Download CHAPTER 1: ECONOMICS AND ECONOMIC REASONING

Answers to End-of-Chapter Questions
by David Colander
A Note about the Answers
The following answers are meant as guides to answering the end-of-chapter questions, not as definitive answers.
The same questions often have many answers; this is especially true of policy-oriented questions. Although we have
tried hard to see that mistakes are eliminated, the reality is that, as in any human endeavor, mistakes are inevitable. If
you have checked and double-checked your answer and it is substantially different from that found here, assume that
our answer is wrong, not yours. If you do come to a different answer, or think an answer misses an important aspect of
the question, please check for corrections at my website to see if the answer has changed. If you don’t find it there,
please e-mail me at [email protected] with your answer and an explanation of why you think it is better. I will
get back to you and if I think you are right, I will post the change on the Web page marked “Corrections,” together with
your name and a thank-you.
Chapter 1: Economics and Economic Reasoning
Questions for Thought and Review
1.
The author focuses on coordination rather than on scarcity to emphasize that wants are changeable and
partially society-determined, and to emphasize that the quantity of goods, services and usable resources
depends on technology and human action which underlie production.
2.
The responses will be varied since this question asks individual students about choices they have made. In
these responses students should be encouraged to consider all the costs and benefits, and to be clear about the
concept of the marginal costs and marginal benefits.
3.
Regretting a decision doesn’t mean that we did not use the economic decision rule when making the decision.
At the time the decision was made, we weighed the marginal costs and marginal benefits, undertaking the
activity if the marginal benefits exceeded the marginal costs and not undertaking the activity if the marginal
costs exceeded the marginal benefits. Many decisions are made without knowing the full marginal costs and
marginal benefits. Sometimes these marginal costs and marginal benefits are revealed at a later date making us
regret our initial decision. An example is going out to a restaurant. From recommendations, we assume that
the marginal benefit is one thing. If that recommendation overstates our actual experience, we will have
overestimated the marginal benefit of eating out. We may regret having spent the money to eat out.
4.
The opportunity cost of buying a $20,000 car is the benefit we would have gained by using that $20,000 for
the next-best alternative, which could be spending or saving it.
5.
Only the marginal costs and benefits of taking the job are relevant. That means the sunk cost of the bachelor’s
degree is irrelevant. Therefore, the relevant cost is the opportunity cost of taking the job (forgone earnings
from your current job) and the tuition to attend the business school. The relevant benefit is the increased
lifetime earnings of $300,000.
6.
I would spend the $5 million on those projects that provide the highest marginal benefit per dollar spent. The
opportunity cost of spending the money on one project is the lost benefit that the college would have received
by spending it on some other project. Thus, another way to restate the decision rule is to spend the money on
the project with the highest opportunity cost per dollar.
7.
Three ways (among many) that dormitory rooms could be rationed include: administrative decree, lottery, and
a market system. In the first, individual behavior would be forced to fit the will of the administrator.
Individuals would likely complain and try to influence the administrator's decision. In the second, individual
behavior would be forced to fit the luck of the draw; individuals would likely attempt to trade rooms after the
draw. In the final example, individual behavior would have already been subject to economic forces, and thus,
there will be no tendency to trade after one has "bought" the room one can afford.
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8.
Two examples of social forces are our unwillingness to charge friends interest, and our unwillingness to “buy”
dates with other people. These issues are still subject to economic forces; however, there is no market in
“dates” or in loans to friends, and hence the economic force does not become a market force.
9.
Two examples of political or legal forces are rent control laws and restrictions on immigration. They both
prevent the invisible hand from working. The rent control laws cause shortages in apartments, and the
immigration restrictions cause the number of immigrants seeking entry to exceed those allowed to enter,
which tends to cause wage rates to differ among countries.
10.
An economic model is a framework that places the generalized insights of the theory in a more specific
contextual setting. Policymakers need to understand the empirical evidence supporting the theory as well as
real-world economic institutions to make policy recommendations.
11.
No; economic theory proves nothing about what system is best. It simply gives ways to look at systems, and
what the advantages and disadvantages of various systems will likely be. Normative decisions about what is
best can only follow from one’s value judgments.
12.
Two microeconomic problems are the pricing policies of firms (price fixing in particular) and how wages are
determined in labor markets. (Why do athletes and celebrities make so much money anyway?) Two
macroeconomic problems are unemployment and inflation.
13.
Schools are economic institutions; they significantly influence economic decisions. Where you attend school
has a role in your future employment
14.
A good economist always tries to be objective. However, no one can ever be completely objective, even some
of the time. Sometimes the best we can hope for is an awareness of the cultural norms and value judgments
that influence our views and decisions.
Chapter 1: Problems and Exercises
1.
2.
The marginal costs are the additional costs. They are 15 cents per mile for miles above 150 plus the cost of
gas. The initial payment can be forgotten because it is a sunk cost; it is not part of marginal costs.
a.
b.
c.
3.
The opportunity cost of attending college is the sacrifice one must make by attending college. It can be
estimated by figuring out the benefit of the next-best alternative. If that alternative is working, one would
guess the likely wage that could be earned at a job that does not require a college degree (minimum wage?
more?) and then multiply by 40 hours for each week in college.
The opportunity cost of taking this course could also be estimated using the same technique as in a if you
otherwise would be working for these hours. If you had taken another course instead, the opportunity cost
would be the benefit you would have received from taking that course.
The opportunity cost of attending yesterday’s lecture again would depend on what you otherwise could have
done with the time (sleep? eat lunch with an interesting person?). Although this is no longer a choice to you,
past activities do have opportunity costs.
The person who gains the kidney benefits if it works when transplanted into his or her body, and will no
longer have the emotional and financial burden of dialysis. The person selling the kidney gains the $30,000.
Their gains will also have impacts on others (their families, for example). Both parties must undergo surgery
and face all of the attendant risks and costs. The seller also faces the potential cost of a future illness or injury
harming his or her only remaining kidney causing a need for the seller to need dialysis. As to whether a
society should allow this transaction, we must recognize that this is a question of value judgments and cultural
norms. In our society we have chosen not to allow such transactions because (among other reasons) those with
more money would have increased access to organs and would therefore have advantages over those of limited
means, and the poor could be exploited in such transactions.
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4.
Assuming who pays for dates reflects supply and demand considerations, and assuming that the majority of
the Chinese are heterosexual, this suggests there will be a shortage of women, and thus men will be paying a
higher percentage of the cost of dates in the future.
5.
a.
b.
c.
d.
e.
f.
Micro with macro implications.
Micro.
Micro with macro implications.
Micro.
Micro.
Macro with micro implications
6.
a.
b.
In this exercise you are asked to obtain prices on a gallon of milk from a supermarket and a convenience store.
Most likely, the price in the convenience store is higher (unless they are being used as a loss-leader). Someone
will buy milk at a higher price because it is easier to purchase it at that store or the store may be the only
source at a given time.
Unlike milk (which is a standardized product), clothes come in different brands, types, and perhaps quality.
Saks clothes cost more, but one is also buying the Saks cachet.
c.
7.
a.
b.
c.
d.
e.
Positive statement since it is a statement of fact.
Normative.
This could be seen as a positive statement since it is a statement of fact, although since it deals with normative
issues, it could also be interpreted as a normative statement.
Since this is relating a normative goal with a decision, this could be statement in the art of economics. It could
also be seen as a normative statement if one interprets it as a normative imperative.
Positive statement since it is a statement of fact.
The Theory of Moral Sentiments emphasizes the importance of morality. The invisible hand directs people’s
selfish desires (tempered by the social and political forces) to the common good but is based on certain
presuppositions about the morality of individuals, which constrains individuals’ selfish actions. What Smith is
suggesting is that the marginal cost and marginal benefit used by individuals must be interpreted within a
social context.
8.
Chapter 1: Web Questions
1.
Students’ answers to this question will vary. Here is an example. Quantitative economist, executive secretary,
WTO unit advisor to Egypt, financial analyst, marketing executive, web ad sales manager, project manager,
etc. The CIA is offering a job to an economist that would analyze foreign economies, international trade,
international finance, etc. General Electric is offering a job to an economist with responsibilities that include
developing pricing and quantitative market models for General Electric.
2.
On www.movingideas.com we found an article about a case heard by the Supreme Court on April 1, 2003 to
review University of Michigan’s policy to promote a diverse student body. Whether their policy is legal
depends on affirmative action laws, or legal forces. Another example of a political force is the United Statesled war on Iraq in 2003. All major news organizations covered this event. We found an article on The
American Prospect at www.prospect.org. The war affects business domestically and abroad.
3.
a.
b.
c.
Students’ answers to this question will vary.
A map is similar to an economic model because both provide a way of understanding relationships among
variables, but are not specific. Both must be combined with additional knowledge to apply to the real world.
Maps need to be combined with landmarks and traffic indicators to travel. Economic models need to be
combined with a knowledge of economic institutions to make policy recommendations.
A limitation of maps is that they cannot provide every detail of a town such as important landmarks,
crosswalks, or the address of a specific person.
The map we used was not topographic, so we could not use it to determine elevation change. It did have a
legend and so, we could estimate distances. It did not indicate traffic speeds. This suggests that if we wanted
to estimate travel time accurately, we might have difficulty. This suggests that the map or model chosen needs
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to fit one’s purpose. If we wanted to estimate the time it would take to hike a mountain, for instance, having a
topographic map would be more important.
Chapter 2: Trade, Trade-Offs, and Government Policy
Questions for Thought and Review
The grade production possibility curve on the right embodies the
principle of increasing marginal opportunity costs. The table is
presented below. Notice that the amount of points lost on the
History grade for each 10-point gain in the Economics grade
steadily increases.
History
40
60
80
Economics
100
80
68
100
Grade in Economics
1.
90
80
70
60
50
40
20
40
60
80
100
Grade in History
If there were decreasing marginal opportunity costs, the production possibility curve would be convex with
respect to the origin instead of concave. This means that (in terms of the example on page 24 of the text) we
would gain more and more guns for every pound of butter we give up. An example of this is found in a
situation in which a practice makes perfect; i.e., smaller and smaller numbers of hours devoted to a task, or
sport, will result in bigger and bigger gains in performance.
3.
In the figure to the right, wadget production is measured on the vertical
axis and widget production is measured on the horizontal axis. If the
society becomes more productive in its output of widgets, it can produce
more of them, and the end point of the curve on the horizontal axis will
move to the right, as shown. If the society is also less productive in its
production of wadgets, the end point on the vertical axis will move
down, as shown. The result is a new production possibilities curve.
Wadget
2.
4.
If a society became equally more productive in the production of both
widgets and wadgets, the production possibility curve would shift out
to the right as shown in the graph on the right.
Wadgets
Widgets
Widgets
5.
The theory of comparative advantage underlies the shape of the production possibility curve. By taking
advantage of each person's comparative advantage, higher total output can be reached than if each produced
on their own, or if each produced goods where they did not have a comparative advantage. As more and more
of a good is produced, resources that have less of a comparative advantage are brought into the production of a
good, causing the production possibility curve to be bowed outward.
6.
This statement is true or false depending on the implicit assumptions made in the analysis. It is true since
individuals will eliminate all inefficiencies they see through trading. It might be false if not everyone knows
all the benefits and the inefficiencies, or does not have the opportunity to correct the inefficiencies.
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7.
A democratic system has elected officials who often promise more of everything, obscuring the difficult
tradeoffs that actually exist. They do so to increase the chances of getting elected.
8.
The combined production possibility curve of two countries that have no comparative advantage in either of
two goods will be a straight line with the same slope as the production possibility curve of each of the
countries, just shifted out to the right, reflecting the fact that the production levels reflect that of both countries
combined. There are no gains to trade.
9.
There are no gains to trade when neither of two countries has a comparative advantage in either of two goods.
10.
If a particular distribution of income is one of society’s goals, a particular production technique that leads to
greater output, but also an undesirable distribution of income, might be considered an inefficient method of
production. Remember, efficiency is achieving a goal as cheaply as possible. Maximizing output is not the
only goal of a society.
11.
The fact that the production possibilities model tells us that trade is good does not mean that in the real world,
free trade is the best policy. The production possibilities model does not take into account the importance of
institutions and government in trade. For example, the model does not take into account externalities
associated with some trades, the provision of public goods, or the need for a stable set of institutions of rules.
12.
The six roles of government in a market economy are (1) providing a stable set of institutions and rules, (2)
promoting effective and workable competition, (3) correcting for externalities, (4) ensuring economic stability
and growth, (5) providing public goods, and (6) adjusting for undesired market results. Which of the six is the
most controversial is open to debate. One possibility is the sixth role, adjusting for undesired market results.
The problem is determining what rules should guide government in deciding on the desired result. Intervening
in the market might create more problems than it solves.
13.
People have made decisions based on the rules that were set up, so changing them after the game has been
started may be more unfair than continuing to play by the original rules. Such decisions must be made based
on the marginal cost and benefit of changing the rules.
14.
Pollution permits require firms pay the cost of pollution they create. By making these permits tradable, firms
that face the lowest cost of reducing pollution will reduce pollution emissions the most. Permits assign rights,
thereby correcting for the externality.
Chapter 2: Problems and Exercises
a.
b.
c.
d.
See the graph on the right.
20
As the output of food increases, the marginal opportunity cost
18
is increasing. To illustrate, giving up 4 of clothing (from 20 to
16
14
16) results in a gain of 5 food (from 0 to 5), but giving up
12
another 4 clothing (from 16 to 12) results in a gain of 4 food
10
(from 5 to 9), and this pattern continues.
8
6
If the country gets better at producing food, the endpoint of
4
the production possibilities curve on the horizontal axis will
2
0
move to the right. If the country gets equally better at
2 4 6 8 10 12 14
producing food and clothing, the endpoint of the production
Output of Food
possibility curve on the horizontal axis will move right, and
the endpoint of the production possibility curve on the
vertical axis will move up by the same proportion,
If the country gets equally better at producing food and clothing, the endpoint of the production possibility
curve on the horizontal axis will move right, and the endpoint of the production possibility curve on the
vertical axis will move up by the same proportion.
Output of Clothing
1.
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c.
d.
3.
a.
b.
c.
1,500
Wheat in tons
See the graph on the right.
The United States has a comparative advantage in the production
of wheat because it can produce 200 additional tons of wheat for
every 100 fewer bolts of cloth while Japan can produce 50
additional tons for every 100 fewer bolts of cloths. Japan has a
comparative advantage in producing cloth.
The joint production possibility curve without specialization or
trade is shown in the graph.
The joint production possibility curve with specialization and
trade is shown in the graph. It is the outermost curve.
1,000
a.
b.
Joint
w ith
trade
U.S.
Joint
w /o trade
500
2.
Japan
500
1,000
1,500
Cloth in bolts
A Toyota in the U.S. costs 4/3 Chevrolets, while in Japan a Toyota costs 2 Chevrolets.
Japan has the comparative advantage in producing Chevrolets.
Since Japan has the comparative advantage in producing Chevrolets, it should produce Chevrolets and the
U.S. should produce Toyotas, regardless of the fact that the U.S. demands more Chevrolets than Toyotas.
4.
The fact that lawns occupy more land in the United States than any single crop does not mean that the United
States is operating inefficiently. Although the cost of enjoying lawns is not included in GDP, lawns are
nevertheless produced consumption goods and are included in the production possibility curve for the United
States. The high proportion of land devoted to lawns implies that the United States has sufficient food that it
can devote a fair amount of land to the production of goods for enjoyment such as lawns.
5.
Following the hint that society’s production possibility curve reflects more than just technical relationships,
we realize that trust is an input to production to the extent that it is necessary for transactions. If everyone
could fake honesty, the production possibility curve would shift inward since no one could trust anyone else
leading to the disintegration of markets. If some could fake honesty, those few will gain at the expense of
others. This is an example of the tragedy of the commons.
6.
This exercise asks students to gather information about the limitations on businesses of different types in their
communities. They are then asked to make judgments as to whether the limitations were necessary (are they
clear about the goals involved?) and whether the number of limitations is correct. The information is linked to
the text’s material in part d. Part e asks students to learn about business taxes in their communities, and part f
has them gather a sense of business satisfaction.
7.
A merit good is a good that government believes is good for you even if you choose not to buy it. An example
might be operas. A demerit good is a good that government believes is bad for you even if you choose to buy
it. An example is alcohol or drugs. A public good is a good that if supplied to one person must be supplied to
all and whose consumption by one does not preclude the consumption by another. An example is national
defense. An externality is the effect of a trade on a person not involved in the trade. An example is cigarette
smoke.
Individuals might disagree as to the categorization of a good as a merit, demerit or public good or a good that
involves an externality. In the case of an externality, they may believe that given sufficient property rights, the
externality will be solved most efficiently by the market, not government.
We discuss the issues of market failure and government failure in the case of operas. There is market failure
only if people do not value operas as much as they should. This normative statement is valid only if the should
can be measured against some absolute truth as to the value of operas, otherwise how would one decide who
decides how much operas should be valued. Because it is only through the market that value is revealed, we’d
argue that government intervention in this case will likely lead to government failure—the failure of
government to accurately value operas. With government intervention, the value will likely reflect those with
political power, not necessarily the general population.
a.
b.
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Chapter 2: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
The answer to this question will vary depending on what country is chosen. We chose Brazil.
Brazil’s major industries are textiles, shoes, chemicals, cement, lumber, iron ore, tin, steel, aircraft, motor
vehicles and parts, other machinery and equipment. Brazil imports machinery and equipment, chemical
products, oil, electricity, autos and auto parts.
Brazil has a comparative advantage in those goods it produces—textiles, shoes, lumber iron ore, and others.
We chose these goods because it produces them. This may not be the best way to determine comparative
advantage because there may be other reasons why Brazil produces these goods. For example, government
may provide subsidies to produce them.
Brazil’s trading partners are the United States, Argentina, Germany, Japan and Italy. Argentina is one of its
trading partners because of its geographic proximity.
The defining belief of libertarians is that everyone should be free to do as they choose, so long as they don't
infringe upon the equal freedom of others.
We were scored as centrists. We’d agree with this result. Government intervention can improve market results
in certain cases. Government involvement in the market economy needs to be assessed on a case-by-case
basis.
Libertarian’s main objections to government regulation is that regulations limit an individual's choices,
especially their choices about what to do with their property.
Chapter 2: Appendix A
1.
a
See the graph on the right.
d.
c
b
a.
b.
c.
d.
3.
See the graph on the right.
The relationship is nonlinear because it is not straight. It is
curved.
From 0 to 5, cost declines as quantity rises (inverse). From 5
to 10, cost rises as quantity rises (direct).
From 0 to 5, the slope is negative (slopes down). From 5 to 10,
the slope is positive (slopes up).
The slope between 1 and 2 units is the change in cost (30-20)
divided by the change in quantity (1 - 2), or -10.
$30
$25
Cost
2.
$20
$15
$10
$5
$0
2
3
4
5
6
7
8
9
Quantity
See the graph on the right.
10
9
8
7
6
5
4
3
2
1
d
b
a
c
1
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2 3 4
5 6 7
8 9 10
4.
5.
a. 1
b. -3
c. 1/3
a. C
b. A, E c. B,D
d. -3/4 e. 0
d. B is a local maximum; D is a local minimum
6.
a.
b.
c.
See line a in the graph on the right.
See line b in the graph on the right.
See line c in the graph on the right.
7.
a.
y = 5x + 1,000
b. y = 3x + 1,500.
8.
a.
line graph
b. bar graph
c. pie chart
d. line graph
Chapter 3: The Evolving U.S. Economy in Perspective
Questions for Thought and Review
1.
The central coordinating mechanism in a market economy is price.
2.
The central coordinating mechanism in Soviet-style socialism is the central planners.
3.
Market economies solve the three problems through markets and the system of rewards and payments. What
gets produced is what businesses believe can be sold. How it gets produced is determined by business;
generally they choose the method that makes the largest profit. Those who are willing to pay for the goods will
get them. Thus, supply and demand determine what, how, and for whom to produce.
4.
Soviet-style socialism solves the three problems by using administrative control. Central planners decide what
to produce according to what they believe is socially beneficial. Central planners decide how to produce
guided by what they believe is good for the country. Central planners decide distribution based on their
perception of individuals’ needs.
5.
The answer to this question requires determining what is meant by better. Economics can explain how each
system functions and explain how efficient each is, but economics does not provide an answer to normative
questions without imposing normative judgments.
6.
Markets have little role in most families. In most families decisions about who gets what are usually made by
benevolent parents. Because families are small and social bonds strong, this benevolence can work. Thus, a
socialist organization seems more appropriate to a family and a market-based organization to a large economy
where social bonds don’t hold the social unit together.
7.
False. Feudalism, mercantilism, Soviet-style socialism, and market economies have all involved planning. The
difference is in who does the planning. Feudalism relied on tradition for the planning. In mercantilism, the
government did most of the planning. In Soviet-style socialism, central planners did the planning. In market
economies, the managers of firms do the planning, with consumers deciding whether those plans are correct.
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8.
An economy depends on coordination, and the mechanisms of coordination depend on people. What is
considered a resource depends on technology, and people develop new technologies. It follows that the
economy’s ultimate strength resides in its people.
9.
Consumers decide what goods they want, and demonstrate their decisions in their willingness to pay for the
goods. Businesses decide what to produce, but their decisions reflect consumer desires. Thus, there is no
contradiction. Advertising, in which businesses attempt to influence behavior, if successful, does, however,
mediate the principle of consumer sovereignty.
10.
