore destabilizing.
If all states followed this philosophy, the effect would be destabilizing on a national
basis. Adverse shocks would send the economy into recession, causing the federal deficit
to swell. If states cannot pursue expansionary policies to help a nation out of the
recession, then they must rely more heavily in the federal government to do so. Thus, a
larger increase in the federal deficit will be necessary to stimulate the economy than
would otherwise be the case.
7. The Fed “leans against the wind” when it increases the money supply to lower interest
rates to counteract contraction of the economy, and decreases the money supply to raise
interest rates to counteract rapid expansion. These policies are designed to stabilize the
economy.
8. Stabilization policy may be difficult to carry out because there are time lags in the
economy’s response to such policies. Stabilization policies can thus be destabilizing
because they may affect the economy much later, when the adjustments are no longer
desirable.
9. It takes a full year for the spending multiplier to take effect because neither individuals
nor firms alter their spending plans immediately. It takes time for the additional income
derived from increased government spending to be translated into additional purchases,
and when taxes are cut there are also decisions to be made about what portion of the
tax cut to spend and what to spend it on. This makes correct timing of fiscal policy more
difficult.
CHAPTER 28
1. (a-g) Answers will vary
2. (a-d) Answers will vary
3. Bond prices depend on the duration of the loan and the risk. Since the duration is
exactly the same in both cases, the entire differences must be due to risk. Treasury
bones are backed by the “full faith and credit of the United States Government,” and are
considered to be risk free. There is a slight probability that GM will not be able to pay
off the bonds in 10 years. Buyers are demanding more because GM is not doing well and
could default.
4. Certainly such big drops have large effects on the wealth of households in these
countries. Counsumers in these countries are therefore likely to spend less, dropping C
and eventually Y. Recessions are likely to result. There are several possible problems
for the United States. First, Americans are invested in foreign stock markets so there is
a modest wealth effect in the United States. Seond, recessions in foreign countries
mean that their consumers buy less from us and export demand drops. Finally prices of
imports from these countries could fall, competing with U.S. firms.
CHAPTER 29
1. Productivity must be part of the answer. It must be the case tat we are producing more
output with fewer workers. This could be in part the result of firms holding onto excess
labor after the peak of the cycle. Holding excess labor and capital may be efficient if a
downturn is seen to be short. The 2001 recession led to slow growth particularly in
terms of profits. Firms may just have been slow to cut.
b
g
2. The labor force dropped by 363,000 430,000  67,000 . Recall that the employed and the
unemployed must add up to the labor force. Possible explanations include the
discouraged worker effect, which is unlikely because the economy had been growing
and jobs were plentiful. In fact, the Census Bureau released 290,000 temporary workers
that month. It could be that people in transition to new jobs simply decided to take time
off.
3. (a) Because the cost of borrowing is higher, households are less likely to buy items for
which they must borrow money such as consumer durables (automobiles and
houses). Firms face a higher cost of capital when r rises, thus the rate of investment
spending is likely to fall.
(b) A fixed rate bond paying 7 percent for the next 10 years is simply worth less to its
holder if potential buyers can now get 8 percent by buying a new bond.
(c) When wealth falls, consumers are less
well off; their net worth is lower and
they are inclined to spend less. Thus,
higher interest rates have a secondary
effect on consumer spending by
reducing wealth, which leads to lower
consumption spending. The AD curve
shifts further to the left than the firstorder impacts would suggest:
AS
AD1
AD
y1 y0
Output
4. When taxes increase (net wages decrease), one of the impacts is a reduction in income.
If leisure is a normal good, the decrease in income will lead to less consumption of
leisure, and therefore an increase in desired work hours. This services to counteract the
substitution effect of a decrease in wages, which lowers the opportunity cost of leisure
and tends to decrease desired work hours.
5.