Business is dynamic; it involves meeting new problems constantly, recognizing needs, and meeting those
needs in a timely fashion. These are precisely the skills of entrepreneurship.
11.
You would most likely choose a sole proprietorship because it’s easy to start, requires minimal bureaucratic
hassle, and is controlled by you, the owner. If you need more money than you have to start this business, you
might consider taking on a partner. This would also allow you to share the work and the risk, but you will also
have to share the profits and figure out a way to maintain a friendship while working together.
12.
The two largest categories of federal expenditures are income security and health and education.
13.
The answer to this question depends on what you mean by importance. Using standard United States measures
which relate importance to international power, this statement is inaccurate or at least misleading. Most
classifications of countries are based on the total output or production, but even these statistics do not
necessarily capture a nation's importance or the strategic role it plays in the world economy. A knowledge of
economic geography is needed to assess a country's importance to the world economy. Area and population
are two useful indicators of a country's potential, but they need to be quantified and assessed.
14.
The Internet has added competition by increasing the amount of information available to consumers and
reducing the importance of geographic location to production and sales. Increasing the amount of information
to consumers lowers the cost of comparison shopping, which gives consumers more negotiating power with
sellers. Because location doesn’t matter, the Internet broadens the potential marketplace for both inputs and
outputs, increasing competitive pressures in both factor and goods markets.
15.
Globalization increases competition by allowing greater specialization and division of labor. Because
companies can move operations to countries with a comparative advantage, they can lower production costs
and increase competitive pressures.
Chapter 3: Problems and Exercises
1. a. Such an idea could be expanded to include college courses, but that is unlikely to happen because the quantity
b.
c.
2.
a.
of college courses demanded would decline as people substitute toward taped lectures. Substitution, however,
is not perfect since videocassettes cannot provide the interaction between student and instructor or among
students. Social forces would act against the movement away from college class instruction even if the
invisible hand pressed action toward it.
Technical problems are virtually nonexistent. Tapes are easily made and VCRs are available cheaply. Socially,
the problems are substantial. A diminishing role of the university would significantly change its role of
providing a focal point for intellectual discussion and discovery thus changing the nature of education. There
would be great social pressures to maintain this role of American colleges. The economic issues are
substantial. A course could be taught once and used over a period of years. This would reduce the demand for
professors and create revenues for certifying agencies that would regulate the distribution and quality of the
tapes.
Even though the program is technically possible and cost efficient, it will not necessarily be a success because
social forces will play a major role in limiting the market. Social forces are not weak.
The fact that more money is spent on adults than on children in the family does not imply that the children are
deprived or that the distribution is unfair. Children and adults have different needs. Moreover, it is the parents
Page 621, Answers to End-of-Chapter Questions
b.
c.
who earn the money, so it is only through their beneficence, and requirements of law, that they provide for
their children at all.
Yes, these percentages probably change with income. The lower the income, the larger the percent of total
expenditures spent on children. The reason is that most families want to provide a basic level of needs for their
children. Many families feel that luxuries should not be given to children until the children have learned how
to work for them themselves.
Our suspicion is that the allocation would not be significantly different in Soviet-style socialist countries as
compared to capitalist countries. If, however, the average income in socialist countries were lower, the
percentage of total expenditure spent on children might be higher, as described in b.
3.
a.
b.
Students are asked to do library research on Poland, Bulgaria, and Hungary.
Students are asked to examine the changes in those countries, and to consider the roles of markets, politics,
and social and cultural tradition.
4.
a.
Innovation requires a certain level of freedom of thought and a possibility of profit-making from the
innovation. Neither was the case with Soviet-style socialism. Government planners directed production with
income based on need, so workers had neither the freedom nor the incentive to innovate.
Both freedom and the possibility of making profits provide the means and incentives for innovation in
capitalist countries.
Schumpeter’s argument was based on the idea that profit-making by innovators was necessary for innovation
to occur. As firms become larger, however, the individual ceases to become the direct beneficiary of his or her
innovations.
Since his predictions did not materialize, one must believe either that firms have been able to create incentive
structures to foster innovation or that some other venue for innovation has arisen. Firms have large research
and development departments designed to promote innovation. In addition, individual innovators have been
able to raise enough capital to start their own companies to profit directly from their innovations. In the United
States there has been enormous growth in the number of such firms. The U.S. government has been a large
motivator of innovation through subsidies to basic research at universities and through support of military
innovations, both of which have large spillovers into private industry.
b.
c.
d.
5.
a.
b.
c.
Firms may produce in Germany, because (1) transportation costs in the other countries may be very high, so
that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas
for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be
so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led
to production in Germany and the cost of moving production may exceed potential gains.
Yes, one would expect some movement from Greece and Italy into Germany, but this is limited by the
minimum wage laws in Germany. Also, social restrictions such as language and culture will limit labor
mobility. With such high unemployment in Germany already, one would not expect much short-run
movement. Movement in the long run, however, may be substantial.
I would need to know the stability of politics, the worker productivity, the infrastructure such as roads, as well
as tax differences between the two countries.
Chapter 3: Web Questions
1.
a.
b.
c.
2.
Levi Strauss is a corporation. It is most likely a corporation because of its size. For large firms, limited
liability becomes important.
Levi Strauss is a global corporation because it has business units throughout the Americas, Europe, the Middle
East, Africa, and Asia. These business units both manufacture and market Levi products.
Shares of Levi Strauss today are privately held, although in 1971 the company traded shares publicly. In 1985,
those shares were repurchased by the descendants of the founder of Levi Strauss.
In the 1930s, government intervened very little in the market. During the Depression, however, as many
people became unemployed and needed assistance, the role of government expanded and capitalism’s
evolution away from a pure market economy began. The Social Security Act was signed into law in 1935. The
Act established two programs–a pension program for retired workers and an income support program for the
unemployed. Both are administered by the federal government. In the late 1990s and early 2000s, there have
Page 622, Answers to End-of-Chapter Questions
been proposals to privatize portions of the Social Security system, giving workers more say about where their
money is invested. This would move the pendulum back toward a market economy.
Chapter 4: Supply and Demand
Questions for Thought and Review
The law of demand states that quantity demanded falls as price increases; or alternatively, that quantity
demanded rises as price falls. Price is inversely related to quantity demanded because as price rises, consumers
substitute other goods whose price has not risen.
2.
The law of supply states that quantity supplied rises as price increases or, alternatively, that quantity supplied
falls as price decreases. Price is directly related to quantity supplied because, as price rises, people and firms
rearrange their activities to supply more of that good.
3.
Four shift factors of demand are income, price of other goods, tastes, and expectations. As income rises,
demand increases. As the price of other substitute goods rise, demand increases. As tastes change to favor a
particular good, the demand for that good increases. If people expect the price of a good to fall in the future,
demand will fall now.
4.
A change in the price causes a movement along the demand curve, a movement to a new point on the same
curve. A shift in the demand curve means that the quantities will be different at all prices; the entire curve
shifts.
5.
Saying that supply increases means that the curve has shifted to the right, which is not the result of a price
change. The correct statement is that, normally, as price rises, the quantity supplied increases.
6.
Shift factors of supply include the price of inputs, technological advances, changes in expectations, and taxes
and subsidies. As the price of inputs increase, the supply curve shifts to the left. As technological advances are
made that reduce the cost of production, the supply curve shifts to the right. If a supplier expects the price of
her good to rise, she may decrease supply now to save and sell later. Other expectational effects are also
possible. Taxes paid by suppliers shift the supply curve to the left. Subsidies given to producers shift the
supply curve to the right.
7.
When adding two supply curves, sum horizontally the two individual supply
curves, as in the diagram on the right.
Price
1.
S1 S2 S3
8.
In the graph in the next column, the demand curve has shifted to the
left, causing a decrease in the market price and the market quantity.
2
3 Quantity
Price
1
S
P0
P1
D1
Q1
D0
Q0
Quantity
Page 623, Answers to End-of-Chapter Questions
The price of airline tickets rises during the summer months
because demand for airline travel increases as more people take
vacations. This is shown in the graph on the right
Price
9.
S
P1
P0
D0
Q0
D1
Q1
Quantity
10.
Sales volume increases (equilibrium quantity rises) when the government suspends the tax on sales by retailers
because the price to demanders falls and hence equilibrium quantity demanded rises. This occurs because the
supply curve shifts to the right.
11.
Increased security measures imposed by government will increase
the cost of providing air travel. This will shift the supply curve to the
left, increase equilibrium price and decrease equilibrium quantity as
shown on the right.
Price
S1
S0
P1
P0
D
Q1
Q0
Quantity
Customers will flock to stores demanding that funky “economics professor” look, creating excess demand.
This excess demand will soon catch the attention of suppliers, and prices will be pushed upward.
13.
As substitutes for bottled water—tap water—decrease, demand for bottled water increases enormously, and
there will be upward pressure on prices. Social and political forces will, however, likely work in the opposite
direction—against “profiteering” in people’s misery.
14.
It suggests that the job is being rationed, which means that the wage is above the equilibrium wage.
15.
It suggests that the price is above the equilibrium price so that the
quantity supplied exceeds the quantity demanded, as you can see in
the accompanying graph.
Price
12.
S
Pf
D
Qd
Qs
Quantity
16.
The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. It
affects the supply/demand model by drawing our attention to the possibility that supply and demand are
interdependent. Feedback effects must be taken into account to made the analysis complete.
Page 624, Answers to End-of-Chapter Questions
17.
A supply/demand analysis that includes only economic forces will likely be incomplete because social and
political forces will also impact equilibrium price and quantity. One example is the prediction that a disaster
that leads to loss of electricity will lead to higher prices for flashlights might be wrong if there are laws that
prohibit such price gauging during emergencies. Social and political forces must be added to the
supply/demand model.
18.
The greatest feedback effects are likely to occur in the markets that are the largest. This is most likely to be
true for housing and manufactured-goods markets.
1.
Price
2
4
6
8
10
12
14
16
Market Demand
64
56
44
36
28
20
12
8
Price
Chapter 4: Problems and Exercises
16
14
12
10
8
6
4
2
0
John
Alex
Liz
M arket
5 10 15 20 25 30 35 40 45 50 55 60
d.
2.
a.
b.
c.
3.
a.
b.
c.
d.
Quantity
See the graph on the right of the table.
At the market price of $4, the total market demand is
56. If the price rises to $8, the total market demand will fall to 36.
All of the curves will shift to the right.
The market demand and market supply curves are shown
on the right.
At a price of $37, quantity demanded is 32 and quantity
supplied is 18. Excess demand is 14. At a price of $67,
quantity demanded is 10 and quantity supplied is 46.
Excess supply is 36.
Equilibrium price is $47. Equilibrium quantity is 24.
The following results are shown in the graph on the right.
The bad weather causes a decrease in supply. This is shown by
a shift in supply from S0 to S1. Equilibrium price rises from
P0 to P1 while equilibrium quantity falls from Q0 to Q1.
The medical report causes a decrease in demand. This is
shown by a shift in demand from D0 to D1. Equilibrium price
falls from P0 to P2 and equilibrium quantity falls from Q0 to
Q1.
The innovation causes an increase in supply. This is shown as
a shift in supply from S1 to S0. Equilibrium price falls from
P1 to P0 while equilibrium quantity rises from Q1 to Q0.
The drop in income causes a decrease in demand. This is
shown by a shift in demand from D0 to D1. Equilibrium price
falls from P0 to P2 and equilibrium quantity falls from Q0 to Q1.
S1
Price of tea
b.
c.
S0
P1
P0
P2
Page 625, Answers to End-of-Chapter Questions
D0
D1
Q2 Q1 Q0
Quantity of tea
a.
b.
I would expect wheat prices to decline since the supply of wheat
is greater than expected. Wheat commodity markets are very
competitive, so the initial 35 percent increase in output was
already reflected in the current price of wheat. It is only the
additional 9 percent increase that will push down the price of
wheat.
This is graphically represented by a shift to the right in the
supply of wheat, as shown on the right.
S0
Price of wheat
4.
S1
P0
P1
D0
Q0 Q1
Quantity of wheat
5.
a.
b.
c.
6.
a.
b.
c.
d.
The cars in Italy are most likely much smaller than in the United States. Italians would be driven to conserve
gasoline and thus demand smaller cars that use less gasoline.
As in (a), Italians will want to conserve gasoline more and thus use public transportation more than Americans
use it.
The cars in Italy are most likely much more fuel efficient than in the United States. Italians would be driven to
conserve gasoline and thus demand more fuel efficient cars that use less gasoline. Americans would demand
fewer cars (shift in demand curve to the left) and drive less; the fuel efficiency of cars sold in America would
rise.
Because the market for pencils is relatively small, supply/demand analysis would be appropriate without
modification.
Because the labor market is very large, supply/demand analysis would not be appropriate without
modification. For example, an increase in labor supply will likely lead to greater income and greater demand
for goods, which will lead to an increase in quantity of goods produced and therefore an increase in the
demand for labor. In this case there are significant feedback effects.
Aggregate markets such as savings and expenditures include feedback effects, so supply/demand analysis
would not be appropriate without modification.
The CD market is relatively small. Supply/demand analysis would be appropriate without modification.
Chapter 4: Web Questions
1.
a.
b.
c.
d.
The age group 0 to 24 is projected to increase somewhat from 1997 to 2025 to 2050. The age group 25 to 54 is
expected to decline somewhat from 1997 to 2025 to 2050. The age group 55 to 85+ is expected to increase
significantly from 1997 to 2025 to 2050. The number of people aged 85 or greater will rise from about 5
million in 1997 to 8 million in 2025 to 91 million in 2050.
The effect of these demographic shifts will increase the demand for nursing homes. The quantity of nursing
homes supplied will rise as will their price.
The demand for prescription drugs will shift to the right as the number of elderly increase and need drugs to
address their health needs. The quantity of prescription drugs supplied will rise as will their price.
The demand baby high chairs will also rise, but not by as much as the increase in products demanded by the
elderly. The quantity of high chairs supplied will rise as will their price.
The demand college education will also rise, but not by as much as the increase in products demanded by the
elderly. The quantity of college degrees supplied will rise as will their price.
Page 626, Answers to End-of-Chapter Questions
The answers to these questions will depend upon the current “ShortS1
S0
Term Energy Outlook.” The answer given here should be used as a
guide.
The Persian Gulf War is the most significant factor that is affecting
supply. Iraq is unable to contribute to world oil supply. This shifts
P1
the supply of oil to the left. In addition, oil strikes in Venezuela are
P0
also limiting oil supply. No demand factors were mentioned
specifically, but the end of the heating season would be expected to
reduce demand for oil. The reductions in supply will lead to higher
D1 D0
prices while the reduction in demand will mediate those price
Q1 Q0
increases.
World oil prices are forecast to remain high and volatile while the
Quantity
U.S. is at war with Iraq. The effect of the supply and demand factors
on price and quantity are shown on the right.
Higher crude oil, an input to the production of gasoline, will reduce the supply of gasoline and increase its
price. As summer ends, the demand for gasoline will decline and put downward pressure on gas prices. The
net effect is a decline in the near term, but a rise in the future. Higher crude oil will reduce the supply of home
heating oil and a colder winter will increase demand. Both will work to increase the price of home heating oil.
Gas is a substitute for oil. As the price of oil increases, the demand for gas will increase. This will lead to
higher natural gas prices in the near term.
Price
2.
a.
b.
c.
3.
a.
b.
c.
Alaska, Delaware, Montana, New Hampshire and Oregon have no state sales tax. Mississippi has the highest
state sales tax.
Sales taxes paid by producers increase the cost of production and shift the supply of goods to the left.
Equilibrium price rises and quantity falls as shown in the graph on the right.
Delaware has no sales tax while New Jersey has a 6% sales tax. This reduces the quantity of goods purchased
in Delaware. The demand for goods in New Jersey shifts to the right and equilibrium quantity sold rises.
Chapter 5: Using Supply and Demand
Questions for Thought and Review
If price and quantity both rise, the simplest cause would be a shift of the demand curve to the right.
2.
If price fell and quantity remained constant, a possible cause would be a shift out of the supply curve and a
shift of the demand curve in to the left. Another possibility would be a shift of the demand curve in to the left
with a vertical supply curve.
3.
See the graph on the right. A price ceiling of Pc below Pe will cause a
shortage shown by the difference between Qd and Qs.
Price
1.
S
Pe
Pc
D
Qs
Page 627, Answers to End-of-Chapter Questions
Qd Quantity
As you can see in the graph on the right, the rent controls
create a situation in which demanders are willing to pay
much more than the controlled price and much more than
the equilibrium price. These payments are sometimes
known as key money. In this graph, landlords are willing to
supply QS at the current controlled rent, PC. Consumers are
willing to pay up to PB for the quantity QS. Key money can
be an amount up to the difference between P B and PC.
Rent per month
4.
S
PB
PE
PC
D
QS
QD
5.
See the graph on the right. A price floor of Pf above Pe will cause
a surplus shown by the difference between Qs and Qd.
Price
Quantity of apartments
S
Pf
Pe
D
Qd
Qs
Quantity
A minimum wage, Wmin, above the equilibrium wage WE will
result in the quantity of laborers looking for work to increase to Q S
and the quantity of employers looking to hire to decrease to Q D.
The difference between the two is a measure of the number of
unemployed.
S
Wmin
We
Wage
6.
D
Qd
Qs
Quantity of workers
A $4 per unit tax on suppliers shifts the supply curve up by $4
shown as a shift in the supply curve from S0 to S1. Equilibrium
price will rise by $4 only if the demand curve is perfectly
vertical. In this case, quantity would not change. Otherwise,
equilibrium price rises by less than $4 and equilibrium quantity
falls as shown on the right. The price increases from P 0 to P1 and
quantity declines from Q0 to Q1
S1
Price
7.
P1
S0
$4
P0
D
Q1 Q0
8.
Quantity
Political turmoil in South Africa likely led both foreign and domestic investors to question the economic
stability of the country. Foreign investors reduced their demand for South African investments, and therefore
their demand for the rand. This shifted the demand for the rand to the left. Domestic investors did likewise,
Page 628, Answers to End-of-Chapter Questions
shifting their investments to those outside South Africa, shifting the supply of rand to the right. The
combination led to a lower price for the rand in terms of other currencies.
A quota places a quantity restriction on imports. Consumers
are willing to pay a higher price, P 1, for the lower quantity
than the equilibrium price, P0, without the quota. Therefore,
quotas lead to higher import prices as shown in the graph on
the right.
Price
9.
S
P1
P0
D
Quota
Quantity
10.
Excess supply in U.S. agricultural markets is caused by the
government’s policy of agricultural price supports, or price
floors on agricultural products. The political forces prevent the invisible hand from working.
11.
Public post-secondary education is an example of a third-party payer market because it is heavily subsidized
by state government. Those consuming the good, students, do not pay the entire cost of the education they
receive. This likely leads to greater expenditures on post-secondary education than if students had to pay the
entire cost of their education.
12.
Governments likely support third-party-payer markets for a variety of reasons. It could be that they believe the
market does not distribute the good equitably (poorer people have less access to the good); there are positive
externalities associated with the good (for example, public education); or that some other market failure exists.
Chapter 5: Problems and Exercises
b.
c.
sugar. The graph on the right shows how a higher
imported sugar price increases the price that domestic
producers can charge and increase the quantity they can
supply to the market. For example, at P0, domestic
consumers demand the quantity D-A from importers and
quantity A from domestic producers After the quotas, the
import price is P1. Domestic consumers demand the
quantity C-B from importers and quantity B from
domestic producers.
The government could also have imposed a tariff on
imported sugar. This would also have raised the price of
imported sugar.
A minimum required import level of 1.25 million will
limit the ability of the United States to support domestic
sugar prices.
Price of sugar
1. a. An import quota will increase the price of imported
Domestic
supply
P1
P0
D
B A
D C
Quantity of sugar
Page 629, Answers to End-of-Chapter Questions
a.
b.
A weakly enforced anti-scalping law would add an additional
cost to those selling scalping tickets and push up the resale
cost of tickets to include the expected cost of being caught. In
the graph on the right, this shifts the supply curve from S 0 to
S1, raising equilibrium price from P 0 to P1. (Note: This
assumes that only selling, not buying, is illegal.)
A strongly enforced anti-scalping law (against suppliers)
would push up prices far more. If enforcement were
sufficiently strong, a two-tier price system would emerge with
a low legal resale price at P0 and another very high price, P2.
S2
Price of tickets
2.
S1
P2
P1
S0
P0
Quantity of tickets
b.
c.
d.
4.
a.
b.
c.
5.
a.
As shown in the accompanying graph, the controlled price is below
S
equilibrium. At this price the quantity of apartments demanded
Pb
exceeds the quantity of apartments supplied. Since there are more
Pe
apartments demanded than supplied at this price, apartments are
hard to find.
Pc
Since at the existing quantity supplied, Qs, demanders would be
D
willing to pay Pb, there is a strong incentive to make side
payments to existing tenants to acquire the apartment. This is one
form of rationing. When market price rationing does not take
Qs Qe Qd
place, some other form of rationing must supplement it.
Eliminating rent controls would most likely allow the market price
Quantity of apartments
of apartments to increase and eliminate side payments. The
quantity supplied will rise until it equals the quantity demanded at the market price. The price, quantity
combination is (Pe, Qe) in the graph.
The political appeal of rent control is that it benefits those who currently have apartments. Rent control
possibly benefits those who are more likely to vote, and this is why it is maintained.
Rent per month
a.
The government subsidy of mohair provided an enormous
S no s ubs idy
incentive, for those who were allowed to sell mohair, to sell
large quantities at lower price than otherwise. The elimination of
Ss ubs idy
this subsidy shifted the supply curve to the left (shown below as
a shift from S0 to S1, increasing the market price for mohair
P0
from P0 to P1 and decreasing the quantity demanded and
P1
supplied from Q0 to Q1.
This program was likely kept in existence because not many
D
people knew about it (mohair is a relatively small market), and
ranchers had no incentive to broadcast the subsidy.
Q0 Q1
If a law were passed so that suppliers would receive $3.60 more
Quantity of mohair
than the market price, the demand curve would shift to the left to
include this tax. The quantity demanded would fall dramatically.
Consumers would not support this law because they would have to pay an enormously high price. Suppliers
would support this law only if they were guaranteed that they could sell at that high price.
Price of mohair
3.
Computer pricing of roads could end bottlenecks and rush hour congestion by price rationing. Currently at
zero price, at certain times, the quantity demanded greatly exceeds the quantity supplied, resulting in
congestion. Raising prices, during those times, could eliminate excess demand and reduce the congestion. This
technological change will spread out congestions over wider geographic areas and over the day, as individuals
with more flexibility with respect to route and timing will choose to demand less of the current high demand
route at rush hour.
Page 630, Answers to End-of-Chapter Questions
6.
b.
Some of the problems are administrative-disputes may arise over computer accuracy of the travel of cars.
Other problems might be the regressive nature of the pricing scheme if low income individuals are the one
who have less flexibility regarding route and timing. They will be the ones to pay more for the use of roads
compared to higher income individuals who might have more flexibility and can avoid the high cost routes.
c.
This is an individual question. A professor in a rural area would change his habits very little because there is
no rush hour traffic. A student with a more flexible schedule and who lives in an urban area may be more
likely to change driving habits.
a.
Boards often exist to benefit the consumer, but also to benefit those who currently produce. Often those who
are currently certified attempt to limit the number of new certifications to limit the supply and thus boost the
price.
Possible changes include eliminating the board of certification, limiting its regulation to only those skills that
it addresses directly, or requiring continual recertification so that skills of those already certified reflect the
current demand for skills in that market.
A political difficulty with implementing these changes is that a relatively small group of those currently
certified will be hurt and will lobby hard for the status quo. The benefits of the changes are also large, but they
are spread out over large groups of consumers, with each consumer benefiting very little. Therefore, it will be
easier for the small group, whose benefit per individual is large, to organize.
b.
c.
7.
a.
b.
c.
8.
a.
b.
c.
9.
a.
b.
c.
The Oregon Health Plan includes a prioritized list of medical services that determine whether a service is
covered. The list is based on comparative benefit to those covered. Those services that have the highest net
benefit are ranked highest.
Economists should not oppose the Oregon Plan because it involves rationing. The market involves rationing
through the price mechanism. Economists might oppose the Oregon Plan because in general they support the
market as the least-cost method of providing goods and services. Economists are open to the argument that the
market may not distribute goods and services in the way that society wants, which may require government
intervention.
In the market, the interaction of demand and supply determines the equilibrium price and quantity that is
bought and sold. Those who are able to pay the equilibrium price are the ones who receive the health care.
Frequent-flyer programs allow companies to lower their effective prices without lowering their reported
prices. Companies also use them to get business travelers to choose their airline. Such programs are an
example of a third-party-payer system: The business traveler gets the benefit (frequent-flyer miles), while the
business pays for the current flight.
Other examples include points that hotels give to travelers and bonus checks based on charges that Discover
gives those who use its credit card.
Firms likely do not monitor these programs because it would be too costly to do so.
Equilibrium price is $6 and equilibrium quantity is 300.
In a third-party payer system where the consumer pays $2, quantity demanded will be 900. Suppliers require
payment of $14 to supply that quantity.
Total spending in a is $1,800. Total spending in b is $12,600.
Chapter 5: Web Questions
1.
a.
b.
Shadow markets are alternative or black markets that develop as result of a shortage in the legal market. One
develops when there is rent control because rent control creates shortages and it is difficult for government to
regulate the entire housing market.
Because the quantity supplied is less than quantity demanded, some other way of rationing besides price
emerges. One method of rationing is first-come first serve and hoarding. Those who have the apartments will
hoard them–by not ever moving and by “giving” them to heirs. Housing is particularly easy to hoard because it
is a durable good. Because of hoarding practices, it is more difficult for newcomers to find housing in a city
with rent control.
Page 631, Answers to End-of-Chapter Questions
2.
c.
Vacancy rates are much lower in rent control cities compared to cities without rent control. This makes sense
because rent controls create shortages.
a.
The minimum wage, adjusted for inflation, has fallen nearly consistently since 1979. If the inflation-adjusted
minimum wage is on the vertical axis, this will reduce the shortage of jobs (number of unemployed) that
results from the minimum wage.
According to the article, minorities are disproportionately represented among minimum wage earners.
Compare column 1 to column 4 for each subcategory. If column 1 is greater than column 4, that category is
over-represented among minimum-wage earners.
The author says that the job-loss effect is small or minimal. He cites the observation that the 90-cent increase
in 1996/97 did not lead to lower employment levels among minorities. The minimum wage did not prevent
economic growth during the mid-1990s from raising employment levels among low-wage earners.
b.
c.
Chapter 5: Appendix A
a.
The tables are shown below:
b.
c.
Price
Quantity Demanded
(dollars
(Gallons per year)
per gallon)
0
600
1
500
2
400
3
300
4
200
5
100
6
0
The graph is shown on the right.
P=3; Q=300
Quantity Supplied
(Gallons per year)
-150
0
150
300
450
600
750
6
Price
1.
Supply
5
4
3
2
Demand
1
100 200 300 400 500 600
Quantity
2.
a.
The following are the demand and supply tables after the
hormone is introduced:
Price
(dollars
Quantity Demanded
per gallon) (gallons per year)
0.00
600
1.00
500
2.00
400
2.50
350
3.00
300
4.00
200
5.00
100
6.00
0
Quantity Supplied
(gallons per year)
225
125
275
350
425
575
725
875
Page 632, Answers to End-of-Chapter Questions
c.
d.
3.
a.
b.
c.
4.
a.
b.
c.
The original supply curve is S0. The growth
hormone shifts the supply curve to S1 (to the
right by 125). Equilibrium price falls to $2.50 a
gallon, and equilibrium quantity rises to 350
million gallons (point B).
The demand curve remains the same at QD =
600 - 100P. The supply curve becomes QS = -25
+ 150P. To solve the two equations, set them
equal to one another: 600 - 100P = -25 - 150P
and solve for P. Doing so, we get P = 2.5.
Substituting this value for P into either the
demand or supply equation gives us equilibrium
quantity of 350.
Quantity supplied would be 425 (-25 + 150 3 3)
and quantity demanded would be 300 (600 - 100
3 3). There would be excess supply of 125. The
price floor is shown in the graph on the right.
6
Price
per gallon
b.
S0
5
S1
4
A
3
2
B
Demand
1
0
100 200 300 400 500 600
Quantity in millions
of gallons
The demand curve is QD = 10-P; the supply curve is QS = 2P -5. To solve for equilibrium price and quantity,
set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution
is P = $5, Q = 5.
The new demand curve is 13-P. To solve for equilibrium price and quantity, set the two equations equal and
solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $6, Q = 7.
The new supply curve is 2P-8. To solve for equilibrium price and quantity, set the two equations equal and
solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $7, Q = 6.
A demand curve follows the formula QD = a - bP, where a is the price-axis intercept and b is the slope of the
curve. A shift in demand is reflected in a change in a. An increase in demand increases a and a decrease in
demand reduces a.
A supply curve follows the formula, Q S = a + bP, where a is the price-axis intercept and b is the slope of the
curve. A shift in supply is reflected in a change in a. An increase in supply reduces a and a decrease in supply
increases a.
A movement in supply or demand is reflected in the effect of a change in P on either Q S or QD.
5.
a.
b.
P = 4; Q = 6
Since the government set price is above the equilibrium price, it is a price floor. Thus it would create a surplus.
Solving the equations, we see the surplus would be 2 million bushels.
6.
a.
b.
c.
The new supply equation is QS = -150 + 150(P - 1) where P is the equilibrium price, or QS = -300 + 150P.
P = 3.60; Q = 240.
Farmers receive $2.60 per gallon.
7.
a.
b.
c.
The new demand equation is QD = 600 -100(P+1) where P is the price suppliers receive, or Q D = 500-100P.
P = 3.60; Q = 240.
Farmers receive $2.60 per gallon.
8.
a.
b.
c.
The new supply equation is QS = -150 + 150(P + 1) where P is the equilibrium price, or QS = 150P.
P = 2.40; Q = 360.
Farmers receive $3.40 per gallon.
a.
b.
c.
d.
Equilibrium price is $2.
P = $3 is above equilibrium price, so it is a price floor. There is a surplus of 8.
P = $1.50 is below equilibrium price, so it is a price ceiling. There is a shortage of 4.
P = $2.25 is above equilibrium price, so it is a price floor. There is a surplus of 2.
P = $2.50 is above equilibrium price, so it is a price floor. There is a surplus of 4.
9.
Page 633, Answers to End-of-Chapter Questions
Chapter 6: Describing Supply and Demand Elasticities
Questions for Thought and Review
1.
E = percentage change in quantity/percentage change in price=20/10=2. It is elastic.
2.
I would check to see if other things remained equal, suspecting that they did not. The reason why is that the
rise in price did not have the expected effect. If all other things did indeed remain equal, the elasticity would
be zero. Percentage change in quantity divided by the percentage change in price.
3.
The price elasticity of demand equals percentage change in quantity demanded/percentage change in price =
(16,000/18,000)/(.25/1.375)= 88.9/18.2 = 4.9.
4.
Price elasticity of demand is equal to the percentage change in quantity divided by the percentage change in
price. Pizzas went from $8 to $2 and quantity from 1 to 100. The price elasticity of demand is (1.96/1.2) =
1.60.
5.
a.
b.
c.
Cars: The broader the category, the less elastic the demand.
Leisure travel: It is more of a luxury.
Rubber during the 20th century: There are more substitutes now.
6.
They are both the same. Any supply curve that goes through the origin has an elasticity of 1.
7.
In real life elasticities are difficult to measure. The effect of a 1% rise in price would probably be swamped by
other effects.
8.
To the degree that colleges are trying to get as much revenue as possible, they will keep raising tuition until
the demand is no longer inelastic. Colleges don’t raise their tuition by more than what they currently do
because they are not profit maximizers, and because social pressures such as student protests would result if
they raised tuition too much.
9.
If the author is profit maximizing, he or she would prefer to raise price. Raising price with an inelastic demand
increases revenue. Because the author’s cost is sunk cost, profit also rises.
10.
More eager students will agree to go to a school even if they don’t get much financial aid. That is, they have
less elastic demands and thus will tend to get less financial aid. Whether this practice is justified is a difficult
normative issue, with many alternative views.
11.
Lowering price will increase output and hence increase costs. Sellers are interested in profits, not total
revenue, so the effect of increasing output on costs must also be taken into account. Increasing prices with an
inelastic demand increases revenues and lowers costs. Thus, it definitely increases profit.
12. a.
Vodka: luxury (except in Russia). Individuals tend to drink more hard liquor as their income rises. (It depends
on the type: Absolut vodka is more of a luxury than store brands.)
Table salt: necessity. It is a small portion of people’s income, and its consumption doesn’t increase with
income.
Furniture: luxury (depends on the type). While we all need some furniture, the wealthy spend large sums on
furniture. The rest of us get by with cheap stuff.
Perfume: luxury (depends on the type). The rich blow money on perfume; the rest of us get by with toilet
water, or we smell a bit.
Beer: necessity (depends on the type) Beer tends to be the poor person’s drink. However, new micro breweries
are trying to change beer’s image, and to make certain types of beer be seen as a luxury.
Sugar: necessity. It is not used significantly more by rich than by poor.
b.
c.
d.
e.
f.
13. a.
b.
c.
Close to zero. While they are substitutes, they are not close substitutes.
Negative. They are complements.
Positive. They are close substitutes.
Page 634, Answers to End-of-Chapter Questions
d.
Close to zero. They are at best distant substitutes.
14.
If there were only two (assuming no saving) the goods must be substitutes because if a person doesn’t
consume one, he or she would have to consume the other.
15.
If demand is inelastic raising tax rates will increase revenue paid by consumers from the tax. Similarly with
supply; thus what happens to total tax revenue depends both on the elasticity of supply and demand.
Chapter 6: Problems and Exercises
1.
a.
b.
Since the price falls by 60/300 (about 18%) the price elasticity would be one.
The same since box size rises by about 18% without price changing.
2.
a.
Using standard reasoning, we would answer that firms decreased the size of the coffee cans to hide price
increases from consumers. However, in reality people often react differently to changes in the size of packages
compared to the equivalent change in price.
Examples include candy bars, soap, and canned tuna fish.
b.
3.
a.
b.
4.
a.
b.
Since demand is assumed to be highly elastic, Professor Heise would respond that this program would
significantly increase the quality of the students enrolled and increase the total number of applicants. Net
income would rise.
If the demand had been highly inelastic, the response in quantity demanded would be small, and the program
would have little effect except to lower revenue from tuition.
A price rise of 10 percent will reduce fuel consumption anywhere from 4 to 8.5 percent. This translates to 9.15
to 9.6 million gallons demanded.
This suggests that there are other forces besides price at work here; making adjustments to higher prices is
much easier than making adjustments to lower prices. This may be due to learning the true cost of substitutes
when those substitutes are consumed. One can imagine a scenario in which a price hike significantly changes
driving behavior—commuters may switch to ride sharing or public transportation, to which there may be
perceived social barriers (costs). Once those barriers are overcome and the perceived costs are lowered after
those alternatives are used, a larger decline in the price of gasoline is required to induce those who switched to
return to driving their own cars.
5.
Keep in mind that the definition of elasticity is percent change in quantity divided by percent change in price.
We want to show that elasticity of supply is less than one. Elasticity of supply can be written as (% change in
Q/ % change in P), or (change in Q/Q)/(change in P/P). Arranging terms, we have: (change in Q/change in
P)/(P/Q). Since (change in Q/change in P) = 1/slope, this can be rewritten as (1/slope)(P/Q). The slope of a
line crossing the quantity axis is given by P/(Q-a), where a is the quantity supplied at zero price (a > 0).
Substituting into the equation for the elasticity, we have {1/[P/(Q-a)]}(P/Q)=(Q-a)/Q= -a/Q.
6.
Point A: 3; point B: 1/3; point C: 3/2; point D: 7/6.
7.
A to B: 3; G to H: 6/7; E to F: 1/2; C to D: 10/3.
8.
a.
0.5
b. 0.60
9.
a.
b.
c.
.06.
Since E > 0, they are complements.
Demand for hot dogs would have to rise for the two to be substitutes.
Page 635, Answers to End-of-Chapter Questions
The supply shifts in and price rises as in the graph on the right.
Elasticity of demand is 1.
S1
Price
10. a.
b.
S0
$1.75
$1.17
D
60
90
Quantity
11. a.
3.33 percent
12. a.
Peak hour travelers are likely to be commuters who have little choice but to go to work and therefore have
lower demand elasticity than those who ride buses during off-peak hours. They could choose to stay at home
instead.
Demand tends to be less elastic in the short run because there are fewer substitutes. If fares rose enough, in the
long run people could find alternative modes of transportation—purchase a car, find someone to share rides
with, etc.
Tolls are likely a much smaller portion of high-income commuter’s total income, contributing to a less-elastic
demand.
b.
c.
b. 14.29 percent c. 5 percent
Chapter 6: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
d.
Young adults would be affected more. Price elasticity of overall youth cigarette demand was –1.44, increasing
the price of cigarettes would reduce smoking over 14%.
Smokeless and other tobacco products for cigarettes could be taxed.
Long-run effects of price on demand will be larger than short-run, about double. Sustained tax increases the
long-run reductions in all segments of population.
$5.50 to $6.50, which is about a 17 percent increase.
The estimate of labor demand elasticity used is 0.22. Inelastic.
Labor costs will be raised $162 million per year. Since demand is inelastic, a rise in the minimum wage will
raise total labor costs. The two are consistent. If elasticity of demand were greater than one, one would expect
labor costs to fall when the minimum wage is raised.
In the long-run firms can hire fewer workers and more of the other factors of production. Labor costs will
rise. What accounts for the difference is that in the long run, all factors of production are variable. In the
short run, firms have fewer substitutes in production.
Chapter 7: Taxation and Government Intervention
Questions for Thought and Review
1.
With either excess supply or excess demand, the number of trades will be lower than if price were allowed to
move to its equilibrium price. That means there is a loss of surplus.
2.
Decision making based on costs and benefits means you make purchases if the marginal benefits are greater
than the price. The market price yields no benefits for the marginal producer or the marginal good. For all
others the consumer gets the surplus.
3.
To the extent that home values reflect income, property tax based on the value of the home is an example of
the ability to pay principle. An assessment for sidewalks per home is an example of the benefit principle.
Page 636, Answers to End-of-Chapter Questions
4.
If demand is inelastic, raising a tax increases revenue paid by consumers; similarly with supply. Thus, what
happens to total tax revenue depends on the elasticity of both supply and demand.
5.
If suppliers were strong lobbyists, the government would prefer demand to be more inelastic, because then
consumers will bear the largest portion of the tax.
6.
I’d recommend goods with a price elasticity of demand or price elasticity of supply as close to zero as
possible. Examples would be cigarettes, salt, required medications, a per capita tax, and land.
7.
The demander. The more inelastic the supply (demand) curve, the larger percentage of the burden is borne by
the supplier (demander).
8.
With a perfectly elastic demand, suppliers will pay the entire cost of the tax regardless of how elastic supply
is—unless supply is also perfectly elastic, in which case no goods will be bought or sold after the tax, so no
one will bear the burden.
9.
The demander will pay 30 percent of the tax [.3/(.7+.3) X 100).
10.
If the economist wanted to get as much revenue as possible from as little output reduction as possible, he
would suggest taxing inelastic supplies.
11.
No. Tenants shouldn’t worry too much. In the short run the supply of apartments is highly inelastic so the
owner will bear the majority of the tax burden; it will not be passed on to tenants. In the long run supply is
more elastic so the renter will pay some of the tax. So in the long run, tenants should worry more.
12.
If the tax were based on street frontage rather than square feet of living space, individuals would have an
incentive to build in this style.
13.
For an equivalent percentage rise in price, the more elastic and demand and supply, the greater the shortage
that will be created. The reason is that the response in quantity supplied and demanded is greater when price
elasticity is greater.
14.
Rent seeking is the restricting of supply in order to increase price. The firm would have a greater incentive to
rent-seek when demand is inelastic.
Chapter 7: Problems and Exercises
a.
b.
Consumers will likely complain the most because they have fewer alternatives. There will, however, be more
suppliers who are kept out of the market.
In the graph on the right you can see that the suppliers decrease
output significantly, but the opportunity cost of their doing so is
S
not great. Those fewer demanders who are hurt are hurt a lot; they
will likely scream loudly. The actual number of complaints will
depend on the costs of complaining and the expected benefits of
Pc
complaining.
Price
1.
D
Qs
Qe Qd
Quantity
Page 637, Answers to End-of-Chapter Questions
2.
a.
Price
b.
In the graph on the right, the government requirement has caused an increase in demand, which has raised the
price. Consumers used to pay Pe for Qe, but now pay P1 for Q + 10%. Welfare loss for society is the bolded
triangle.
If eating beets makes people healthy, their decisions ought to
reflect that fact. One could argue that if the government knew
S
better than consumers, this action would be justified if the
P1
marginal benefits exceeded the marginal costs. However, if
people are choosing not to be healthy, and are rational, then
Pe
any regulation making them eat beets would make them worse
D + 10%
off.
D
Qe Q+10%
Quantity
Welfare loss is shown by the bolded triangles in the figures below.
S1
Price
Price
3.
P1
t
S0
P1
S
Pe
Pe
D
D
Q1 Qe
Q* Qe
Quantity
Quantity
b.
Pe
S0
s
S
Price
Price
a.
S1
D
P1
D
Q*
Qe Q1 Quantity
c.
4.
Qe
Quantity
d.
a.
A poll tax would have no incentive effect, as shown in the graph below. A tax on property, where supply is
somewhat elastic, will reduce the quantity of property supplied (negative incentive effect), which may not be
desirable.
b.
Margaret Thatcher was almost thrown out of office because of this tax, and her successor, John Major,
returned to a property tax. Citizens were far more concerned with the distributional consequences associated
with a poll tax than they were with the loss of efficiency associated with a property tax.
Page 638, Answers to End-of-Chapter Questions
a.
b.
c.
See the graph on the right.
In the case of a tax, t, the revenue (rectangles A and B) goes to
the government.
In the case of a price floor, Pf, the “revenue” (areas A and B)
goes to the suppliers who still supply.
The bolded area in the graph on the right represents the
welfare loss.
S1
Price
5.
Pf
Pe
t
B
D
C
Qe
6.
a.
b.
7.
a.
b.
c.
d.
8.
a.
b.
c.
d.
9.
a.
b.
c.
d.
e.
S0
A
Quantity
With time the job searchers will get discouraged and drop out of the labor force, disguising the unemployment.
Another possibility is that firms invest in machinery to replace labor, increasing the productivity of labor and
thereby increasing the demand for labor and reducing the shortage of jobs.
It is likely to decrease.