(a)
C  300  .5 y
C  .5 y
300
0
Income
For the first consumption function:
If Y  $100 , C  300 .5 100  350 , APC  350 100  3.5
If Y  $400 , C  300 .5 400  500 , APC  500 400  1.25
bg
b g
If Y  $800 , C  300 .5 b
800 g
 700 , APC  700 800 .875
For the second consumption function:
If Y  $100 , C  5 b
100 g
 50 , APC  50 100 .5 0
If Y  $400 , C  5 b
400 g
 200 , APC  200 400 .5 0
If Y  $800 , C  5 b
800 g
 400 , APC  400 800 .5 0
(b) For the first consumption function (with the constant term 300), as income
increases, APC decreases. For the second consumption function (with no constant
term), the APC remains constant as income increases.
(c) For the first consumption function, the APC is always larger than the MPC. For the
second consumption function, the APC is equal to the MPC.
(d) When income changes, it is the MPC (not the APC) that determines how consumption
spending changes. Even though the APCs for the two families differ, the MPCs are
the same. Thus, the decrease in consumption in one family is the same as the
increase in consumption in the other.
6. (a) The value of homes is an important component of household wealth. When home
prices rise, household wealth rises and consumption tends to increase. When home
prices fall, household wealth falls and consumption decreases.
(b) Because changes in consumption are changes in aggregate expenditure, they lead to
changes in output and employment in the same direction.
7. (a) Over his life, Smith will have a total of $20,000  20 $14,000  $300,000 available for
b
g
spending. He has 25 years to consume, so each year his consumption will equal
$300,000 25  $12,000 .
(b) Smith’s annual saving is equal to the annual increase in his wealth. When Smith is
65, his wealth starts to decline because his consumption continues to be $12,000
while his income goes to zero. When he dies, Smith has zero wealth.
(c) The permanent tax rebate will give additional lifetime income of $100 20  $2,000 .
bg
This must be spread out over 25 years, so consumption each year will be
$2,000 25  $80 higher than before.
(d) The temporary tax rebate increases lifetime income by only $100. Each year,
consumption will be $100 25  $4 higher than it was before.
8. A given consumption path requires a given amount of lifetime income to pay for it. But,
given initial wealth, lifetime income is determined by working hours. This implies that
income is not really an “independent” variable in the consumption function. Rather, the
desire to consume and the desire to enjoy leisure together will determine how much
income one will earn.
9. Expectations of future sales determine how much capital a firm will want to have in
place in the future. To have this capital when it is needed, investment spending must
take place in earlier periods. Because expectations of future sales are affected by
government policy announcements, release of economic data, and “animal spirits”—all
of which can change rapidly—the resulting investment spending is quite volatile.
10. Maintaining inventory stocks helps a firm maintain a smooth production level. When
sales unexpectedly increase, goods can be sold out of inventory. When sales
unexpectedly decrease, goods can be added to inventories. By smoothing production, a
firm can save on the adjustment costs associated with frequent changes in capital stock
and employment levels. The cost of this policy is the forgone interest from investing
funds in inventory stocks instead of lending out the money in financial markets.
CHAPTER 30
1. The new technology clearly enhances productivity. There are countless examples. Just
imagine writing a paper or doing research without a search engine. Law clerks can do
in ten minutes what would have taken a hundred hours to do reading printed documents
and looking through newspapers. Also, E-mail and on-line banking, and the list goes on.
Any time you get over expansion in a sector, inventory builds and output falls. We
upgraded and changed most of the systems in the country for the Y2K bug. Everyone
and every business put up a website during that period. The economy ‘overbuilt’ the
new technology and a downturn was inevitable.
2.
Y/L
4.28
4.23
4.17
4.12
Table 1
Growth Rate
—
3.7
3.6
3.7
Y/L
4.28
4.41
4.53
4.66
Table 2
Growth Rate
—
3.9
3.9
3.9
Y/L
4.28
4.45
4.63
4.81
Table 3
Growth Rate
—
5.0
5.0
5.0
In Table 1, L is growing rapidly while K is growing slowly. It is likely that much of the
growth in Y is due to growth in L. Because of diminishing returns to L, it is not
surprising that Y/L is declining.
In Table 2, L is growing slowly while K is growing rapidly. In this case, it seems that the
growth in Y is caused mainly by growth in K. The ratio Y/L is increasing because each
worker has more capital with which to work.
Finally, in Table 3, both L and K are growing slowly relative to Y. Technology must be
the cause of most of the growth in Y in this case. This technological improvement also
has the effect of increasing the amount of output per worker (Y/L).