The equilibrium price is $6, the equilibrium quantity is 45.
Producer surplus is the area below equilibrium price and above the supply curve. Assuming the supply curve
intersects the price axis at $1, the numerical value is ½ 3 45 3 5 = 112.50.
Consumer surplus is the area above equilibrium price and below the demand curve. Assuming the demand
curve intersects the price axis at $15, the numerical value is ½ 3 45 3 9 = 202.50.
Producer surplus is the area above the supply curve below $10 up to 25. Numerically this is equal to 212.50
(10325 – ½(3325)). Consumer surplus is the area below the demand curve above $10 up to 25. Numerically
this is 62.50 (1/2(2535)).
Before the tax, equilibrium price is $6 and equilibrium quantity is 200. After the tax, equilibrium price is $8
and equilibrium quantity is 100.
Producer surplus before the tax is the area above the supply curve and below price. This is a triangle with base
200 and height 4. So, producer surplus is 1/2 (200)(4) = 400. After the tax, the triangle representing producer
surplus has a height of 2 and base of 100. So producer surplus is 1/2 (100)(2) = 100.
Consumer surplus before the tax is the area below the demand curve and above price. This is a triangle with
base 200 and height 4. So consumer surplus is 1/2 (200)(4) = 400. After the tax, the triangle representing
consumer surplus has a height of 2 and base of 100. So consumer surplus is 1/2 (100)(2) = 100.
Total tax revenue is $4 times equilibrium quantity, 100, or $400.
Percent borne by demander = 80; percent borne by supplier = 20.
Percent borne by demander = 40; percent borne by supplier = 60.
Percent borne by demander = 67; percent borne by supplier = 33.
Percent borne by demander = 50; percent borne by supplier = 50.
Consumers will relatively more elastic demand curves bear a smaller percent of the tax. The same is true for
producers.
Chapter 7: Web Questions
1.
a.
b.
c.
d.
e.
California ranks 8th highest among the states with gasoline taxation.
In transportation expenditures, highway investment per $1000 of personal income, California ranks 49 th in the
nation.
User fees, fuel tax correlate with the amount of road usage and are earmarked for transportation uses. Thus, it
is based upon the benefit principle.
With fuel economy cars and alternative fuels, fuel taxes have grown slower than vehicle miles traveled. What
accounts for this change is that people buy more efficient cars and substitute other modes of transportation
such as walking.
The tax rate is the same across income levels however low income groups spend a much greater share of their
income on gasoline therefore gasoline tax has a regressive impact.
Page 639, Answers to End-of-Chapter Questions
2.
a.
b.
c.
d.
3.
a.
b.
c.
1) Taxation should bear as lightly as possible on production. 2) It should be easy and cheap to collect, and fall
directly on the ultimate payer. 3) It should be certain. 4) It should bear equally so as to give no individual an
advantage.
The broad based taxes burden production, but they are relatively easy and cheap to collect at least compared to
other taxes and the burden is shared relatively equally. They do not necessarily fall on the ultimate payer.
A land value tax best fits the criteria.
The tax falls directly on the owner; tax on land does not affect cost of production or its supply, so price is not
increased. Because quantity sold doesn’t change, the welfare loss is zero.
The moratorium was still in effect in the Spring of 2003. It is set to expire October 31, 2003.
New taxes on Internet sales will reduce the quantity of goods purchased over the Internet to decline
significantly because there are close substitutes—goods from brick and mortar stores. This suggests that the
elasticity of demand is high.
I would argue that Internet sales should be placed on equal footing with sales from brick and mortar stores. In
addition, Internet sales, because they are not taxed, results in a loss of state revenue. These are arguments for
taxing Internet sales. On the other hand, to the extent that the government wants to nurture the Internet
market, perhaps the moratorium should be extended.
Chapter 8: The Logic of Individual Choice
Questions for Thought and Review
1.
Marginal utility is the satisfaction you get from consuming an additional unit of a good over and above what
you’ve already consumed while total utility is the satisfaction you’ve gotten from consuming all the goods
you’ve consumed so far.
2.
According to the principle of diminishing marginal utility, marginal utility falls as one consumes more of a
good. Marginal utility of the last unit consumed rises as one consumes less of the good.
3.
The principle of diminishing marginal utility means that as individuals increase their consumption of a good,
at some point consuming another unit of that good will not yield as much additional pleasure as did consuming
the preceding unit or units. This is important because the marginal utility you get from a good plays a central
role in determining how much you're willing to pay for it and how much of it you will demand. If the principle
of diminishing marginal utility seldom held, the patterns of consumption and demand would be radically
different; individuals' consumption would focus on a single good.
4.
Economists’ theory of value depends on the underlying assumptions. Given those assumptions, price and
value are related. If those assumptions (such as assumed rationality and freedom of choice) don’t hold, the
statement is true; if they do hold, the statement is false.
5.
This question asks students to put a utility value on their study pattern and consider it in terms of rational
choice. It is likely that their study patterns are rational.
6.
There are many psychological explanations for people’s actions, but economists use an easy underlying
psychological foundation: rational self-interest.
7.
This question asks students to explain the motivations for four choices they have made in the past year. The
student will explain in each case that the opportunity cost of not undertaking the activity was greater than the
opportunity cost of undertaking that activity. In other words the marginal utility per dollar of the activity
undertaken exceeded the marginal utility per dollar of all other choices at that time.
8.
The law of demand states that quantity demanded falls as price rises and quantity demanded rises as price
falls. If you are already in equilibrium and the price of a good rises, you will no longer be in equilibrium. The
marginal utility per dollar of the good whose price has risen is too low. To raise it, you must reduce your
Page 640, Answers to End-of-Chapter Questions
consumption of that good. Therefore, as the price of the good rises, you consume less of it—the law of
demand.
9.
The law of supply states that as price increases quantity supplied increases. The opportunity cost to the
supplier is the value of the next best alternative they had when they supplied that good. If we are talking about
labor it is the next best alternative value of the person's time. The opportunity cost of that forgone pleasure
tends to increase the more you supply which is why opportunity costs underlie the law of supply.
10.
If the supply curve is perfectly inelastic, the supplier has no alternative; thus, the opportunity cost is zero.
11.
As usual, the answer is: it depends. Specifically, it depends on their utility function. If they value the uses of
their time spent in "voluntary simplicity," it would definitely be rational. If most people had this type of utility
function, then a decrease in measured production could well be associated with an increase in total utility.
12.
For Americans, a large part of utility (happiness) is relative to others. As everyone gets more relative
happiness does not increase.
13.
What explains this paradox is the difference between total utility and marginal utility. Although our total
utility for the consumption of water (a necessity) is much higher than that of diamonds (a luxury), the marginal
utility of a gallon of water is much lower than the marginal utility of another diamond because of the principle
of diminishing marginal utility. It is the marginal utility that determines willingness to pay, and thus defines
the demand curve.
14.
Most people buy goods without a lot of thinking. An example of ours is when we buy meat at the store. We
have a general idea of what the price should be, and if the price is lower than that (and a sign or sticker says
sale) we buy it. It follows the principle of rational choice only if that principle takes into account the costs of
deciding.
15.
The purpose of conspicuous consumption, according to Thorstein Veblen, is to demonstrate to others that one
can afford the goods consumed. Utility is derived not from consuming the good or its functionality, but from
how much one spent for the good, or its price. An example of such goods today is a Rolex watch. People don’t
buy Rolex watches just to keep the time, but to show to others that they can afford to buy a $10,000 watch.
Chapter 8: Problems and Exercises
1.
The table looks like this (interpret marginal as between the two numbers).
Cans of Soda
0
1
2
3
4
5
6
7
a.
b.
c.
2.
Total Utility
0
10
22
32
40
44
44
42
Marginal Utility
0
10
12
10
8
4
0
-2
Marginal utility begins to fall at the third soda.
Scout will not consume the 7th soda because it reduces total utility. It provides negative marginal utility.
We don’t know whether Scout is following the utility maximizing rule without more information. If this were
her only choice and the soda were free, she’d drink 6 cans of soda—maximize total utility. Drinking 2 cans
would maximize marginal utility.
Given the information in the table, the best combination to purchase will be where the (MU/P) is equal for all
three goods. Doing the calculations, we have:
Page 641, Answers to End-of-Chapter Questions
#
(MU/P) for A
(MU/P) for B (MU/P) for C
1
20
10
8.33
2
18
7
1.67
3
15
6
1.67
4
10
5
1.67
5
5
4
1.67
6
2
4
1.67
7
27
3
21.67
8
220
2
21.67
(Note that marginal utility should be interpreted between units of consumption.) We start by buying that good
with the highest util per dollar. With $20 to spend we would buy 1 of A, for 20 utils per dollar, leaving me
with $10 to spend. We would then buy 1 more of A, getting 18 utils to the dollar. This would exhaust our
money.
3.
From the information in the table, the marginal utility per dollar is:
#
1
2
3
4
5
6
a.
b.
c.
(MU/P)
for A
10
9
8
7
6
5
(MU/P)
for B
25
20
15
10
8
6
(MU/P)
for C
15
10
8
6
5
4
(Note that marginal utility should be interpreted between units of consumption)
With $12 to spend the consumer should buy 1 of A, 4 of B, and 2 of C.
If the price of B rose to $2 its (MU/P) would be cut in half. The consumer should now buy 1 of A, 2 of B, and
2 of C.
If the price of C was 0.50 but the other prices are the same as in part a, the (MU/P) for C would increase, and
the consumer would buy all 6 of C, and 5 of B and 2 of A.
4.
You should continue your present pattern of consumption. One more widget will give you 2 more units of
utility for $2, and one more wadget will give you 3 more units of utility for $3, and since (MU1/P1) =
(MU2/P2), your present consumption pattern gives you as much total utility considering your income and
prices, as any variation.
5.
I would expect that Wicksteed would equate the marginal utility of fresh eggs divided by their cost including
walking time to fetch them and the marginal utility of visits from friends divided by the cost to induce them to
visit.
6.
a.
b.
c.
7.
If he or she is not a 100 percent rational economist, it is likely that you will lose your spouse or significant
other—or at least lose his or her love or fondness.
The utility gained from a diamond is not just its brilliance or perfection but also the knowledge that it is real
(and thus expensive) and that some sacrifice (driven by affection) was made for its purchase. A fake diamond
suggests that there was little sacrifice and thus the giver’s love was cheap as well.
Who is to say that the utility from the consumption of a product is not just?
I would buy 2 Charlie Parker at $10 each, and 4 Lester Young CDS at $5 each. When the price of Lester
Young CDS rises to $10, we would buy 3 Charlie Parkers and 1 Lester Young. This demonstrates the law of
demand because as the price rises, we buy a smaller quantity.
Chapter 8: Web Questions
1.
a.
This is one example.
From Newark to Fort Lauderdale, $169 through Cleveland or $172 direct. The price is higher for direct flights
Page 642, Answers to End-of-Chapter Questions
b.
c.
2.
a.
b.
c.
d.
because people who are willing to have a stop are more responsive to price.
$187 and $229. Business demand is more inelastic than pleasure demand.
$235 and 268. Demand is more inelastic.
iwon.com is a full search engine.
The site gives out prizes to increase use, and thereby increase their advertising revenue since that is tied to
usage.
Advertisements are in the links, they include webMD, Sprint and DVD Express.
If advertising works it likely means that preferences can be influenced.
Chapter 8: Appendix A
Zachary’s budget constraint for a, b, and c are shown in
the graph on the right.
Video games
1.
20
18
16
14
12
10
8
6
4
2
0
a
b
c
0 2 4 6 8 10 12 14 16 18 20
Hot dogs
2.
a.
b.
With budget constraint in a, Zach will be on utility curve II. With budget constraint in b, Zach will be on
utility curve III. With budget constraint in c, Zach will be on a utility curve that is to the right of III.
Zachary prefers the budget constraint that is the furthest to the right, c.
The marginal rate of substitution for a is -2, for b is -1 and for c is -1. The marginal rate of substitution equals
the slope of the budget constraint at the optimal combination of goods. Even though we do not know the
optimal combination with budget constraint c, we can still figure out the marginal rate of substitution for that
combination.
3.
A horizontal line. A straight line with negative slope if marginal utility were constant.
4.
It would be bowed away from the origin if there were increasing marginal utility.
Chapter 9: Production and Cost Analysis I
Questions for Thought and Review
1.
Economists include all opportunity costs as costs. This includes not only explicit costs but also implicit costs
such as the opportunity cost of the owners of the business. Accountants don’t include this second item as a
cost. Economists include changes in the value of any assets owned by the firm in revenue (implicit revenue) as
well as total sales. Accountants include only total sales. An example of an implicit cost is the salary the owner
of the firm could have earned if the owner worked somewhere else. An example of implicit revenue is a rise in
the value of the building owned by the firm.
2.
The terms long run and short run do not necessarily refer to specific periods of time independent of the
production process. The long run, by definition, is a period in which the firm can vary the inputs as much as it
wants; in the long run, all inputs are variable. The question is whether a firm ever really gets to this degree of
flexibility. It may be true that firms are always constrained in regard to what production decisions they can
make, so in reality this statement is probably true.
3.
Marginal product is the additional output that will be forthcoming from an additional worker, other inputs
constant. Average product is output per worker, the total output divided by the number of workers.
Page 643, Answers to End-of-Chapter Questions
If average productivity is falling, short-run average variable cost is rising; to say that productivity falls is
equivalent to saying that cost rises.
5.
If marginal cost is increasing, average costs could be rising, falling, or constant. The direction of average costs
depends upon whether marginal cost is higher or lower than average cost.
6.
If average productivity is falling, average costs must be rising; if marginal productivity is falling, marginal
cost must be rising. But there is no necessary relationship between average productivity and marginal costs.
7.
If neither factor is fixed there is no diminishing marginal returns.
However, the quick order premium means that short-run marginal
costs are 50% higher than long-run average costs. Assuming constant
returns, then both the long-run and short-run marginal cost curves are
flat. Thus, once you have determined an initial production level, to
change in the short run you must use the short-run marginal costs.
The average total cost curve will initially be U-shaped, but then it
will become asymptotic to the short run marginal cost curve as in the
graph on the right.
Costs in dollars
4.
ATC
MC
Output
8.
The shapes of the short-run average cost curve and marginal cost curve would be the same as in the more
usual case where machines are the fixed factor. Either way you are still adding more and more of a variable
factor to a fixed factor and encountering diminishing marginal productivity as a result. The marginal cost and
average cost curves would be U-shaped.
9.
This is true because the fixed cost will be spread over such a large quantity of output that the average fixed
cost, the difference between average variable cost and average fixed cost, will approach zero.
10.
These statements are true. Labor does not need to be produced (at least in the time periods that microeconomic
analysis usually considers) and hence the choice for individuals is how to divide up that labor among various
activities such as work, play, and studying (opportunity costs). Goods that need to be produced ultimately
depend on the opportunity costs of the factors producing them, but in the standard economic model, those
costs are assumed fixed; thus, the opportunity costs are assumed fixed. This leaves the analysis of production
free to focus on technical aspects of production such as diminishing marginal productivity as the determinant
of costs, and hence supply.
11.
Assuming one organizes one's studying reasonably, initially you focus on the parts of the text that are most
likely to show up on the exam, and are most likely to raise one's grade. Then, the areas of study's influence on
the grade decrease. At some point additional studying can have a negative return.
12.
Productivity gains can reduce the percentage of labor costs per vehicle, allowing GM either to lower its price
(thereby increasing the quantity of its cars sold) or to increase its profits (making its shareholders happy).
13.
This is not true. While profits are important to business, because of internal monitoring problems it is not clear
that managers maximize profit. They may waste profit potential in high-priced benefits for themselves and in
inefficiency generally. The market, however, provides a limit on inefficiency, and firms that exceed that limit
and have losses go out of business.
Chapter 9: Problems and Exercises
1.
Her accounting profit is revenue minus explicit costs: $170,000. Her economic profit is revenue minus
(explicit and implicit costs): 41,000.
Explicit Costs:
Labor
Rent
40,000
10,000
Page 644, Answers to End-of-Chapter Questions
Ingredients
Utilities
Total
Implicit Costs:
Opportunity cost of Labor
Opportunity cost of Capital
Total
Total Cost
b.
35,000
5,000
90,000
125,000
4,000
129,000
219,000
Revenue
260,000
Economic Profit
Accounting Profit
41,000
170,000
Since she is earning economic profit with her current business that she would forgo if she were to accept the
position, which significantly exceeds the present value of what she can sell the firm for, she should continue to
bake her own cookies.
2.
Rent is $4,000; labor is $40,000; utilities are $5,000; total revenue is $100,000; the opportunity cost of the
entrepreneur is $50,000; and that of the funds invested is $4,000. By the accounting definition of cost and
profit, Economan is making a profit equal to $100,000 - ($4,000 + $40,000 + $5,000) = $51,000. From an
economist’s point of view, where explicit and implicit costs are considered, Economan now has a loss of
$100,000 - ($4,000 + $40,000 + $5,000 + $50,000 + $4,000) = -$3,000.
3.
From the data given:
Q
FC
VC
TC
AVC
AC
MC
AFC
0
100
0
100
0.00
inf
0
1
100
40
140
40.00 140.00 40
100
2
100
60
160
30.00 80.00
20
50
3
100
70
170
23.33 56.67
10
33.33
4
100
85
185
21.25 46.25
15
25
5
100
130
230
26.00 46.00
45
10
(Note: Marginal costs should be interpreted as between levels of output.)
ATC
150
125
AFC
Costs
Costs
100
75
50
AVC
25
MC
0
0
1
2
3
4
5
250
225
200
175
150
125
100
75
50
25
0
TC
0
1
2
3
Output
4.
a.
4
5
Output
Given the price of labor at $15 per hour, and the data in the total product table; the following table represents
the average variable costs:
Page 645, Answers to End-of-Chapter Questions
Costs
Labor
TP
VC
AVC
AP
MP
MC
1
5
15
3.00
5.0
5
3.00
2
15
30
2.00
7.5
10
1.50
3
30
45
1.50 10.0
15
1.00
4
36
60
1.67
9.0
6
2.50
5
40
75
1.88
8.0
4
3.75
b. This is done in the next column. The AVC curve is shown on
the right, and the AP curve is shown below on the right. You
can see that the AVC curve and AP curve are mirror images
of each other.
c. The MP curve is shown below on the right.
d. As you can see from the graphs, the MC curve and the MP
curve are approximate mirror images of each other.
4
3.5
3
2.5
2
1.5
1
0.5
0
MC
AVC
0
5
Output
Productivity
16
14
12
10
8
6
4
2
0
AP
MP
0
5.
a.
b.
c.
d.
10 15 20 25 30 35 40
5
10 15 20 25 30 35 40
Output
See the graph below on the left.
The marginal cost curve intersects the AVC curve at the
minimum of the AVC curve. This is to the left of the intersection of the MC curve and the ATC curve, which
is at the minimum of the ATC curve.
See graph below on the right.
The ATC and AFC curves shifted down because they are the only two of the four that include fixed costs. The
MC and AVC curves did not shift because they include only variable costs.
140
120
250
100
Costs
Costs
200
150
100
MC
80
ATC
60
AVC
40
50
20
ATC
AFC
0
AVC = M C
MC
0
1
2
3
4
5
6
7
8
9 10
AFC
0
0
1
2
3
4
5
Output
6.
a.
b.
c
d.
e.
6
7
8
9 10
Output
The AFC, ATC, AVC, and MC curves are shown below on the left.
The AFC curve has its normal shape. Because average variable costs do not change, the marginal cost curve is
coincident with the average variable cost as shown. The ATC curve is always falling since the costs are always
above the MC curve. They asymptotically approach $25.
The law of diminishing marginal productivity is not operative.
The new AFC, ATC, AVC, and MC curves are shown in the right-hand graph below. The AFC curve remains
the same. The MC curve is now upward-sloping, with a slope of 10. The AVC curve is also upward-sloping,
with a slope of 5. The ATC curve now has a more normal shape, with a minimum where it intersects the MC
curve.
Marginal costs would have to decline at first and then rise for the curves to have their “normal” shapes.
Page 646, Answers to End-of-Chapter Questions
250
200
200
Costs
Costs
250
150
150
MC
100
100
50
ATC
AFC
AVC
0
0
1
2
3
4
5
6
7
8
ATC
AVC
50
AFC
MC
0
0
9 10
1
2
3
4
5
7.
a.
b.
c.
d.
6
7
8
9 10
Output
Output
Assuming labor can be hired and fired and is a variable cost, this will shift up AVC, ATC and MC.
This involves a shift up of the AFC and the ATC.
This will shift up AVC, ATC and MC.
This will shift down AVC, ATC and MC.
Chapter 9: Web Questions
1.
The answer to this question will be different for every student. This is the information retrieved in 2002 for travel
between Allentown, PA and Chicago, IL. It cost $500 for the week. The first 700 miles were free and
additional mileage was 30 cents a mile.
a.
Miles
0
500
1000
1500
2000
b.
c.
2.
a.
b.
c.
d.
e.
Total
Cost
$500
$500
$590
$740
$890
Marginal Cost
0
$90
$150
$150
Average Fixed
Cost
Average
Variable Cost
$1
$0.50
$0.33
$0.25
0
$.09
$.14
$.195
Average fixed cost falls as total number of miles driven rises.
Marginal cost increases up to 1500 miles and falls thereafter.
This answer is based on 2001 data.
The operating cost of producing an acre of corn is $170.83. The total cost of producing an acre of corn is
$390.59.
Two major components of the variable costs are seed and fertilizer.
Two major components of fixed costs are land and equipment.
Each acre yielded an average 139 bushels. Dividing operating cost per acre by 139, we calculate the price of
corn needed to cover operating costs to be $1.23 per bushel.
Dividing total cost per acre by 139, we calculate the price of corn needed to cover total costs to be $2.81 per
bushel.
Page 647, Answers to End-of-Chapter Questions
Chapter 10: Production and Cost Analysis II
Questions for Thought and Review
1.
Technical efficiency in production means that as few inputs as possible are used to produce a given output.
Economic efficiency means using the method that produces a given level of output at the lowest possible cost.
2.
It is incorrect because in the long run firms can change any input they want. In the long run there would be no
fixed cost—all costs would be variable. The shape of the long-run average total cost curve is determined by
economies of scale.
3.
The inputs used in studying would certainly be labor, probably energy (i.e., lighting, temperature control), and
a place (desk, bed, etc.) which would represent the "plant." Pens or pencils and paper to take notes and a
highlighter to mark the text are also likely inputs to be mentioned, as well as study snacks (food for thought?).
The shapes of the long-run average total cost curve and the marginal cost curve will depend on whether or not
there are economies or diseconomies of scale in studying, and that will be determined by the relation between
the usage of the resources above and the study time.
4.
If production relationships were only technical relationships, diseconomies of scale would never occur
because the same technical process could be used over and over again at the same cost. In reality, however, the
social dimensions of production relationships introduce the potential for diseconomies of scale because, as the
firm size increases, monitoring costs increase and team spirit or morale generally decreases.
5.
The draftsman was right because marginal cost curves pass through the minimum points of their short-run
average cost curves, and short-run average cost curves are not all tangent to the long-run average total cost
curve at these minimum points. Thus Viner really wanted the marginal cost curves to pass through two
different points simultaneously, which was not possible.
6.
An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average cost
of producing it. The entrepreneur then looks at the cost of production to see if a profit can be made. If so, he or
she will create supply by organizing production.
7.
No, not in the long run. In the long run you should not continue to produce at a loss, and since all inputs are
variable you can get out of business. In the short run it depends on what portion of your costs are fixed.
8.
Cost curves are defined within a period of time. In the short run, technology is assumed constant. In the long
run, technological change shifts the cost curves down. It does not explain the downward-sloping portion of
cost curves.
9.
The marginal costs of an additional car driving on a road would be the added costs of the road's usage. This
includes the added wear and tear to the road surface, which is minimal. There could also be a congestion cost
which at certain times can be substantial. Most likely the marginal cost curve would be a straight line at close
to zero, and then a highly inelastic line as the highway becomes congested. The congestion factor means
marginal costs increase as more and more cars use the road.
10.
Producing steel in this fashion involves an enormous fixed cost. These fixed costs must be spread out over
sufficient production to lower average total costs and make the average total production costs (which includes
fixed costs) less than the price.
11.
Because the second farmer can produce the same amount of corn with fewer inputs, both methods cannot be
technically efficient. All economically efficient methods are also technically efficient, so it is not possible for
both methods to be economically efficient either.
Page 648, Answers to End-of-Chapter Questions
Chapter 10: Problems and Exercises
1.
a.
b.
c.
3.
4.
Variable costs would likely include: Manufacturing labor and materials and possibly sales costs to the extent
that they are for the sale of additional production. Certain other costs have a variable component to them, but
they will unlikely vary directly with production.
Fixed costs would likely include: Factor overhead, operating expenses and profit, R&D, interest, and to some
extent advertising. In the real world, the division between fixed and variable costs is not as clear-cut as in the
texts.
If output were to rise, average total cost would likely fall because fixed costs seem relatively important. This is
the case for many real-world firms.
This question has students investigate their college or university budget, and suggests that they invite a college
administrator to class to discuss it.
a.
b.
c.
d.
e.
The long-run cost curve is shown on the right. Initially it will fall
because of economies of scale.
It will later rise due to diseconomies of scale.
The average cost curves in the short run are also U-shaped. Their shape
is due initially to increasing marginal productivity and eventually
decreasing marginal productivity.
There is no fixed component.
A straight line.
Costs per unit
2.
This question asks students to visit a company and obtain information on costs and then apply it to cost
analysis in the real world.
economies
of scale
diseconomies
of scale
Output
5.
a.
b.
c.
6.
a.
b.
In the short run, the college is probably right. However, it depends on how short the short-run is. To the extent
that fewer laborers could be hired to prepare less food and to the extent that the empty dining halls could be
used for other purposes, these are variable costs and could be rebated as saved variable costs. In reality, labor
contracts are somewhat fixed and the opportunity cost of college dining halls (or the additional seats available)
is minimal. Thus they are indivisible costs so that one less meal does not allow fewer laborers or alternative
uses of the space.
At the planning stage, the argument can be made that they are all variable costs and that the college could plan
for a percentage of off board students, building fewer dining halls and hiring fewer laborers. In fact some
dining halls allow a set number of off board students and do not charge board. Still, however, colleges must
accommodate visitors and all students who would like board and must build a too-large hall. Thus the
variability of demand also plays a role. However, the longer the time period, the higher the relevant marginal
cost.
It would be hard to do, but that won't stop the administration from doing so. They probably would argue that
the $6.00 cost is justified because it is the expectation of guests (peak use) that led them to build the large
dining halls. Therefore, some of the cost of the building space should be assigned to them. However, if that is
correct, it is difficult to see why that higher marginal cost should not be used for determining rebates.
It is possible that both methods are technically efficient because neither dressmaker is using more of both
inputs to produce the same number of garments.
The economically efficient method is the least-cost method. The cost of 800 garments for the first dressmaker
is $46,000 [(160 3 $100) + (3,000 3 $10)]. The cost of the same number of garments for the second
dressmaker is $40,000 [(200 3 $100) + (2,000 3 $10)]. Therefore, the second method is economically
efficient. The first method is not.
Chapter 10: Web Questions
1.
a.
About.com provides information related to a variety of areas, including economics such as data. The service is
free.
Page 649, Answers to End-of-Chapter Questions
b.
c.
d.
2.
a.
b.
c.
The fixed costs associated with running About.com include designing and setting up the website, finding new
information and posting it. The marginal cost of providing About.com to one additional person is zero.
The advertising we saw was MSN, Allegra, Wal-Mart, and many others.
An entrepreneur will supply this to the market if the profit exceeds the profit he or she would have earned in
another venture. Some assumptions have to be made to answer this question. The assumption is that
About.com sells advertising space on its home page. This is the revenue that About.com receives for its
services. Advertisers pay to be on this home page based upon the marginal cost and marginal benefit of such
advertisements. It must be that BellSouth and other advertisers get paying customers from these
advertisements. Otherwise they would not pay to advertise on About.com.
Glaxo and SmighKline likely merged to create economies of scope—efficiencies in production and research
that would lead to greater productivity.
The article mentions difficulty of monitoring a business with many offices, bureaucratic hassles associated
with layers of management, and loss of “spark” in leadership.
These problems are associated with diseconomies of scale—increasing long-run cost as production rises.
Perhaps long-run costs are higher for a combined firm GlaxoSmithKline than for separate Glaxo and
SmithKline companies.
Chapter 10: Appendix A
Due to diminishing marginal productivity, the marginal rate of substitution falls as the firm adds more of the
variable input.
2.
See the graph on the right. The dotted line is the
original isocost curve. Each of the following is shown
with respect to the dotted line.
This is line a in the graph.
The isocost curve rotates in along the machinery axis
as shown in the graph to line b.
The isocost curve shifts in along both axes as shown
to line c.
a.
b.
c.
Materials
1.
50
45
40
35
30
25
20
15
10
5
0
b
0
c
a
5 10 15 20 25 30 35 40 45 50
Labor
As shown in the graph on the right, land is cheaper in the
United States than in Japan. And, labor is cheaper in
Japan than in the United States. This accounts for the
differing isocost lines. For each country to produce
efficiently (equate the marginal rate of substitution to the
relative costs of inputs), then, they will choose different
combinations of labor and land. Japan will choose more
labor and less land as shown by point A. The U.S. will
choose more land and less labor as shown by point B.
Japan
Labor
3.
A
Lj
B
Lu
Unite d State s
Kj
Page 650, Answers to End-of-Chapter Questions
Ku
Land
Technical efficiency in production means that as few
inputs as possible are used to produce a given output.
On the graph on the right, this would be anywhere on
the isoquant curve, including points A and B.
Economic efficiency means using that method that
produces a given level of output at the lowest
possible cost. Given the cost of inputs, the efficient
point to produce that level of output corresponding to
the isoquant curve is point B.
Labor
4.
Is oquant
B
A
Is ocos t
Land
a.
b.
See the graph on the right. The efficient
combination of inputs for isocost line A is point A.
Technological innovation that makes land and
labor equally more productive will increase the
output that corresponds to Isoquant A.
The isocost curve rotates in along the x-axis to
Isocost B. The firm cannot produce as much as
before. The efficient combination of inputs is now
point B on a lower isoquant curve.
Labor
5.
Isoquant B
Isoquant A
B
A
Isocost A
6.
If the price of labor falls to $3, the isocost
curve shifts out along the labor axis,
intersecting at 20 units of labor. Producing 60
earrings with the new labor costs is now
inefficient. The firm can now produce more
than 60 earrings, shown by point D and the
new isoquant curve, I2, to the right of the one
corresponding to 60 earrings, I1.
Units of Machines
Isocost B
20
18
16
14
12
10
8
6
4
2
0
B
C
Is oquant > 60
A
Is oquant 60
0
A rise in the cost of machines shifts the isocost
curve in along the machine axis to intersect at
12 machines. The firm can no longer produce 60
earrings. It must produce fewer at a point such as
A.
2
4
6
8
10 12 14 16 18 20
Units of Labor
Machinery
7.
20
18
16
14
12
10
8
6
4
2
0
Is oquant < 60
A
Is oquant 60
0
2
4
6
8 10 12 14 16 18 20
Labor
Chapter 11: Perfect Competition
Questions for Thought and Review
1.
Buyers and sellers must be price takers because if sellers set prices, they would be able to raise them to make a
profit and the demand curve they would face would not be horizontal.
Page 651, Answers to End-of-Chapter Questions
2.
Typical marginal cost, marginal revenue, and average total cost
curves are shown on the right. The profit-maximizing level of output
is Q*. The total profit is shown by the blue shaded rectangle. As we
have drawn it, the firm is not in long-run equilibrium since it is
earning a profit.
3.
The typical MC, MR, and ATC curves for a firm in long-run
equilibrium are shown on the right. Because the firm is in long-run
equilibrium, it does not earn any economic profit.
4.
The firm’s supply curve is that portion of the firm’s marginal cost curve that lies above the minimum of the
average variable cost curve. The sum of all individual firms’ marginal cost curves (above the minimum AVC
curve) is the market supply curve.
5.
The typical ATC , AVC and MC curves are shown on the right. The
price at which the firm shuts down temporarily is P1, minimum of
the AVC curve. The price at which the firm exits the market in the
long run is higher at P2, the minimum of the ATC curve.
6.
The shutdown point is the same as the point at which a firm exits a market in the long run when there are no
fixed costs. That is, when AVC is the same as ATC.
7.
The long-run market supply curve is upward sloping for an increasing cost industry because as output rises,
average total cost curve shifts up. Increased marginal costs increases the price at which firms make zero profit
and increases the long-run equilibrium price. As output rises, so does equilibrium price. Thus, the long-run
supply curve is upward sloping. The long-run market supply curve is downward sloping for a decreasing cost
industry because as output rises, average total costs shift down. Decreased marginal costs decreases the price
at which firms make zero profit and increases the long-run equilibrium price. As output rises, equilibrium
price falls. Thus, the long-run supply curve is downward sloping. The long-run market supply curve is
horizontal for a constant cost industry because as output rises, average total costs do not change. Increased
profits entice new entrants and the equilibrium price falls to the original price at which no profits are made.
Page 652, Answers to End-of-Chapter Questions
8.
A technological development that shifts the MC curve down will shift the market supply curve to the right.
Market price will fall and output will rise. Profit for each firm will still be zero because the price will decline
sufficiently so that each firm earns zero profit.
9.
If a perfectly competitive firm is owned by its workers, its output decisions will differ from those of any other
perfectly competitive firm even though its goal will still be to maximize profit. It will not maximize profit at
the expense of existing workers. This will cause its decisions to differ from the non worker-owned firm.
10.
If both firms are producing where MR = MC and we could buy either for the same amount, I’d buy the one
with the highest total profit. Remember, it is total profit, not profit per unit that is maximized by a firm. If
there are perfectly competitive firms, however, eventually both will earn 0 economic profits regardless of
which we bought.
11.
The firm should produce where MR = MC. If the price is $20, then for the perfectly competitive firm, MR also
is $20. If MC is four times the quantity, produce 5 units (MC = 4 35 = 20).
12.
This question requires students to find current articles in newspapers and apply supply/demand analysis to
them.
13. a.
Firstly, the average total cost curve is mislabeled as the average fixed cost curve. With that correction, the
profit maximizing output level is not where MC = ATC as indicated, but rather where MC = MR.
Firstly, the demand curve facing a single firm in a competitive market is perfectly elastic (horizontal) instead
of upward sloping. Secondly, the firm's supply curve is that portion of the marginal cost curve that is upward
sloping; the MC curve should be shown to be upward sloping.
As with (b) the demand curve facing a single firm in a competitive market is horizontal instead of downward
sloping. Secondly, the profit maximizing level of output is not where MC = AVC, but where MC = P = MR.
Third, the MC curve should go through the minimum point of the ATC curve. It currently doesn’t.
This graph would never represent any real firm since a firm would have shut down where ATC = P. Output
should be zero.
b.
c.
d.
14.
If the older retail stores had higher costs than the new stores, they would be forced to cut prices below their
costs. If that happened, they might stay in business in the short run, assuming they were covering their average
variable costs, but they wouldn’t stay in business in the long run. If the market remains perfectly competitive,
equilibrium price will fall.
Chapter 11: Problems and Exercises
1.
a.
b.
2.
a.
b.
3.
4.
Given that this is a perfectly competitive firm. To maximize profits a competitive firm should produce where
MR = MC (and MC is rising). This is between 4 and 5.
If the price of the good increased to $15, MR would also increase to $15, and the profit maximizing level of
output would increase to between 5 and 6.
With the information given, the clear answer is to change output in an attempt to lower costs and achieve an
economic profit. We are not told whether MR = MC at the level of output at which ATC = $4. If it is, then it is
maximizing profit, even though at a loss. If the firm is perfectly competitive, in the long run it should close.
If we now know that AVC = $3.50, we know that price is less than the average variable cost but not whether
we are at the quantity where MR = MC. If AVC cannot be reduced, the firm should stop producing since it
loses more by producing than it would if it shut down.
If this situation refers to the output level at which MR = MC, the price covers the AVC of $4, but only half of
the AFC; in the short run the firm should still produce. By producing it will lose $2 per unit, but if it did not
produce it would lose $4 per unit.
a.
b.
Zapateria will produce 500 pairs of shoes if the market price is $70 because at 500 pairs, the market price $70
equals marginal costs of $70.
The total profit that Zapateria will earn is $20 times 500 pairs of shoes, or $10,000.
Page 653, Answers to End-of-Chapter Questions
c.
d.
Since Zapateria is making an economic profit, it should expect other shoe stores to enter the market.
The long-run equilibrium price is $40 a pair because at $40 a pair, zero profit is made.
5.
a.
b.
c.
d.
The market equilibrium price and the price that each firm gets for its product is $14.
The market equilibrium quantity is 50 units. Each firm produces 5 units.
Each firm is making $17 total profit.
Firms will begin to exit the market when the price falls below $9.75, the minimum average total costs.
6.
a.
As demand decreases, price will decrease in the short run. As price declines, some firms will exit the market.
As firms exit, marginal costs will decrease. The price at which zero profit is made falls. Market equilibrium
price falls in the long run.
The market equilibrium quantity falls.
The number of firms also falls because the decrease in demand decreased economic profits, making firms exit
the market.
Profit per firm returns to zero for all firms, and for the industry in the long run.
b.
c.
d.
a.
Output Q* shown in the graph on the right is the profitmaximizing level of output. A slightly larger quantity would
not be preferred because the marginal cost of the additional
MC
output exceeds marginal revenue, reducing total profit.
AVC
Reducing quantity below where MC = MR would not make
P=M R
sense to a profit maximizing firm since the MC would be below
Ps
MR, meaning the loss in revenue from reducing output will
exceed the saving from reducing marginal cost, reducing total
profit.
The shutdown point is at the minimum of the AVC curve
Q*
Output
(where MC = AVC), at price Ps in the graph on the right.
The fact that the permit would be lost if the firm shut down
shifts the AVC curve down, decreasing the price at which shut down is chosen. It is no longer a cost that can
be saved if shut down, but an asset to staying in business.
Price
7.
c.
d.
8.
a.
b.
c.
d.
9.
Once the new tomato is generally available, it will likely reduce the price of equal-quality tomatoes in the offseason. However, the new, higher-quality tomato may well sell for more than the cardboard-tasting ones
normally bought in winter.
Its effects on farmers depends on what the biotechnology firm charges for its seeds. Further, since the demand
for tomatoes is fairly inelastic, the increased supply of good tomatoes (reducing their price) in the off-season
will reduce revenues of farmers.
Tomatoes will be grown in areas much farther from their point of sale.
To the degree that the price of tomatoes falls, tomatoes in the winter will more likely be moved from the rear
to the front of the salad bar.
a. In the short run, the price of gold would decline as the supply
curve shifts to the right. In the long run, the drop in the price of
gold would have caused some gold mining firms to shut down. If
there are no specialized inputs for the mining of gold, the price will
rise again to its original level, P0, the supply curve shifts back to
S0.
b. I would advise them to sell the gold slowly, reducing the fall in
price in the short run and allowing time for price to rebound and
thus gain the maximum revenue from the sales. In addition, in the
long run, demand is more elastic making the change in price due to
a shift in supply smaller. This savings from minimizing the price
decline must be weighted against the lost interest central banks
would receive from investing the cash from the sale of gold.
S0
Price
b.
S1
P0
P1
Page 654, Answers to End-of-Chapter Questions
D
Q0
Q1
Quantity
10. a.
b.
c.
11. a.
b.
c.
Reconstituted milk can be shipped from low-cost production areas to high-cost production areas, threatening
local dairy monopolies with competition.
This probably resulted in strong regional lobbies to protect regional markets.
He is most likely incorrect economically, but correct politically. Price supports cause overproduction of milk
and its elimination most likely will cut production. He made this statement because he wanted to get reelected
and his supporters are dairy farmers who benefit from the price supports.
Straight whiskey producers were given a tax advantage of deferring tax payments which reduced production
costs.
Since other whiskey producers (such as blended) were not able to use the stamp, the stamp was used as a
symbol of purity and high quality.
Other whiskey producers established name brands to indicate quality, monitored the quality of their goods and
advertised this fact.
Chapter 11: Web Questions
1.
Both buyers and sellers are price takers, there is a large number of firms, there are no barriers to entry, and
there are profit-maximizing entrepreneurial firms. The problems are lack of complete information and its not
clear if goods are homogeneous.
2.
One possible answer is, Vermont 7.5%; New Jersey 7.5%; California 6.64%; South Dakota 8.1%; Alabama
7.25%.
6.64%-8.1%, a wide range.
Both buyers and sellers are price takers, there is a large number of firms, there is a homogeneous product,
there are profit-maximizing entrepreneurial firms.
If they are price takers there should be a single price. However, since there is a lack of complete information.
The information is not necessarily inconsistent.
a.
b.
c.
1.
As shown in the graph on the right, the profit maximizing
condition MR = MC holds for both a perfect competitor and a
monopolist. The difference is that for a perfect competitor, MR = P
and so P = MC at the profit-maximizing level of output. In the case
of a monopolist, MR < P, and so P > MC at the profit-maximizing
level of output. The monopolist produces Qm and charges a price
of Pm. The perfect competitor produces Qc and accepts a price of
Pc.
Price
Chapter 12: Monopoly
Questions for Thought and Review
MC
Pm
Pc
De m and
Qm
Qc
MR
Quantity
2.
This is not necessarily true. Monopolists may or may not make pure economic profit. In long-run equilibrium
perfectly competitive firms tend to break even, which means they make only a normal profit. So profit is not
the distinguishing factor. Instead, the distinguishing characteristic is that the monopolist will restrict output to
hold up price; a perfect competitor will not.
3.
To sell an additional unit the monopolist has to reduce the price not only to the marginal buyer but to all
buyers.
4.
The development of such a machine would probably reduce the demand for college education to the extent
that it would be a lower-priced substitute. (But remember, gaining knowledge is not the only aspect of
college—what about the social experiences, the sports, etc.?) If one college could monopolize the production
Page 655, Answers to End-of-Chapter Questions
of this machine, it could probably charge close to the current price of college and hire professors to do pure
research with the proceeds.
5.
A lump sum tax on a monopolist would change her fixed costs but not the variable costs (or marginal costs).
Consequently, the output and pricing decisions would not be affected.
6.
A monopolist will tend to sell at a point on the demand curve where demand is elastic, but as the fish gets
older (and smelly) the monopolist will wish to lower its price. The price will not be likely to be in the inelastic
range, but it may if disposing of the fish is costly.
7.