3. This is a current events question; answers will vary.
4. Households would receive a higher after-tax rate of return on their stock portfolios. It
could lead to higher saving. It could also lead households to shift their portfolios toward
stocks and away from bonds. Some argue it could lead to more frequent trading among
stockholders, leading to a more efficient stock market. Firms would be more likely to
retain earnings for investment purposes because paid-out dividends would be taxed at a
higher rate than capital gains. Some argue that it would lead to more start-up
companies. When a small firm goes “public,” successful entrepreneurs who cash in have
to pay capital gains rates on the proceeds of their stock sale; lower CG rates increase
the incentive to start a firm. Empirical research suggests that these effects are small.
5. In the short run, output responds to aggregate expenditure, and an increase in
consumption will cause output and employment to increase. In the long run, output will
gravitate to potential output, so fluctuations in aggregate expenditure are less relevant.
But higher levels of consumption spending in the long run use up funds and resources
that would otherwise by available for the purchase of capital equipment by business
firms. Thus, in the long run, high consumption spending slows down economic growth.
6. Assuming that the economy stays at full employment, the bill would cause the economy
to produce more capital goods and fewer consumption goods. This would lead to a
higher growth rate over time. The trade-off is less consumption today. There are also
distributional consequences. Capital income earners (who have higher incomes on
average) would benefit. Higher-income households (who spend a smaller fraction of
their incomes) would bear relatively less of the consumption-tax burden, while lowincome households (who spend a higher fraction of their incomes) would bear relatively
more of the consumption-tax burden.
7. (a-d) There is no right answer in each case. In vegetable farming and airline
transportation, obvious candidates are bushels of vegetables and air passenger miles,
respectively. In these two sectors, productivity can be measured with at least some
degree of accuracy. However, even these present problems. For example, vegetables are
now genetically engineered, and air travel is much faster. A trip from Boston to Paris on
the Concorde takes 3 hours and has a high cost in dollars. The same trip costs much less
and takes many more hours on a more conventional aircraft. Output measures for
software firms are very difficult to arrive at. Every application is different, and every
program provides a different set of services. Education is similar. One could imagine
measuring “contact hours” or number of classes, but consider the difference between an
hour of biochemistry at Stanford and an hour of hair dressing at a proprietary school.
The product in each case is human capital. How to measure it is a problem in both
theory and practice.
8. High budget deficits are financed with private saving. That saving otherwise would have
found its way through financial markets into private capital production. If the deficit is
used to finance current expenditures like paying judges and congresspeople, it is not
contributing to an expansion of output in the long run. The same is true of a tax cut,
which is used to increase current consumption expenditures. But if the government used
the money to build capital such as roads and bridges or to increase human capital
through better education and job training, it would at least offset part of the reduction
in private investment spending. Whether the net result for output growth is positive or
negative depends on whether private capital or public capital has a higher rate of
return. This is a subject of much debate, and would depend on the specific capital
expenditures undertaken by the government.
9. One principal stimulus to growth is capital accumulation. Capital investment requires
savings and savings come mostly from the rich rather than the poor. Also, growth
requires high incentives for those who work and invest in the “right” way (the way that
matches consumer desires most closely), and this means that the rewards for work and
investment will be unequally distributed. It is possible for the poor to benefit from
economic growth because capital accumulation ultimately raises wages. Also higher
average incomes can mean more tax revenues, which can be used to finance government
programs aimed at helping the poor.
CHAPTER 31
1. (a) It’s hard to make predictions based on two numbers, but if you took them as signs of
a trend you would worry anytime the money supply (M1) was growing more rapidly
than the rate of real growth (rate of growth of real GDP). Thus Canada and Australia
seem to have the biggest problem, followed by Japan and Britain. Money supply
growth in the United States is much less than its rate of growth of real GDP.
(b) If you were a Keynesian, and assuming an activist central bank, you might interpret
the same data as indicators of policy to expand those economies (particularly true
for Japan).
2. (a) Graph I: Supply-side economics; it focuses on the supply-side effects of a tax cut and
tends to ignore the demand-side impacts. Tax cuts should increase the incentive to
work, save, and invest. If work effort, saving, and investment all increase, the AS
curve will shift to the right, increasing output and reducing the price level. The
extent to which the supply curve is likely to shift depends on the responsiveness of
behavior to the tax cuts. This is the subject of much controversy.
Graph II: Monetarism/New classical economics. Both schools believe that fiscal
policy cannot have an impact on the level of real output. Monetarism believes that
nominal GDP cannot change as long as the money supply and the velocity of money
remain constant. Thus real GDP will not respond to a tax cut. New classical theories
predict that “anticipated” fiscal policies will have no effect on real GDP, which
remains at the potential output level determined in the long run in markets such as
the labor market.
Graph III: Keynesian economics. As long as the economy is not operating at capacity,
and as long as
the Fed accommodates somewhat by increasing the money supply, a permanent tax
cut can increase
the level of real GDP and is likely to be inflationary. The impact on the price level is
determined by
how close to capacity the economy is operating.
(b) Individual response.
3. Answers will vary, but should explain that the issue turns on what is likely to be more
expansionary in a time of full employment, a substantial tax cut that would increase
aggregate expenditure or a reduction in long-term interest rates that would also
increase both consumption and investment (and both could ignite inflation).
4. The supply-side logic is that cutting taxes increases the incentive to work, save, and
invest. Expanding the work force and the capital stock clearly can have an expansionary
effect allowing the economy to grow more rapidly. But a lower T means that disposable
income, Y d rises. Higher disposable income increases C and thus aggregate expenditure.
If AE  Y , inventories contract and Y rises. Thus, the AD curve shifts; there is an
expansionary demand side effect.
5. Answers will vary based on where students reside.
b
gbg
6. Nominal income  M  V  $1,000 5  $5,000 . If we select the current year as our base
year, real income is also $5,000. If you are a strict monetarist you believe V is constant.
Therefore, a doubling of the money supply to $2,000 will cause a doubling of nominal
GDP to $2,000 5  $10,000 . If, however, velocity is a function of the interest rate as well
b
gbg
as institutional factors, then it cannot be assumed a constant. In this case, an increase
in the money supply (which reduces interest rates) would lower velocity, so M  V
would not increase by as great a percentage as M itself increased, and nominal GDP
would rise by a smaller percentage than the money supply increased. If the money
supply doubles (rises by 100 percent), nominal GDP will rise by less than 100 percent.
(We cannot know how the rise in nominal GDP is apportioned between a rise in P and a
rise in real GDP without knowing more about the current state of the economy).
7. (a) Clinton’s tax increases and spending cuts would be a fiscal contraction. With no
change in Fed policy, output would decrease and unemployment would increase. If
the Fed matches the fiscal contraction with a monetary expansion, lowering interest
rates to stimulate investment, the decline in output, could be avoided.
(b) Monetarists would worry about imperfect policy timing. Fed stimulation might take
effect at the wrong time (e.g., after the economy has recovered from the impact of
the fiscal contraction). Supply-siders would worry that higher tax rates would
decrease the incentive to work and invest. Extreme supply-siders might worry that
an increase in tax rates would decrease tax revenue and result in an even larger
budget deficit.
(c) To evaluate the supply-side argument, you would need to see what happened to tax
revenues and labor supply after the tax rate increases. An increase in tax revenues,
ceteris paribus, would contradict the view of extreme supply-siders. If labor supply
did not decrease much, general supply-side arguments would be weakened. To
evaluate the monetarist argument, you would need to see if investment spending
increased as consumption spending declined (proper policy timing), or only after
consumption began to recover (poor timing).
8. Quite simply, it is because the labor market clears if wages are fully flexible. If there is
unemployment, wages will fall, the quantity of labor demanded will rise, and the
quantity of labor supplied will fall until there is no more excess supply.
9. A policy of cutting taxes and increasing expenditures on national defense should be
inconsistent with balancing the budget. However, supply-side economists believe that
cutting tax rates can actually result in greater tax revenues, and so it would be possible
to have all three. The question really turns on how tax revenues respond to reductions
in tax rates. Reagan believed that lower taxes would cause a substantial increase in
work effort and investment.