Both computer printers and cheap home faxes require, but don’t come with, cartridges. If these cartridges are
specific to the machine, the company will have a monopoly in them, and can charge a high price relative to the
cost. So what the firm is doing is buying a monopoly in cartridges by giving the printer of fax away free. (I
recently paid $40 for a color ink cartridge for a printer that initially was given away free.)
8.
The additional costs are the lost profit by Bayer. If drug makers believe that government will ignore patents on
future drugs, thereby lowering future profits, they will spend less on developing new drugs. So the cost to
society of a policy of disregarding a patent is having fewer drugs to fight disease in the future.
9.
1.
2.
3.
4.
Price discrimination arguments for the unexplained examples in the text:
Monday and Tuesday nights tend to be slow at most movie theaters, so lowering the price attracts customers
who can go to the movies any night (elastic demand). Those who can only go on weekends, (people work and
go to school, people with children need baby-sitters) and who therefore have a more inelastic demand pay the
higher, undiscounted, price.
Most people tend to buy tires when they need them (inelastic demand). By running a sale about half the time
the company can hope to attract those customers who are currently in the market for them over their rivals (if
they had the price low all the time it wouldn't be a sale).
People with inelastic demands don't worry what they spend on liquor, so they don't care how the costs are
divided. People with elastic demands can drink at home and still go out, thereby helping to fill up the
restaurant.
Parents and relatives who are visiting friends in colleges will often frequent college-town stores. Since they
are there for only a short time and may want a token of the area, college-town stores will charge a high price
for their goods. Students, on the other hand, are there for 9 or more months and tend to have more elastic
demands. That is why they are given discounts.
The most likely information involves price discrimination. Existing low fares can be used to attract highly
price-elastic customers who spend a lot of time searching for the lowest fare. The individuals who happen to
see the advertisement for the special fare likely have a less elastic demand, allowing the airlines to pricediscriminate against them.
11.
In the graph on the right, the welfare loss is shown as the
bolded triangle.
Price
10.
MC
Pm
Dem and
Qm
MR
Page 656, Answers to End-of-Chapter Questions
Quantity
A perfectly elastic marginal cost curve is shown on the right as
the horizontal straight line MC0. Because the opportunity cost
of providing additional units does not increase, welfare loss is
greatest with constant marginal costs—shown below as the
shaded triangle. One can see that welfare loss falls with
increasing marginal costs by rotating the marginal cost curve
up. An example, MC1, is shown. Welfare loss is bounded by
the MC curve, the demand curve, and the quantity line.
Price
12.
M C1
Pm
M C0
Dem and
Qm
MR
Quantity
13.
Blocking entry raises prices and reduces the number of flights. Airlines should be willing to spend up to the
additional rent they will get if they can assure that blocking entry will keep competition out.
14.
The argument for copyrights (and patents) is that without some guarantee of profits from their ideas, people
would be unlikely to engage in the effort (and incur the costs) associated with generating new ideas, products,
etc. If that is the case, then copyrights may be justified. If people would write good books anyway, then
probably society would be better off without copyrights because more books would be sold at a lower price.
15.
The more efficient a firm is, the fewer firms there are in the industry with strong economies of scale. The
natural monopoly would be the limiting case; there would only be one firm.
Chapter 12: Problems and Exercises
1.
Given the information in the problem, we can calculate:
a.
b.
c.
P
12
11
10
9
8
7
6
4
4
3
2
TR
24
33
40
45
48
49
48
45
40
33
24
MR
24
9
7
5
3
1
-1
-3
-5
-7
-9
FC
20
20
20
20
20
20
20
20
20
20
20
VC
6
9
12
15
18
21
24
27
30
33
36
See graph on the right.
The monopolist would produce where MR = MC, at 6
units of output.
A perfectly competitive firm would produce where P =
MC, shown on the graph where demand crosses MC;
thus at 11 units of output.
TC
26
29
32
35
38
41
44
47
50
53
56
Costs
Q
2
3
4
5
6
7
8
9
10
11
12
ATC
13
9.67
8
7
6.33
5.86
5.50
5.22
5
4.82
4.67
20
18
16
14
12
10
8
6
4
2
0
MR
De m and
ATC
MC
0
1
2
3
4
5
6
7
8
9 10 11 12
Output
2.
a.
b.
This is what is wrong in the graphs shown:
The marginal revenue curve is too steep. It should cut
the x-axis at Q. In addition, quantity should be determined where MR = MC.
The curve labeled ATC is really the MC curve. Correctly labeled, the profit-maximizing level of output is
determined where MC = MR.
Page 657, Answers to End-of-Chapter Questions
c.
d.
3.
a.
b.
c.
4.
a.
b.
c.
d.
5.
a.
b.
c.
6.
a.
b.
c.
d.
Quantity should be determined MR = MC, not MC = ATC. Also, the MC curve should intersect the ATC
curve at the minimum point of the ATC curve.
Quantity should be determined where MR = MC.
Wyeth-Ayerst Labs likely priced Norplant differently in the two countries because of the differing elasticities
of demand for Norplant between the two. Charging more in the U.S. suggests that the elasticity of demand for
Norplant is lower in the U.S. than in other countries.
Price discriminating due to differing elasticities is not inherently unfair. Such normative issues have many
answers.
With such a large differential one would expect the two to converge. Specifically, as competition in the
production of Norplant increases, the price of Norplant would be expected to decline in the U.S.
Q
P
TR
MR
TC
MC
ATC
0
4.20
0.00
3.20
1
3.80
3.80
3.80
4.20
1.00
4.20
2
3.40
6.80
3.00
5.60
1.40
2.80
3
3.00
9.00
2.20
7.80
2.20
2.60
4
2.60 10.40
1.40 10.40
2.60
2.60
5
2.20 11.00
0.60 13.40
3.00
2.68
6
1.90 11.40
.40 16.80
3.40
2.80
Fixed cost is $3.20 per month per resident.
MC = MR at 3 collections per month. The price charged is $3 per pickup. Profit is 40 cents per pickup per
person.
P = MC at 4 collections per month. The price charged would be $2.60 per pickup. There would be only normal
profits. Economic profit would be zero.
The city government should prefer competitive bidding unless there is a natural monopoly. The quality of the
pickup would be expected to be greater for the competitive industry because monopolists do not face
competitors.
Since MC is falling, the firm will not cover its costs at a price equal to marginal cost. To stay in business,
firms must at least cover costs.
It would set quantity where MR = MC and then charge a price that consumers are willing to pay for that
quantity (reading from the demand curve).
At a minimum it must be allowed to charge its average cost. Alternatively if the government subsidized all
fixed costs, it could price at its marginal cost.
The limitation of medallions likely increases the price of taxi medallions because it creates a monopoly
position for medallion holders. There is no threat of new suppliers to compete away profits. Since the demand
for taxis is always shifting to the right as the population grows, the relative monopoly position also grows.
Requiring single cab medallion owners to drive their cabs full-time would reduce cab drivers’ ability to limit
supply and thus would tend to reduce the value of the medallion. However, it would also limit the use of the
taxis (since they now rent them out when they are not using them). This effect would be the equivalent to a
decrease in the number of medallions and would slightly offset the first effect.
The price of medallions would decline as the supply increased. Before the sale, however, the windfall from the
sale of new medallions would increase the value of existing medallions mitigating the fall in price from the
lower expected revenue from existing medallions.
The wealth of existing medallion owners, if one includes the value of the existing medallions, will increase by
the windfall but decrease by the reduced value of the medallion from the sale because the expected future
stream of profits will have declined. It’s unclear what the final result would be.
Chapter 12: Web Questions
1.
a.
We found documents about assignment of licenses to Nextel Communications, Inc. by Motorola, Inc. at
http://www.fcc.gov/transaction/nextel-motorola.html. We read a letter by Southern LINC dated November
2000 in opposition to the merger. Their argument is that Nextel controls a large amount of the spectrum
Page 658, Answers to End-of-Chapter Questions
b.
c.
2.
already and gaining greater frequencies would not be in the public interest. Specifically it states that “no new
product line can be successful,” which is to the detriment of the consumer.
In a letter responding to Southern LINC’s opposition, Motorolla states that granting of additional licenses
would enhance consumer choice by allowing Nextel to offer additional services. Other benefits are mentioned.
The theory of the monopolist is the basis for opposing party’s arguments. What was in dispute was the
definition of the market and therefore whether the granting of additional licenses was in the public interest. If
the market is more narrowly defined, it is easier to argue that controlling a concentration of the spectrum will
reduce competition and harm consumers. If the market is defined in a wider basis, as Motorolla argues, the
anticompetitive effects are smaller.
a.
A patent is “a property right granted by the Government of the United States of America to an inventor “to
exclude others from making, using, offering for sale, or selling the invention throughout the United States or
importing the invention into the United States” for a limited time in exchange for public disclosure of the
invention when the patent is granted.” Inventors can produce and sell their inventions without a patent. An
example is Coco-cola.
b.
The cost of a patent has been estimated by some to be between $5,000 and $10,000 over the life of the patent.
The basic filing fee is $750 and maintenance fees are $890 at 3.5 years, $2,050 at 7.5 years, and $3,150 and
11.5 years. However, cost will also include a patent search, the patent application process, amendments to the
patent application.
c.
The term of a new patent is 20 years from the date on which the application for the patent was filed in the
United States.
Chapter 12: Appendix A
1.
a.
b.
c.
For a competitive industry the profit maximizing output is 8.8 and the price is 51.2.
For a monopolist the profit maximizing output is 7.33 and price is 52.66.
The quantity of lower and the price is higher for the monopolist.
2.
a.
b.
c.
Q = 2, P = $39.50
ATC = $52
Profit = -$25
3.
a
b.
c.
The profit-maximizing level of output does not change as fixed costs change.
ATC = $78.
Profit = -$77.
4.
a.
b.
Q = 6, P = $18
Q = 12, P = 0
Chapter 13: Monopolistic Competition, Oligopoly, and Strategic Pricing
Questions for Thought and Review
1.
A Herfindahl index of 1200 means that the sum of the squared market shares of all the firms in the industry is
1200. The related concentration ratios are between approximately 35 and 70, depending on whether the four
firms have equal sizes or one firm has almost all of the market. Thus it is impossible to say which industry is
more concentrated.
2.
Firms differentiate products through advertising. The overriding objective of product differentiation is to
maintain or increase market share by creating their own small monopolistic niche.
Page 659, Answers to End-of-Chapter Questions
Of the main characteristics of monopolistic competition, having many sellers gives it its competitive aspect
and product differentiation gives it its monopolistic aspect.
4.
Product differentiation makes us better off to the degree that we prefer having choices of different varieties of
the same product. However, in some cases, the differences may be imagined rather than real. Firms reinforce
product differentiation with advertising, and so there is a question whether devoting resources to advertising is
a benefit (due to increased information) or a waste.
5.
As shown in the graph on the right, the profit maximizing condition MR
= MC holds for both a perfect competitor and a monopolistic competitor.
The monopolistic competitor, however, does have some market control
and thus, MR < P, and so P > MC at the profit-maximizing level of
output. However, to maintain that market share it must advertise, which
raises its ATC until it earns no profit. The monopolistic competitor
produces Qm and charges a price of Pm. At Qm, average total cost is Pm
and it earns no profit. The monopolistic competitor faces some
competition. The perfect competitor produces Qc and accepts a price of
Pc. It also makes no profit because there are no barriers to entry and new
entrants into the market eliminate any profit.
Price
3.
MC
Pm
Pc
De m and
Qm
Qc
MR
Quantity
6.
The monopolistic competitor does not earn economic profits because of free entry into the market.
7.
Barriers to entry in the restaurant industry would include the advertising expense needed to introduce the new
restaurant as well as the licenses required to operate such an establishment. In the automobile industry a major
barrier would be the size of plant and amount of equipment a firm would need to compete with the existing
firms, as well as the advertising to introduce the new brand.
8.
Strategic pricing is the central characteristic of oligopoly. Monopolistic competitors face too many
competitors to price strategically.
9.
The two extremes of an oligopoly model are the cartel model which is equivalent of a monopoly and the
contestable market model which, if there are no barriers to entry, is equivalent to a competitive industry. In
both models firms set their price based on reactions of other firms.
10.
The contestable market is more interested in the pricing structure and firm behavior arising from free entry
into the market. Therefore, the contestable market is more likely to judge by performance.
11.
Smith meant that such discussions can lead to collusion, formal or informal, meaning that the firms act in
harmony rather than competing. Generally this results in higher prices being charged to consumers.
12.
(In answering this question students may be aware of media coverage in the 1990s that suggested colleges
colluded in establishing financial aid packages for students and in setting tuition.) Since colleges are not profit
maximizers, it is difficult to characterize them as a cartel type of oligopoly. There certainly has been implicit
and even explicit collusion; the goals of that collusion are complicated and not simply profit maximization.
13.
This requires an individual answer based upon personal experience. One possibility would be sharing the
purchase of a television with a roommate. Even if only one bears the burden of the cost of the television, both
will be able to watch it (assuming the TV must be in a common room). Each, therefore, has the incentive to
hold out and let the other bear the entire cost of the television to maximize expected utility. Since they are
living together and the game is played many times, there is stronger reason to collude and both to share in the
cost of the television, especially since cheating has other consequences such as ruining the relationship with
your roommate.
14.
The breakfast cereal market is definitely oligopolistic; the firms made interdependent decisions.
Page 660, Answers to End-of-Chapter Questions
Chapter 13: Problems and Exercises
a.
b.
Given this table the monopolistic competitor would produce where MC = MR which is at Q = 8.
The firm's marginal costs are constant at 6, its total variable costs are $48 at 8 units of output. Since a
monopolistic competitor makes zero economic profits in equilibrium and its total revenue at 8 units of output
is $112, fixed costs must be $64. Average fixed costs are $8 .
2.
a.
The demand curve is kinked at $8 and the MR curve is discontinuous at $4. The kink for the demand curve is
the opposite to that in the text. There are two places where MC = MR, at quantities 4 and 8, as shown.
The firm would prefer the equilibrium with the lower output,
higher price, and higher profit. This is where output is 4 and
price is about $7 a unit.
If marginal cost falls, the level of output rises by a lot while the
price decline falls by just a little.
If marginal cost rises, the level of output falls by a little while
the price rises by a lot.
This part asks students to survey firms in their area about pricing
strategies. The kinked demand model presented in the book is
more likely.
b.
c.
d.
e.
3.
a.
b.
c.
See the graph on the right. The profit maximizing quantity
is 150, the price will be $9, and profit will be $3 per unit
or $450.
In the long run, with entry, the demand curve would shift
in shown by the bolded dotted lines until price falls until
existing firms break even.
If marginal cost falls to zero, the firm should produce 300
units of output (point B on graph), and charge a price of
$6 (point A). The entire $6 will be profit (segment AB on
graph) per unit.
Costs
1.
12
11
10
9
8
7
6
5
4
3
2
1
0
A
M C = ATC
De m and
B
0
100
200
300
400
MR
4.
a.
b.
c.
5.
a
b.
c.
6.
a.
500
600
Output
This market is most likely characterized by oligopoly or possibly monopolistic competition. We say oligopoly
because the largest firm will consider the response of its rivals in its decisions. We say monopolistic
competition because there are many firms but their products are differentiated. There is some label recognition
and loyalty.
The Herfindahl index is 428.49 + 289 + 44.9 + 4.84 + 4 + 51.4 = 822.63.
The four-firm concentration ratio is 46.6% = 20.7 + 17 + 6.7 + 2.2.
This is an example of colluding and moving toward monopoly price and output and increased combined profit.
If one of us were the Braniff chairman, we would not have gone along because such an action would be
subject to a law suit and heavy fines. There would be other ways to implicitly collude and arrive at the same
solution that does not attract government scrutiny.
Crandell should not have been so direct in his attempt to collude with Braniff. There are a number of ways to
collude indirectly. Besides, as former President Nixon might say "It is wrong."
See the table below.
Page 661, Answers to End-of-Chapter Questions
A: Tweedledee
Does not cheat
B: Tweedledum
Does not cheat
B: Tweedledum
Cheats
c.
d.
7.
a.
b.
c.
d.
e.
8.
a.
b.
c.
d.
e.
A $3 mil
A $2 mil
B $1 mil
B $2 mil
A less than
$1 mil
B $3 mil
B less than
$2 mil
A less than
$2 mil
If the game is played only once, we would advise that Mr. Notsonice’s profit-maximizing strategy is to cheat
to maximize expected profit. What his “best” strategy is depends on how much he values being honest.
If the game were played over and over, we would advise that his profit-maximizing policy would be to
develop some level of trust between the two players and agree not to cheat, avoiding the prisoner’s dilemma.
The benefit of colluding compared to expected benefit of cheating would have to be greater. It would have to
be greater by $2 million.
Mattel might want to buy Fisher Price (1) to increase market share to 35 and increase its ability to set prices
and increase profit, (2) to enjoy economies of scope decreasing their joint average total costs, and (3) to get a
good buy if they believe Fisher Price is undervalued.
Since entry is relatively easy in this market, judging the market by performance would suggest that the merger
would not add to the monopolistic nature of the market.
Arguments against allowing such a large concentration would include Mattel's new ability to control the
distribution routes of toys in general, thus creating barriers to entry and moving the market to a monopoly
position.
The four-firm concentration ratio for the entire industry would most likely be much lower since the wider the
definition of the market the lower the concentration ratio.
Mattel was allowed to purchase Fisher Price.
The hypothetical payoff matrix is shown on the right. If
Amazon.com
neither offers free shipping each earns $1,000 profit. If
only Amazon.com offers free shipping its profits are
No Free
Free
$2,000 while Buy.com loses $300. If both offer free
Shipping
Shipping
shipping each earns profit of $200.
$2,000
$1,000
Amazon.com is best off when it offers free shipping
No Free
and Buy.com does not. It makes a profit of $2,000.
Shipping
-$300
$1,000
Buy.com is best off when it offers free shipping and
Amazon.com does not. It makes a profit of $2,000.
$200
-$300
Joint profits are maximized when neither offers free
Free
shipping. Combined profits are $2,000, instead of
Shipping
$1,700 in the case when one offers free shipping and
$2,000
$200
the other does not.
Answers to this question will vary. At the time we
answered the question, Amazon.com offered free shipping on purchases of $25 or more and Buy.com offered
free shipping with no minimum purchase.
Buy.com
b.
A: Tweedledee
Cheats
Chapter 13: Web Questions
1.
a.
The Agency will delineate the product market as a product or group of products such that a hypothetical
profit-maximizing firm, which was the only present and future seller of those products ("monopolist"), would
impose at least a "small but significant and nontransitory" increase in price. That is, assume that buyers likely
would respond to an increase in price for a tentatively identified product group only by shifting to other
products, what would happen? If the alternatives were, in the aggregate, sufficiently attractive at their existing
terms of sale, an attempt to raise prices would result in a reduction of sales large enough that the price increase
would not prove profitable, and the tentatively identified product group would prove to be too narrow.
Page 662, Answers to End-of-Chapter Questions
b.
c.
d.
2.
a.
b.
c.
3.
a.
b.
c.
Cross price elasticity of demand shows the responsiveness of supply and demand to changes of other goods.
The Agency takes into account; 1) evidence that buyers have shifted or have considered shifting purchases
between products in response to relative changes in price or other competitive variables and 2) evidence that
sellers base business decisions on the prospect of buyer substitution between products in response to relative
changes in price or other competitive variables.
Market concentration is a function of the number of firms in a market and their respective market shares. As
an aid to the interpretation of market data, the DOJ uses the Herfindahl-Hirschman Index ("HHI") of market
concentration.
The DOJ divides the spectrum of market concentration as measured by the HHI into three regions that can be
broadly characterized as unconcentrated (HHI below 1000), moderately concentrated (HHI between 1000 and
1800), and highly concentrated (HHI above 1800).
The industry code for potato farming is 111211, for tire manufacturing is 326211, and for family clothing
stores is 448140.
The SIC categorized by end product. The NAICS categorizes by production method.
The NAICS has the ability to classify the new growing technology sectors and also includes other countries’
firms. Firms are grouped according to a more consistent principle, grouping similar productions processes
together. It will be easier to identify product markets.
OPEC’s objective is to maintain a stable and prosperous petroleum market. It meets this objective mainly
through coordinating the production policies and quotas for the 11 members.
OPEC’s 11 members are: Algeria, Libya, Nigeria, Indonesia, Iran, Iraq, Kuwait, Qatar, Saudi Arabia, United
Arab Emirates, and Venezuela. They account for more than 40% of the world’s oil production. OPEC is a
cartel; it is a combination of firms that act like a single firm.
For example, the former Soviet Union, Mexico, Britain. OPEC takes their production into account when
setting prices.
Chapter 14: Real-World Competition and Technology
Questions for Thought and Review
1.
The monitoring problem is that employees have differing incentives than those of the owners. Incentivecompatible contracts have incentives for each of the two parties that correspond as closely as possible.
2.
False. While profits are important to business, because of internal monitoring problems it is not clear that
managers maximize profit. They may waste profit potential in high-priced benefits for themselves and in
inefficiency generally. The market, however, provides a limit on inefficiency, and firms that exceed the limit
and have losses go out of business.
3.
Economists recognize that there is a monitoring problem: employees' incentives differ from the owner's
incentives and it's costly to see that the employee does the owner's bidding. When appropriate monitoring
doesn't take place, high-level managers can pay themselves very well. To get a sense of whether they are
really "worth it" one could compare the salaries to those earned where closer monitoring does take place (the
text suggests comparing U.S. salaries to those earned in similar industries in Japan).
4.