10. A tax cut from .25 to .20 is a 20 percent reduction, and if labor supply did not change,
tax revenues would fall 20 percent. Tax revenue = tWL. In order for tax revenues not to
change, we need to have .25WLOLD = .2WLNEW. This implies LNEW = .25WLOLD/.2W =
1.25 LOLD. Thus, the new supply of labor must be 25 percent higher than the old supply
of labor. What does this tax cut mean to net wages? It means that net wages rise from
.75W to .80W, an increase of .05/.75 = .0667 or 6.67 percent. Thus, in order to keep
revenues constant, a 6.67 percent increase in net wages would have to generate a 25
percent increase in labor supply, implying an elasticity of 25/6.67 or 3.75. This is much
larger than any empirical estimates of the actual elasticity of labor supply.
CHAPTER 32
1. (a)
Germany
France
100,000
50,000
200,000 pounds of butter
75,000 pounds of butter
(b) Yes. The opportunity cost of a gun in Germany is 2 pounds of butter. The opportunity
cost of a gun in France is only 1.5 pounds of butter. France has a comparative
advantage in guns. Similarly, the opportunity cost of a pound of butter in Germany is
1/2 of a gun, whereas the opportunity cost of a pound of butter in France is 2/3 of a
gun. Germany has a comparative advantage in the production of butter.
(c) As long as the agreement specifies between 1.5 pounds of butter and 2 pounds of
butter per gun, specialization and trade will benefit both countries. For example,
sending 1.75 pounds of butter from Germany to France in exchange for a gun
benefits both countries.
2. Answers will vary.
3. (a) You cannot tell from the information given which country has an absolute advantage
because you are not given any information that would indicate the actual quantities
of inputs used in production in either country.
(b) If resources are fully mobile between sectors, the opportunity cost of a cap is 2/3 of
a quart of wheat in Russia; the opportunity cost of a cap is 7 10 of a quart of wheat
in the United States. Russia has a comparative advantage in cap production. The
opportunity cost of a quart of wheat in Russia is 1.5 caps. The opportunity cost of a
quart of wheat in the United States is 10 7 or 1.43 caps. The United States has a
comparative advantage in wheat.
(c) At $1  1 Ru, both goods in the United States are cheaper to everyone. That would
mean that there was a big demand for dollars and no supply on foreign exchange
markets. The price of the dollar would rise. When a dollar was valued at between
1.43 and 1.50 Ru, caps would be cheaper in Russia and wheat would be cheaper in
the United States. If the price of a dollar rises to more than 1.50 Ru, everyone would
buy both goods in Russia.
4. (a) Imported items might include coffee, tea, chocolate, oranges, tomatoes, kiwi fruit,
and dates. Exported items might include corn, wheat, apples, and beef.
(b) One would need data on input requirements for various agricultural goods and
nonagricultural goods, in both the United States and other countries. From this, the
opportunity cost of producing various food items in terms of nonfood items could be
determined and compared with the same figures in other nations.
(c) Yes, these numbers are consistent with a U.S. comparative advantage in food,
although we are not completely “specializing” in food production. A more detailed
breakdown would probably reveal that the United States tends to export capitalinvestment foods (wheat, corn) or foods easily produced in our climate, and that we
import labor-intensive foods (tomatoes) or foods more easily produced in foreign
climates (coffee, dates).
(d) A theory of trade based on the desire for variety might explain why a nation imports
and exports the “same” good (the varieties of the good imported would differ from
the varieties exported).
5. (a) Illinois would have an absolute advantage in both wheat and soybeans.
(b) In Illinois, taking 1 acre out of wheat and moving it into soybeans sacrifices 48
bushels of wheat for 39 bushes of soybeans. This is 48 39  1.23 bushels of wheat for
each bushel of soybeans. In Kansas, the sacrifice is 40 24  1.67 bushels of wheat for
each bushel of soybeans.
(c) Based on the calculations in (b) above, Kansas has a comparative advantage in
wheat, and Illinois has a comparative advantage in soybeans.