X-inefficiency is the result of firms operating far less efficiently than they could technically. The economic
forces of a market would knock a firm out of business if it operates less efficiently than the rest of the market.
Only a monopolist can produce inefficiently and remain in the game.
5.
X-inefficiency refers to firms operating far less efficiently than they could technically. Such firms have
monopoly positions but don't make monopoly profits because the inefficiency raises their costs. Competition
generally pushes prices down, and so puts pressure on profits. If firms respond by trying to cut costs, then
competition will have the effect of reducing (if not eliminating) X-inefficiency. If, however, entry of new
firms is impeded, as it is in the real world, all existing firms would remain inefficient forever.
Page 663, Answers to End-of-Chapter Questions
6.
This is not true because even if existing colleges are inefficient, competition from for-profit colleges would
not necessarily force them out of business. The political and social forces can keep such colleges from
developing. Moreover, some colleges receive state assistance or have endowments that allow them to hold
their costs down even if they are inefficient.
7.
This is true. If it were easier for consumers than producers to collude, the result would be to force prices down,
perhaps even below the equilibrium level. This could result in shortages as suppliers would be reluctant to
provide quantity at a low price. The final collusive equilibrium would depend on the rationing mechanism for
supply.
8.
This is true. By the same reasoning used in the answer to question 7, the price could decrease below the
competitive equilibrium level. At that below-equilibrium price, some consumers could not get goods, but the
consumers who could get goods would be able to hold the prices low nonetheless; it would be in their interest
to do so.
9.
This is false. Patents are not necessarily bad. Patents encourage the research and development of new products
by offering some limited monopoly profits. Without patents many new products might not be developed.
10.
Natural monopolies, by definition, are the result of a process in which market conditions dictate that monopoly
is the most efficient way to produce in that industry. To break up such firms would likely result in higher
costs, and thus while it would be true that there could be more competitors, the benefits associated with more
competition (principally, lower prices) would not be achieved.
11.
Technically competent firms may succeed, but the statement “will succeed” is false. Success depends on much
more than technical ability. Luck, legal fights, marketing ability, and a non-collusive industrial environment
all play a role in making a firm successful.
12.
It launched a marketing campaign to retain brand recognition and loyalty to round up before the year 2000. In
the year 2000 it also began to lower price to further cement its position in the market and discourage entry.
13.
Firms are not interested in just short-term profit, they also look to long-term profit. The company believes
establishing a market position in the short run will increase long run profits.
14.
It needs funds to carry on research or new technologies and an ability to earn profits from that research.
Oligopoly best meets these criteria.
15.
The basic supply and demand framework of perfect competition leads to efficient outcomes but it assumes
technology is unchanging or is unaffected by market structure.
16.
Network externalities lower costs as more people use a product. As network externalities broaden the use of a
product, the need for a single standard becomes more important and eventually wins out. The firm with the
standard is the big winner and will dominate the market. Even better technology will have a hard time
competing with the standard.
Chapter 14: Problems and Exercises
1.
a.
b.
c.
d.
These differences do not undermine economists' analysis of pricing, although they do not directly fit into it.
These goods are sold in oligopolistic markets in which consumer's information is highly limited.
These are all examples of high fixed costs and low marginal costs.
What is being sold is more than the good; the image is part of the product and much of the cost is in the
production of that image. This suggests that the cost of producing is lower than the cost of selling.
Each of these would be characterized as a luxury market as opposed to a necessities market where economists'
pricing analysis holds better. In luxury markets, buyers can afford to be irrational (or whimsically rational) and
be led to believe that the products do in fact differ.
Page 664, Answers to End-of-Chapter Questions
3.
If suppliers were able to restrict their output to Qr, price would rise
to Pr. Suppliers kept out of the market lose area E in producer
surplus. The consumers, on the other hand, lose both areas D and
S
Pr
B. Area B is transferred to suppliers as additional revenue leaving
D and E as deadweight loss.
B
D
Pe
Two reasons are: (1) it is a promotional tool appearing to give out
E
free merchandise to stimulate consumer excitement for the
D
product; (2) it is a way to create a third party payer system
whereby the individuals making the decision which airline to fly
Qr
0
Qe
Quantity
and receive free merchandise, are not the ones who endure the
direct cost of the purchased airline ticket.
Another example of such programs is credit cards which provide rebates for high use. A person who uses the
credit card for business will enjoy the benefits of the program, but the firm pays for it.
Although this does represent a cost to the firm, the cost of monitoring these programs probably exceeds the
benefits of eliminating their misuse. The cost of monitoring may include disgruntled employees who lose the
benefits. (Note, large companies have begun negotiating with airlines for cheaper fares but not mileage
benefits on business flights.)
Since these benefits are income to the individual, they should be taxed as such. However, the cost of
measuring this income and enforcing the taxes make it too costly to implement relative to additional revenues.
Price
2.
a.
b.
c.
d.
See the graph on the right. The monopolist would be
willing to spend any of its profit. This is depicted as the
shaded rectangle.
Price
4.
A
M arginal cos t
De m and
MR
5.
a.
b.
c.
c.
Quantity
Perfectly competitive markets are the most statically efficient because competition in the market weeds out
inefficient firms so that products to the market at least cost and least price. Perfectly competitive markets,
however, are the least dynamically efficient because they do not promote technological change; there is no
incentive of future profits to innovate nor are there profits to devote to researching innovations.
Monopolistically competitive firms price the same as a monopolist, so it is not statically efficient. Firms
restrict output and price exceeds marginal cost resulting in welfare loss. Monopolistically competitive firms do
not have the long-term profits to devote to research and development, though if they were able to discover an
innovation, it may be able to generate future profits because it already controls some market power.
Oligopolists, because they price between the competitor and monopolist price, are somewhat more statically
efficient than monopolists. Oligopolistic markets are the most conductive to technological change because
they have profits to devote to research as well as the potential for future profits as an incentive to innovate.
Because oligopolists do face some competitors, they will likely devote money to innovate to maintain their
market share.
Monopolistic markets, like monopolistically competitive markets, are the least statically efficient because they
can restrict output the most and therefore charge the highest prices, creating deadweight loss. Monopolists do
earn profits needed to research innovations, but because they already have monopoly positions, they have less
incentive to devote funds to innovation.
Chapter 14: Web Questions
1.
a.
b.
Compensation issues on the game of Greed! for CEOS are stock options, pay perks, and stock grants.
Compensation issues on the game of Greed! for workers are insufficient pay to cover rising childcare cost,
higher health care costs, and loss of jobs due to those jobs moving overseas.
Page 665, Answers to End-of-Chapter Questions
c.
2.
a.
b.
c.
The AFL-CIO comes from the perspective of the worker and labor unions.
We chose Laurence Ellison, CEO of Oracle.
The 6-year average annual return for Oracle was 24 percent, above the industry average by 11 percent.
The average over the past 5 years is about $26,000.
What’s fair is difficult to say. Forbes gave him a B rating. We would need to know how his compensation is
determined—whether it was based on performance and what risks he took to receive that salary. Also, what
are his opportunity costs?
Chapter 15: Antitrust Policy and Regulation
Questions for Thought and Review
1.
Judgment by performance is the view that competitiveness of a market should be judged by the behavior of
firms in that market. Judgment by structure is the view that competitiveness of a market should be judged by
the structure of that market.
2.
In the Standard Oil case the Court determined that the company was a structural monopoly (it controlled 90
percent of its market), but that alone was not a violation of the Sherman Act. Rather, it was the firm’s behavior
that brought it into violation. Thus, the firm was found guilty of unfair business practices. In the ALCOA case
the key issue was the determination of the firm’s market, and hence its share of that market. Determining that
ALCOA had 90 percent of the aluminum market, the Court declared it a monopoly, and ALCOA was broken
up.
3.
Whether a particular company, even one as important as Standard Oil, was, or was not, broken up would
probably not have much impact on the economy. However, if the populist forces that led to the breakup of
Standard Oil had not existed, our entire industrial structure could have been different. How? That is tough to
say: Maybe the United States would have had a Communist revolution; maybe the firms and the United States
would have been stronger. The possibilities are endless.
4.
The Clayton Antitrust Act gave more guidance and provided for more vigorous enforcement. It is a law that
made four specific monopolistic practices illegal when their effect was to lessen competition.
5.
A tie-in contract is one in which products are linked, even though there is no legitimate reason why they
should be linked. To decide whether some college requirement is a tie-in contract, one would have to look at
the specific course and offerings of the school. Some make sense; some don't. Whether such rules should be
against the law is a much more difficult question: for government to enter into internal rule-making of nonprofit firms would involve an enormous increase in government control and regulation which has significant
costs.
6.
Financial aid is often need-based, and so in some sense is an attempt to equalize the price as a proportion of
income for students. Again, the test is the impact, and for many students financial aid is the key to access to
the college of their choice. It may be more discriminatory in another sense not to have it. Moreover, the fact
that something is discriminatory does not necessarily make it bad.
7.
Interlocking directorships are against the law because having the same individuals on the boards of supposedly
competing firms tends to lessen the degree of competition. The cost of the regulation is an intrusion of
government into private issues and the fact that the regulation makes it harder to get knowledgeable people on
the board makes appropriate monitoring more difficult. As with all such policy questions, a decision might be
made by weighing the costs and benefits.
8.
As an economist for the firm, I would want the broader definition of the market to make the firm’s share a
smaller proportion. Thus, I would argue for the three-digit industry as the definition of the market.
9.
Since we would want there to be more competition, we would argue that the relevant market was as broad as
possible. This would make it less likely that the merger would violate the merger guidelines. Since the offer is
Page 666, Answers to End-of-Chapter Questions
unsolicited, we would assume that Hasbro does not want to be taken over. Thus, if we were the lawyers for
Hasbro we would argue for the narrowest definition of market.
10.
In some ways the service has improved, but in other ways it has worsened. What would have happened in the
absence of the breakup is difficult to say. What this tells us is that making judgments about policy is
enormously difficult and requires intricate knowledge of the industry affected.
11.
The anti-trust case against IBM likely led them to pass on acquiring DOS fearing that to enlarge their control
on the PC market may have forced a government enforced break-up. This took IBM out of the front of the PC
market and it took years for their competitive position to improve.
12.
Microsoft was charged with having a monopoly in the personal computer operating systems market. In a
dynamic view of the market, technological advances, such as open-source operating systems and the merging
of software and hardware, will see the market open to more competition in the future.
13.
According to the 1982 guidelines this merger would be challenged, however, the 1997 guidelines from the
Department of Justice allows some mergers if the companies can show that their merger will lower price or
improve a product or service even if it does not met the guidelines.
14.
Conglomerate mergers occur when two relatively unrelated businesses merge. They tend to be approved under
our antitrust laws on the assumption that they do not significantly restrict competition. These mergers should
be considered like other mergers in terms of their effect, and approved or not on that basis. A blanket policy
against such mergers might foreclose some opportunities that would benefit firms and the economy.
15.
The globalization of the U.S. economy has enlarged the relevant market to the international market in some
cases. Policy focus has changed from: Is the industry competitive so not to take advantage of the consumer?
to: Is the industry internationally competitive so that it can compete effectively in the world economy?
16.
The two methods government may use to deal with natural monopolies are regulation and government
ownership. Price regulation usually takes the form of requiring the firm to charge its average total cost plus a
profit margin; this gives the firm no incentive to hold down costs, and cost increases lead directly to price
increases. Another problem is that once regulation is established it may extend far beyond the natural
monopolies and be introduced into industries where competition could work. Government ownership of
natural monopolies is used most often in countries outside the United States, and also has the problem of no
incentive to hold costs down or to introduce new technologies. Government-owned firms guarantee jobs and
offer high wages, but they pass these higher costs on to the consumers.
17.
An industrial policy is the formal policy that government takes toward business. There are difficult political
issues involved in such a policy. To avoid these problems one would want it administered by a semiautonomous agency such as the Fed, which would be immune to political pressures. Whether this is possible is
difficult to say.
Chapter 15: Problems and Exercises
1.
a.
b.
Since 1982, the Department of Justice has looked at mergers that would result in a Herfindahl index of over
1000. There is no Ecofame guideline which exactly corresponds to a Herfindahl index of 1000 since the
Ecofame index places more weight on large market shares than does the Herfindahl index. One might consider
a hypothetical industry where the four top firms each have 16 percent of the market and all other firms are
very small. Such an industry would have a four firm concentration ratio of 64, a Herfindahl index of about
1,000, and an Ecofame value of about 16,000. Thus an Ecofame value of 16,000 would correspond to a
Herfindahl value of 1000 for this particular industry structure.
The result of using the cubes instead of the squares is that the effect of large market shares is magnified. So
uneven market shares would be more strongly discouraged. Whether this is an advantage or a disadvantage
may be a matter of point of view.
Page 667, Answers to End-of-Chapter Questions
3.
In a monopolistic competition model the firms have only a small share of the market and make no profit, so
antitrust would have little effect. In a cartel market, firms get together and allocate market share. Antitrust
would prevent that, holding prices down and increasing quantity. The graph of monopoly is the relevant graph.
In a contestable market model, potential competition, not market structure, determines equilibrium, so antitrust
would have little effect unless it influenced potential competition.
a.
b.
c.
d.
4.
a.
b.
5.
a.
b.
c.
In the toy industry, the four-firm concentration ratio is 35. The Herfindahl index is about 112 + 240 + 25 + 16
+ 65 = 458. This value assumes there are 69 firms, 65 of which have one percent of the market apiece. In the
infant/preschool market the four-firm concentration ratio is 72. The Herfindahl index is about 64 + 144 + 729
+ 625 +28 = 1590. This value assumes there are 32 firms, 28 of which have one percent of the market apiece.
I would suggest using the broader toy industry market that has a lower concentration ratio and Herfindahl
index.
The merger might decrease competition to the extent that increased market share allows Mattel to limit output
and increase prices or if it is then able to create significant barriers to entry by controlling distribution.
It may increase competition since a combined Mattel and Fisher Price (15% market share) might be in a better
financial position to compete against Hasbro, which already enjoys a 15 percent market share. If there are
economies of scope and scale, this is especially true since production costs would decline.
The likely basis of this suit was predatory pricing to keep price so low that American Airlines’ competitors
would go out of business and so that the company would enjoy a monopoly position and raise prices.
Knowledge of their financial instability only strengthens the argument. It suggests that American Airlines
would not have to hold prices down for too long before its competitors folded.
Regulating the price of a monopolist makes the relevant demand
curve perfectly elastic. In this example, regulators set price where
MC intersects demand. Monopolist charges Pc and produces Qc.
MC
The demand curve would be the marginal revenue curve, and the
Pm
monopolist would produce where MC = MR = P just as a
competitor would as shown in the graph at the right.
Pc
Regulation in a contestable market view of the competitive process
is far less likely to have the effect shown in the diagram because
with contestable markets, with fewer barriers to entry, the
MR
D
oligopoly will set prices closer to the competitive price thus
0
Qm
Qc
eliminating the need for regulation. There would not be much
Quantity
room for regulation to reduce price and increase output.
If one follows the cartel view, the argument for regulation is much
stronger since the stronger is the cartel, the closer it can restrict supply and increase price. As the cartel or
cartels become stronger, then, regulation is far more effective in reducing price and increasing output as in the
graph above.
Price
2.
Chapter 15: Web Questions
1.
a.
b.
c.
d.
2.
a.
b.
On November 18, 2002, AT&T Broadband and Comcast merged.
According to the AT&T press release, “Customers will benefit from powerful, innovative new capabilities and
high-quality service. What's more, exciting new features are on the way.”
AT&T is now the largest broadband and cable company in the United States. To the extent that it has
monopoly power, it will have the incentive to raise price and restrict output.
From http://www.fcc.gov/transaction/attcomcast-clockhis.html. The FCC approved the merger in November
2002.
The guidelines state that entry must be sufficient to defeat a price increase, timely (within 2 years), and likely
to occur in response to an anticompetitive price rise, i.e. profitable only because of the merge.
In the U.S. vs. The Gillette Company and Parker Pen Holdings, the government argued that entry was unlikely
due to the brand name barriers as well as the time required to design and manufacture a pen. The government's
expert argued further that product repositioning was unlikely, sunk costs were large, and consumer loyalty
reduced the disciplining effects of entry. In contrast, Carl Shapiro, the parties expect, argued that entry barriers
Page 668, Answers to End-of-Chapter Questions
c.
were low. The judge agreed that entry barriers were low.
United States v. Syufy Enterprises featured entry in the judge’s decision. He concluded there were no barriers
to entry in the movie screen market in Las Vegas and dismissed the objection to the merger.
Chapter 16: Work and the Labor Market
Questions for Thought and Review
1.
Social and political forces are more active in the labor market than in most other markets because of the key
role labor markets play in determining people's income and the key role jobs play in a person's life. People
often define themselves in terms of their jobs.
2.
This chapter opens with a quotation from Voltaire: “Work banishes those three great evils: boredom, vice, and
poverty.” Welfare laws, to the degree that they discourage work, therefore, can be said to harm the people they
are meant to help. While they help people in the short run, they establish a dependency relationship, which can
hurt people in the long run.
3.
As noted in the text, the choice for many people depends on their views of the real costs of being arrested, etc.
The student is asked to assess whether the benefit of the large amount of compensation is worth the cost of the
risk, and why.
4.
The elasticity of the labor supply is measured by the percent change in the quantity supplied divided by the
percent change in the wage. In this case, 5 divided by 20 is less than 1 (it is 0.25), so the supply is said to be
inelastic.
5.
A choice of a career should be made on the basis of what you will enjoy and be good at. Assuming these were
equal, expected income can play a role. Since plumbing generally requires a license and carpentry does not, it
is likely that monopoly rents will be higher in plumbing, which is why he was so advised.
6.
Supply/demand analysis is partial equilibrium analysis; immigration policy often affects the general economy
and thus requires an analysis of spillover effects and changes that partial equilibrium analysis cannot capture.
7.
As you can see in the graph on the right the minimum wage causes a
difference between the quantity supplied and the quantity demanded.
Economic theory does not tell us that such a law would be a bad idea.
That depends on what one's goals are and how one judges the
redistributional consequences of the minimum wage.
S
Wmin
Wage
We
D
Qd
Qs
Quantity of workers
If the labor market were monopsonistic, so that the pay were less
than the competitive wage, the minimum wage could change the
effective supply facing the monopsonist and could raise the
wage and increase employment simultaneously, as in the graph
on the right. In the graph, the monopsonist would hire Qm
workers, paying Wm. With a minimum wage We, higher than
Wm, the monopsonist would hire Qe workers, higher than Qm.
MFC
S
Wf
Wage
8.
Wm
D
Qm Qf
Quantity of workers
Page 669, Answers to End-of-Chapter Questions
9.
Comparable worth laws would likely politicize the labor market much more than it currently is politicized. It
would involve an enormous increase in government involvement in pay.
10.
The fact that unemployment among blacks is nearly twice as high as it is among whites can be explained by
many factors, including discrimination. There are also differences in existing income levels, with the result
that many blacks reside in poorer neighborhoods and thus do not have equal access to education and other
services that would lead to higher employment. The choices available in terms of opportunities may also lead
young people to choose nonmarket activities over participation in the labor force.
11.
On average, women receive about 75 percent of the pay that men receive to do the same kind of job.
Somewhat more than half of that difference can be explained by factors like length of time on the job, but
there is still a relatively large difference that can be attributed to discrimination. There is demand-side
discrimination, which occurs when an employer hires a man rather than an equally qualified woman or pays a
woman less for doing the same job as an equally qualified man. There is also sociological supply-side
discrimination, which includes examples like women changing jobs to move with her partner (thus lowering
her average pay) or women taking a larger role in child care (and therefore perhaps missing work or meetings),
again resulting in lower pay and reduced opportunities for promotion and advancement. The reasons that are
most responsible for the difference may vary from situation to situation.
Chapter 16: Problems and Exercises
1.
a.
b.
c.
2.
a.
b.
3.
a.
b.
c.
4.
a.
It seems that the market pays more for individuals who are good looking. This could be due to the fact that
appearance is directly related to the productivity of individuals, who have to deal with customers on a one-toone basis such as in sales positions. Or it could be that appearance correlates with some other variable such as
higher self-esteem, from years of compliments, which increases productivity. There is insufficient information
to make any conclusion.
The findings do not necessarily mean there is looks discrimination; however, it is a case where further
investigation might reveal discrimination.
The greater the pay penalty for men might relate to the fact that more men hold more high level, high
visibility, jobs where appearance is a larger factor in productivity (demanders of the product prefer good
looks). There also might be more correlations with other variables in males than in females.
Based on standard economic theory, one would expect the number of teens employed to rise and the
employment of nonteens to decline as the relative wage of teens declines. This assumes that the minimum
wage is above the market-clearing wage. Further, one would expect that a large number of employees would
lose their jobs at the end of their training period (six months) for “just” reasons, such as not learning the job
adequately.
It is likely that the administrative costs of participating in the program were higher than the benefits of hiring
teens at the lower training wage. It could also be that market clearing wage in teen labor market was already
higher than the subminimum wage. A third possibility is the focal point phenomenon: teens may focus on the
mandated minimum wage as their reservation wage and refuse to accept a job at the subminimum training
wage.
One would expect economists' salaries to decline or rise less than average salaries.
Since economists are bright, dynamic individuals, it is likely that they will leave the traditional market for
economists and either start their own business or accept jobs in other markets or in other countries. This would
mitigate the decline in their wages.