(d) Yes, the data are consistent with the conclusions in (c) above. Kansas has more
acreage devoted to wheat than soybeans, whereas in Illinois there is more acreage
devoted to soybeans than to wheat. Although neither state completely “specializes,”
each state seems to be devoting more of its resources to producing the good in which
it has a comparative advantage.
6. (a-c) Answers will vary.
7. (a) The opportunity cost of a bottle of red wine is 1.5 bottles of white in France and 2
bottles of white in Germany. France, therefore, has a comparative advantage in red
wine. The opportunity cost of a bottle of white wine is .66 bottles of red in France
and .5 bottles of red in Germany. Germany, therefore, has a comparative advantage
in white wine.
(b) No. At the current exchange rate, both white and red wine are cheaper in Germany.
French citizens will want to import both types of wine from Germany, but Germans
will not want to import French wine.
(c) In this situation, we would expect the price of the franc to decrease until French red
wine became attractive to Germans whereas German white wine is still attractive to
the French. (An exchange rate between 1.5 and 2 francs per mark would accomplish
this.)
(d) In the long run, we would expect exchange rates to adjust until the French are
exporting red wine to Germany and the Germans are exporting white wine to
France.
CHAPTER 33
1. (a) Disagree. The opposite is true. The fed had been expanding the money supply to
push rates down to help stimulate the economy during a period of slow growth. Low
interest rates mean that the buyers stay away from low yielding U.S. securities,
reducing the value of the dollar.
(b) Disagree. This is good news of U.S. exporters whose goods are now cheaper on
world markets. Demand for exports for the U.S. should rise. The real point is that
foreigners now pay less for the dollar that the need to buy U.S. exports.
(c) Disagree. This is bad news for European exporters. A weak dollar means that for
Americans, European good are more expensive. This is likely to reduce the demand
for exports from Europe.
3. Answers will vary.
3. (a) Answers can include an increase in U.S. incomes, an increase in British interest
rates, a decrease in U.S. interest rates, a decrease in the British price level, and an
increase in the U.S. price level.
(b) All of the above, except for the increase in U.S. incomes, would also cause the supply
curve to shift left.
(c) The two changes in interest rates listed in (a) above (which would raise the value of
the pound without any other simultaneous change in import or export demand)
would make British goods relatively more expensive and decrease Britain’s trade
balances (shrink the surplus or increase the deficit).
4. Answers will vary. The trade balance is simply made up of exports and imports of goods
and services. A country with a trade deficit is one that imports more than exports. The
current account balance takes account of investment income paid to foreigners as well
as foreign investment income paid to a country’s citizens. Investment income earned
abroad is added to exports, and investment income paid to foreigners is added to
imports.
5. (a) The expansionary fiscal policy increased incomes and the demand for money. This in
itself would cause U.S. interest rates to rise. In addition, the contractionary
monetary policy caused interest rates to rise further.
(b) The supply curve for dollars would shift to the left, and the demand curve would
shift to the right. The value of the dollar would rise.
(c) The rise in the value of the dollar (with no other change in the desire to buy more
imports or exports) would make U.S. goods relatively more expensive. The U.S. trade
deficit would worsen, and the trade balance of other countries with the United
States would rise.
6. (a) The consumption function does not change, so instead of spending their money on
Japanese goods, U.S. citizens will spend it on domestic goods. All else equal, this will
stimulate U.S. output and decrease U.S. unemployment, and decrease output and
employment in Japan.
(b) If income rises, consumers are likely to buy more imports as well as more domestic
goods. Imports from Japan will increase somewhat after the initial decrease.
(c) If imports decrease, then the demand for yen will also decrease because importers
will not need as many yen to purchase Japanese goods.
(d) The yen will depreciate and the dollar will appreciate. This gives U.S. consumers
more buying power in the market for foreign goods. Consumers will buy more
imports, causing a decrease in aggregate expenditure on domestic output. Output
and employment in the United States will fall. The current account deficit will rise,
but the total balance of payments will still sum to zero.
(e) The quota would have to increase U.S. output and employment, at least in the short
run. The increase in the U.S. trade balance increases U.S. output and employment.
This causes the dollar to appreciate, which works to decrease output.
7. (a) Under fixed rates, higher U.S. income would increase the demand for imports. The
U.S. current account balance would decrease (i.e., the trade surplus would decrease
or the trade deficit would increase). Under floating rates, there would be two forces
acting on the exchange rate. Higher U.S. income would increase the demand for
imports, increasing the supply of dollars on foreign exchange markets and causing
the dollar to depreciate. However, with higher income, assuming the Fed is not fully
accommodating, the interest rate in the United States would rise due to the higher
demand for money. This increase in the interest rate would increase the demand for
(and decrease the supply of) dollars on foreign exchange markets, causing an
appreciation of the dollar. The net effect on the value of the dollar is ambiguous.
However, because of the increase in U.S income, the demand for imports would
increase and the current account balance would decrease, although this change in
the current account balance may be partially offset if the dollar depreciated.
(b) Under fixed rates, higher U.S. prices would make U.S. goods less attractive. U.S.
imports would increase, and exports would decrease, causing a decrease in the
current account balance. Under floating rates, the dollar would depreciate, with no
effect on the current account balance.
(c) Because U.S. interest rates fall, foreigners will take their money out of U.S. financial
markets and the demand for dollars will decrease. U.S citizens will find foreign
financial markets more attractive, so the supply of dollars will increase. At the same
time, U.S. income increases so the demand for foreign goods also increases, further
increasing the supply of dollars. Under fixed rates, all this would decrease the
current account balance. Under floating rates, the dollar would depreciate, causing a
decrease in imports and increase in exports. As imports would increase due to the
higher U.S. income, the net effect on the current account balance is ambiguous.
(d) Imports will decrease and consumers will buy more domestic goods, so the demand
for foreign currency decreases. Under fixed rates, this would increase the current
account balance. Under floating rates, this would cause the dollar to appreciate, and
the impact on the current account balance would be ambiguous.
8. (a) Y  C  I  G   EX  IM   100  .8 Y  40   38  75  25  .05 Y  40 
 238 .8 Y .8 40 .05 Y .05 40   208 .75 Y  832
Government deficit  G  T  75  40  35 .
Current acount balance  EX  IM  25 .05 832  40   14.6
(b) The multiplier  1 1   MPC  MPM   1 1  .8 .05   4
When G increases from 75 to 80, Y will increase by 5 4  20 . Imports will rise by
bg
bg
.05 20  1.
b g
With the quota, the MPM is zero, so the multiplier  1 1.8  5 . Y will rise by
bg
5 5  25 . (This assumes that IM is greater than or equal to 40 without the quota,
before the increase in G. Actually it is 39.6, but assuming MPM  0 is a very close
approximation.) Imports that rise with income act as a leakage and reduce the size
of the multiplier.
(c) With EX  25 , we need IM .05 Y  40  25 . This implies Y  540 . Income is currently
832, so it must be decreased by 832  540  292 . With a multiplier of 4, this will
require a decrease in government spending of 292 4  73.
b
g
CHAPTER 34
1. Answers will vary.
2. Answers will vary.
3. China is selling its currency on world markets for dollars and is accumulating a huge
basket of reserve assets now well over $400 billion. This was a successful strategy
for the Japanese during the 60’s and 70’s. Another possibility is that the capital
account is in surplus. That is people are exchanging dollars to put capital in place in
China or to buy Chinese stocks and bonds. While there is some direct investment, it
is not enough to explain a trade deficit of $9 billion a month. This is a growing
problem for the U.S.
4. Public goods, sometimes called social goods, are goods or services that bestow
collective benefits on members of society. Stopping the AIDS pandemic would
provide numerous public benefits, not the least of which is a lower probability of
being infected. In addition, we would save billions in foreign aid, and increase the
productivity of parts of the world that are not producing enough to grow. It would
be a safer world, as it would have fewer desperate potential terrorists. Generally,
no one can be excluded from enjoying the benefits of public goods once they are
produced. Classic examples are clean air and national defense. Private goods like
hamburgers are produced by the private sector because a firm can exclude those who
don’t pay. If exclusion is impossible, two problems arise for markets: the “free
rider problem” and the “drop in the bucket problem.” Why should I pay for a good if
I get the benefits whether I pay or not? Since many people benefit from production,
my contribution is so small as to not matter. As a result, the private sector is
powerless because it is in peoples’ interests to not pay, and it falls to government to
provide public goods. This is compounded when governments of many nations are
involved.
CHAPTER 35
1. Answers will vary but should include the direct cost of health care, the loss of
workforce, declining productivity, shortage of saving and capital investment,
uncertainty, etc.
2. Answers will vary. There is no clearly “right answer” to this problem, only trade-offs.
Capital accumulation requires saving (reduced consumption), and when most citizens
are earning subsistence wages, reducing consumption is not an option for many.
3. (a) Capital increases the productivity of labor. A given-sized labor force can produce
more output, and output per capita rises.
(b) In a market economy, individual household savings decisions determine the pool of
aggregate savings. Aggregate savings, in turn, is the amount made available for
firms to purchase capital. Savings, are matched to investment projects in financial
markets, where the interest rate adjusts to equate total desired investment with
total desired savings.
(c) In developing countries, a greater fraction of output is needed just to ensure the
current population’s survival. An increase in investment—which requires a decrease
in current consumption—cuts dangerously close to this survival level of
consumption, and at a minimum causes more discomfort than it would in developed
countries.
(d) Answers will vary. Market-oriented economists would stress increased incentives for
private investment (political stability, lower government budget deficit, and perhaps
loans from abroad). Planning-oriented economists might stress government-directed
projects, taxes on luxury goods, and capital controls designed to prevent capital
flight to developed countries.
4. The statement is partially correct, but ignores human capital requirements (the
knowledge and skills needed to operate machinery and manage factories).
5. It is true that poor countries must accumulate capital in order to grow, but many poor
countries do indeed have little or no extra output available for savings. The problem is
often that the available savings goes abroad (capital flight). Increased political stability
and a more stable investment climate would help investment in the domestic economy.
In addition, poor countries can get loans and other assistance from developed countries
to help them accumulate capital.
6. Many recent famines have resulted from government policies. In some cases, keeping
farm prices artificially low has led to a decrease in production. In other cases, a failure
to invest in a distributional infrastructure has led to famine in outlying rural areas.
7. This situation changes daily. Among the interesting developments to watch are the
development of a ruble zone among the former republics of the USSR and the continuing
economic integration of Central Europe (Czech Republic, Poland, Slovakia, Slovenia)
with Western Europe. One approach could be to contrast incremental reform (Hungary)
with drastic reform (Poland). Another approach could be to contrast reform imposed by
democratically elected officials (Czech Republic) with that imposed by more autocratic
figures (Russia, Ukraine).
8. The speaker confuses political systems with economic systems. The Soviet economic
system was one of socialism (government ownership of land and capital) and central
planning (government direction of resource allocation). Totalitarianism is a political—
not an economic—system in which the ruler exercises authoritarian control without the
consent of those governed.
9. Socialism is an economic system in which the “means of production” (land and capital)
are owned and controlled by government. The possible strengths: rapid growth from
planned capital accumulation, internalization of external costs, and more fair
distribution of income (because no property income).
10. There are arguments on both sides. Firms that acquire market power tend to overprice
and underproduce relative to the efficient price and output levels. Market power, it is
argued, stifles both price and quality competition. Microsoft was charged with
anticompetitive behavior by packaging its web browser with its dominant operating
system, Windows. After knocking out the competition, the story goes, they can raise
prices without competitive pressure. But what about foreign competition? Isn’t it a
bigger, tougher game when the competition is a foreign firm receiving government
support? The real problem is that the government is likely to be lousy at picking
winners. What makes us think that the government can pick winners better than the
market? Even recent Japanese attempts to subsidize a winner (fifth-generation
computers) have failed.
11. In a capitalist economy, wages and profits are “market signals” that pull resources
where they are needed most. Those who work harder to supply needed resources will
receive higher rewards, even if they do not work hard. The result is an efficient
allocation of resources, but unequal rewards to the members of society. Experiences in
the United States (e.g., the welfare system) and around the world (e.g., the former
Communist nations) have shown that efforts to increase equality often have the result
of reducing risk taking and hard work.