In most markets, prices do not adjust downward quickly for institutional reasons. In the meantime, the supply
curve may shift inward as unemployed economists leave the market altogether. Currently employed
economists have an incentive to see that their salaries do not fall and will work toward keeping their salaries
high by limiting the number of new Ph.D.'s or by using social influences to keep their wages from falling.
Since they will have to pay 20 percent of what they save in added tuition in addition to the 20 percent income
tax rate, the implicit marginal tax rate they face on income they save will be 36 percent. The tax on assets is a
Page 670, Answers to End-of-Chapter Questions
b.
c.
d.
5.
a.
b.
c.
6.
a.
b.
c.
7.
a.
b.
c.
d.
tax on savings after income taxes have been subtracted, so the tuition tax has to be adjusted to make it a tax on
pre-income-tax income. So the relevant tax on tuition as a percent of pretax income is (1 - ti) 3 tt = [(1 - 0.2) X
0.2 = 0.16] where ti is income tax and tt is the tuition tax. Add this to the 20 percent income tax to get 36
percent.
The second child will raise it to 48.8% = [(1 - 0.36) X 0.2 + 0.36] X 100. The third child will raise it to
59.04% = [(1 - 0.488) X 0.2 + 0.488] X 100.
This is a complicated question, but one could argue that divorced parents share in the obligation to pay for
college equally and therefore the relative incomes and asset shares of combined incomes and assets should be
used to determine contributions. In reality one parent might alone bear the burden of the cost, having to
shoulder contributions by both. The second part to this question is for the student to research.
An ability-based scholarship program would attract students of significantly higher caliber if their elasticity of
demand is high, but it would most likely compromise the diversity of the student body with respect to income.
It would also promote retaliation by other schools, and the long-run benefit in having brighter students might
be very small.
Firms pay above “market wages” because they want to establish close personal ties with their workers. Doing
so can lead employees to work at maximum efficiency and the gain in efficiency may exceed the additional
cost. If so, it is known as an “efficiency wage” when firms do so it would be an example of social forces
modifying the invisible hand result.
Firms do not change wage rates much when demand fluctuates both to keep good social relations with workers
and also, in some instances, to avoid violating contracts that determine wages. Lowering wages when demand
declines would lead workers to expect higher wages paid when demand rises to remain, even when demand
falls at some future date. This is an example of social and political (legal) forces modifying the invisible hand
result.
Firms keep wages of various disciplines roughly equal to keep good social relations with the workers. Pay will
vary somewhat because of market conditions in the disciplines, but generally social issues predominate. So
again this is an example of social forces modifying the invisible hand result.
Firms hire children because children’s marginal productivity relative to their wage is higher than it is for
alternative workers. Children’s marginal product/wage ratio could be higher because the child wage is lower
or because the marginal product is higher. Children are often energetic, pliable, and dexterous. For certain jobs
these traits could make the children’s productivity high. Children may also be more trainable than older
employees, and they may work for a lower wage.
Children work for the same reasons that others work—they need money, work is what is expected of them,
and so on.
In deciding whether there should be an international ban on child labor, one must look at the effects of that
ban. What are the children’s opportunity costs of working? If the ban will lead to children starving, the ban
does them no good; if it allows them to go to school while the firm hires their parents instead, the ban may
help the children. One must also look at the ease with which some firms may get around the ban. If it can be
easily avoided in some countries, then the ban will likely hurt children in those countries where it is effective.
Also, one should consider whether the work gives children anything useful (such as education) besides pay.
At the school we looked at, among college professors, the share of household work done was more equal than
expected but females still had slightly more responsibility for child rearing. The sample included only dual
income families. This suggests that even those who might be enlightened about equality of the sexes
experience some supply-side discrimination.
Salaries at most colleges, on average, is equal for equal rank and years of service up until the higher salaries,
where information is often confidential, and there are few women. Discrimination from somewhere, however,
is suggested by the relatively high proportion of untenured and non-tenure track women compared to men as
well as the small relative number of full and chaired professors.
These findings in (a and b) suggests that institutional supply-side discrimination may affect a woman's ability
to devote the time and mobility necessary to get a tenure track position and attain tenure just at the peak of her
child-bearing years.
The existence of supply-side discrimination does not eliminate the possibility of institutional demand-side
discrimination. One does not preclude the other.
Page 671, Answers to End-of-Chapter Questions
Chapter 16: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
d.
Pay equity, according to NCPE, means the elimination of sex and race based discrimination in the wage
setting system; that is, the criteria employers use to set wages must be sex and race neutral.
The Equal Pay Act of 1963 and Title VII of the Civil Rights Act of 1962 are the two laws that are designed to
protect workers from wage discrimination.
The NCPE believes women are still segregated into a few low-paying occupations. Anti-discrimination laws
cover pay equity within occupations.
Stephen Moore in his commentary states that he believes immigration should be increased for highly skill
workers.
Externalities; every additional high-tech worker brings to the United States about $110,000 of free human
capital.
In 1998, the unemployment rate in the high-tech field was less than 2%, the high tech fields were growing
rapidly.
No, Stephen Moore would not argue that the number of visas for unskilled labor should increase. Unskilled
labor does not have the externalities of additional jobs for the U.S.
Chapter 16: Appendix A
1.
At a wage of $7.00 they would hire 33 workers. If the price of the good fell to $1.00, the marginal revenue
product would fall and they would reduce the workers they hire to 30.
2.
They would likely hire fewer workers since they would take into account the fall in the marginal revenue
product that hiring more workers would cause.
3.
A likely reason for the switch is technological advances that lowered the cost of machines or a rise in the
relative pay students demand.
4.
Yes. Widespread introduction of such programs would likely reduce the demand for teachers and lower their
pay.
It can pay up to the marginal revenue product or up to $9.00.
5.
6.
If the firm were a monopolist, the marginal revenue would be less than $3.00, and thus the amount it would be
willing to pay would fall.
7.
Num. of
workers TP
1
10
MPP
AP
10
9
2
19
3
27
4
34
5
40
18
9.5
8
16
9
7
14
8.5
6
8.
a.
b.
MRP
12
8
The proposal that should be adopted is the one that minimizes costs. Using the cost minimization condition,
proposal A is the one that minimizes costs (30/5 = 42/7 = 36/6).
If the price of labor rises to $14, none of the proposals meets the cost minimization condition. There are other
combinations that would meet the cost minimization condition.
Page 672, Answers to End-of-Chapter Questions
Chapter 17: Who Gets What? The Distribution of Income
Questions for Thought and Review
1.
Research has shown that income differs substantially between men and women, and between whites and
blacks. Some of these variations are the result of sociological and cultural differences, but a substantial
fraction is the result of discrimination. There is no evidence to indicate discrimination exists on the basis of
hair color, although there might be some.
2.
The top 20 percent of individuals in Bangladesh earn 38 percent of the income.
3.
A Lorenz curve is a geometric representation of the size distribution of income among families in a given
country at a given time. To do this just for lawyers, you would be showing how income is distributed just
among members of that profession. (It might surprise people to find out that the distribution is not as even as
they might think.)
4.
Arguments could be made for both approaches. Poverty could be defined relatively since one of our concerns
is the distribution of income and the gap between the rich and poor. Poverty could also be defined absolutely
since another of our concerns is that people have enough to eat, which is an absolute concept.
5.
Nowadays in the United States classification is based on characteristics other than source of income, including
education, what someone reads, and job or career. Using these factors one could argue for a class distinction
between managerial decision makers and other workers. Whether it makes sense to do so depends upon the
light it sheds on social and economic problems.
6.
The observed difference may be due to supply and demand factors. If many people wish to be English teachers
and few wish to be garbage collectors, then market factors will result in a higher wage for the garbage
collectors—and if one believes in the market mechanism, this is right. That question raises other, more
complicated questions about fairness of compensation and the social value of different occupations; it has no
right answers.
7.
This question raises issues of fairness and equality and requires value judgments. As the author notes,
considering the circumstances that have led to someone starving or being homeless, or that are involved in
someone's consumption of chocolate, will affect some people's judgments about the appropriateness of
society's response.
8.
The answer to this question will depend in part on the individual student’s circumstances. In general, the
incentive effects of a tax may result in a switch from labor to leisure.
9.
Expenditure programs have been quite effective as a method of redistribution; taxation has not proved
effective.
10.
On the surface the democratic system of one person/one vote would seem to suggest that the politics of
redistribution would favor the poor, but it doesn’t. One would expect that the poor would use their power to
make sure that income was redistributed to them from the rich, but they don’t. The reasons for this include the
fact that many of the poor don’t vote, and so consequently they are not seen as a voting bloc by politicians.
Another reason is that when poor people do vote, they vote with other issues in mind. Also, campaigns require
financing, which is often supplied by the rich, and so their interests may be more represented than those of the
poor.
Page 673, Answers to End-of-Chapter Questions
1.
a.
b.
c.
d.
See the graph on the right.
A perfectly equal distribution of income would
be shown by a diagonal line; thus the country
with the most equal distribution of income
among the three is the Czech Republic.
The country with the least equal distribution of
income among these three is Mexico.
One could not tell which country has the most
progressive tax system without looking at the
curves over time.
Cumulative percentage of income
Chapter 17: Problems and Exercises
100
90
80
70
India
60
Cze ch Re p.
50
M e xico
40
30
20
10
10 20 30 40 50 60 70 80 90 100
Cumulative percentage of population
2.
a.
b.
Taking into account in-kind benefits and nonreported income would reduce the number of people seen in
poverty. Taking account of the fact that food makes up only a quarter of the family’s benefits would suggest
that the inflation adjustment was probably too high in reference to what was defined as poverty in the past, and
that the measure of poverty has increased. Taking into account unreported income would reduce the measure
of poverty. Taking account of home ownership and cost-of-living differences would involve distributional
consequences. It would raise the level of poverty for some and lower it for others.
What is fair involves normative judgments. Even if the adjustments were made, one could still argue that the
current definition of poverty is too low and that benefits should be increased.
3.
If people's desire for equality is so great that any sense of initiative is undermined, economic growth based on
individual initiative is impossible.
4.
Four conditions that you might list before you would favor equality of income are (1) that individuals have
essentially the same needs, (2) that they work the same amount, (3) that they have essentially the same health,
and (4) that they have put in the same effort up to this point.
Depending on what conditions you listed, it could change your views on welfare in a number of different
ways.
Again, it depends on what conditions you chose. If the condition does not include differences in ability, then
you would likely favor a progressive income tax.
If the tax were progressive in wage rates, rather than income, hard work would be encouraged and raw ability
would be taxed more. If you did not list ability, then you should say that the conditions would be better met.
a.
b.
c.
5.
a.
b.
c.
6.
a.
b.
c.
d.
You will pay no tax on the first $10,000, $5000 on the next $20,000, $6000 on the next $20,000, and $8750 on
the remaining $25,000, for a total tax payment of $19,750.
Dividing $19,750 by your income of $75,000 gives an average tax rate of 26.33 percent. The marginal tax rate
will be the tax on one more dollar of income, which in your case will be 35 percent.
If the two systems are designed to bring in the same amount of revenue, the question will be how that revenue
is collected (meaning from whom) and that is hard to assess without knowing more about what conditions will
make someone eligible.
This would increase the incentive to work since working longer hours will not push one up into the higher tax
bracket.
To the extent that the wage rate measures taxability better than income does, this tax system is fair.
Making the tax system regressive in hours worked would further increase the incentive to work longer hours.
Instituting such a tax system faces enormous difficulties. Wage rates for each individual would have to be
measured, and many positions have no explicit wage rate. Some method for calculating wage rates of salaried
positions would have to be designed.
Page 674, Answers to End-of-Chapter Questions
Chapter 17: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
d.
e.
Long term capital gains are presently taxed at 20%, 10% if your regular tax bracket is 15%. Short term capital
gains are taxed at 28%, or 15% if in tax bracket below 28%.
The alternative minimum tax, AMT, is an alternative set of rules to determine the minimum tax one should be
required to pay. It is an extra tax some have to pay on top of regular tax. The original idea was to prevent
people with high incomes from using special tax benefits to pay little or no tax.
Education credits are tax benefits for families to help with the cost of higher education. These tax credits are
for parents filing jointly who can take the cost of tuition up to a maximum, in the case of Lifetime Learning or
Hope for only the first two full years, for dependent children.
Social Security earnings credits are based on wages an employee earns and these credits are used later to
determine eligibility for Social Security benefits. In 1999, one credit is earned for each $740 in earnings up to
a max of 4 credits a year.
Most people need 40 credits (10 years of work) to qualify for Social Security benefits.
There is no charge for a social security number.
Medicare is automatic age 65 or with the start of Social Security or Railroad Retirement benefits. Someone
who is on Social Security disability for more than 24 months or someone with permanent kidney failure is also
automatically eligible.
Part A Medicare is hospital insurance and carries no fee, Part B is medical insurance and at present carries a
fee of $45.50 a month.
Chapter 18: Government Policy and Market Failures
Questions for Thought and Review
1.
Reasons for a potentially beneficial role of government intervention include: preventing restraints on trade,
correcting informational and rationality problems, correcting for externalities, and preventing unfairness.
2.
The marginal social benefit of a good that exhibits positive externalities is greater than the private social
benefit because the trade results in a benefit to people outside the trade.
3.
A market incentive program is more efficient because it makes use of the powerful force of the invisible hand,
and unlike the direct regulation approach, it gets people to equate the marginal costs with the marginal
benefits.
4.
An economist might argue about the word acceptable. While not many people would argue that any pollution
is good, an economist who realizes that eliminating pollution completely is probably an impossible goal would
find pollution acceptable if it could be reduced to a cost-efficient level.
5.
This tax is an example of a tax incentive program that attempts to make the price of oil reflect the negative
externality. If it works it should provide an incentive for the users with the lowest cost of reduction to decrease
their consumption of oil. If those with the lowest costs are significant users, then there will be a significant
reduction. Its effect depends on how high the tax is.
6.
The tax on oil will affect the pollution coming from oil, but it is possible that users could switch to other fuel
sources that actually result in other and greater forms of pollution. Moreover, some types of pollution would
be unaffected. Thus, the net impact on the environment is difficult to predict.
7.
If economists support a tax on a specific good, it is usually because of a suspected externality. In the case of
gasoline, the likely externality involves carbon emissions. The higher tax would encourage individuals to use
less gasoline and to switch to less polluting alternatives.
8.
The public aspect of safety is that if safety provides a safe environment, it is provided for all people and one
person enjoying safety does not preclude others from benefiting from that safety. Naming streets allows
people to orient themselves in towns and facilitates communication. Once a street is named, it benefits all
people. No one can be excluded from referring to that name. In addition, one person using that street name
Page 675, Answers to End-of-Chapter Questions
does not preclude others from referring to that street with its name. Before the street is named, however, if a
particular name is used to refer to more than one street, the value of that name in providing geographic
orientation will be diminished. The public good aspect of the lighthouse and newspaper is that once it is
produced it can be consumed over and over again. Though in the case of the newspaper, the owner can keep
others from benefiting by keeping it to himself.
9.
You might offer the average, $600. If sellers of cherries want $700, your $600 would bring you only lemons,
since only the seller knows whether they are selling a chance on a lemon.
10.
In a market, when buyers and sellers have different amounts of information about the good for sale, a problem
occurs called the adverse selection problem. The problem is that the market for quality products disappears. In
commercial dating services, the seller certainly has more information about the negative (and positive) aspects
of the product than the buyer. We suspect that the market has fewer “acceptable” dates than the general
population.
11.
Not only would buyers and sellers not have equal information to make a decision, they would not have any
information, the mix would become potluck and the distribution of problems would reflect the natural aging of
cars.
12.
To keep rates to a minimum, insurance companies estimate information about individuals by categorizing
them. If everyone paid the same amount, low-cost customers would be paying for high-cost customers and
eventually change companies, leaving only high-cost customers. One would expect that, statistically, married
drivers are safer drivers.
13.
The FDA protects us from unsafe drugs, but in so doing it creates enormous bureaucratic hassles for the
manufacturers of all new drugs, many of which could be beneficial. In some cases, by the time the FDA has
approved a drug many potential users were already dead. This question requires weighing the costs against the
benefits.
14.
Many answers are possible, beginning with (1) the label on their breakfast cereal, (2) the roads they use to get
to school, (3) either the school they go to (if it is public) or the federal funds their school receives (if it is
private), (4) the tax they pay on the snack at the snack bar, and (5) the laws that are enforced on the roadways.
The benefits of labeling is that consumers can better plan nutritional balance and they are better informed
about the product they are buying. Whether this is justified is unclear. If consumers wanted such labeling,
there would be market pressure to include that information on cereal boxes. Some labeling, such as whether
the product contains genetically modified food could unnecessarily alarm consumers, hurting those companies
that use genetically modified food and help others who don’t. Whether genetically modified food is harmful is
still up for debate.
15.
While there are benefits of licensing, it is often used as a way of restricting entry into the profession, and
thwarting competition. Thus, while some type of certification program may be warranted, licensing is
probably not warranted.
16.
The advanced degree serves the same purpose as a license. It reduces the supply and increases the wage.
17.
If the informational alternative were introduced, existing doctors would likely lose, as their monopoly is
reduced. Customers who have wider options will gain, as will individuals just coming into medicine who also
have more options about what type of study to pursue.
Page 676, Answers to End-of-Chapter Questions
Chapter 18: Problems and Exercises
a.
b.
c.
d.
2.
a.
b.
3.
a.
b.
c.
4.
a.
b.
5.
a.
b.
6.
a.
b.
c.
The graph of the market demand curve is shown on the right. The
market curve and the demand curve for B are the same from quantity 4
and up. Remember that with public goods, sum the individual demand
curves vertically to create the market demand curve.
Because people do not actually purchase public goods, their true
preferences are not revealed. Because people will not directly pay for
those goods, they will tend to overstate the value they receive from
public goods.
The socially optimal amount of the public good at a price of $2 is 4
units.
Given the free-rider problem, the answer to c is most likely an
overestimate.
P
$5
Market
4
3
2
1
B
A
Q
0
2
4
6
8
10
12
Proposal A would force a downward shift in each demand curve, while Proposal B would raise the price at
each quantity, also shifting the demand curves down.
The consumers in group 1 have a more elastic demand, so a small increase in price results in a large decrease
in quantity; these consumers can more easily adjust their usage and would therefore favor Proposal A. The
members of group 2 would be more likely to favor the tax because changing their usage is more difficult.
Their inelasticity can be interpreted to mean that they are more willing to pay a higher price than to use less.
Assuming perfect competition, the price and quantity will be set
where demand crosses marginal cost with equilibrium price, P0, and
equilibrium quantity, Q0.
The socially efficient price and quantity would be where demand
crosses marginal social cost, a higher price and a smaller output (P1,
Q1).
Such a proposed ban would have to be assessed in terms of the costs
and benefits to everyone involved. There is a lot of pertinent
information not given here: for example, is this a community where
commercial fishing represents a major industry? Is sport fishing a
major tourist attraction? The answer to this question largely depends
upon the questions it raises.
M SC
Price
1.
MC
P1
P0
D
0
Q1 Q0
Quantity
One could explain the Seattle Stomp if there were a per can charge for garbage. To maximize the amount of
waste per can (and thus per flat fee), Seattle citizens stomp their garbage.
A fee structure based on weight would eliminate the Seattle Stomp.
The advantages of such fees reduce the quantity of animal trophies demanded, (assuming poaching can be
prevented) thus reducing the damage to the stock of animals. Further, the revenue could be used to improve
the stock of animals or meet other needs of African nations. This also provides an incentive for the local
people to preserve big game since the price they could receive by poaching is less than the revenue from the
fees.
One argument against it is that condoning such slaughter at any price is immoral. A second argument is that,
by the time the optimal price is found, the animals may well be extinct.
Most likely the price of all cars in California rose, and air quality rose as well.
This law could possibly have increased pollution if consumers held on to their older, less efficient but lowercost, higher-performance gas cars and delayed purchase of an electric car. This would have increased the
average age of cars on the road, increasing pollution. Furthermore, if electric cars (the most likely candidates)
were designed to meet the no-pollution requirement, it could be that the process of generating sufficient
electricity to run the cars would produce even more pollution, at which point even more regulation might be
imposed. (The law was modified and never went fully into effect.)
Economists generally favor market incentive programs over direct regulation. A market incentive program to
reduce pollution by a certain percent might be to tax drivers of older, high-pollution cars and use the tax
Page 677, Answers to End-of-Chapter Questions
revenue to subsidize those who purchase the new, no-pollution cars. This approach will more likely equate
marginal cost with marginal benefit.
7.
a.
b.
No, their findings do not necessarily mean that the U.S. has too many regulations.
Each regulation must be examined in terms of marginal cost and marginal benefit to see whether it is
worthwhile.
8.
a
Some dairy farmers would probably argue that labeling is unnecessary since the drugs they administer have
been certified by the FDA. Dairy farmers who do not use BST would support BST labeling.
If BST were to be listed on milk containers, one could argue that all drugs and antibiotics should be listed.
However, such listing (without more information) may cause consumer concern. To support BST labeling and
not other labeling, one must argue that BST is different.
One would suspect that dairy farmers who support BST labeling would not support the broader law that might
include so many drugs that consumers become outraged at dairy farmers. Only those few farmers who use
wholly organic farming would support full labeling.
b.
c.
Chapter 18: Web Questions
1.
a.
b.
c.
d.
2.
a.
b.
c.
e.
Cap and Trade is a program that has two goals, first focusing on a problem and putting a limit on how much
pollution can be emitted and second, allowing the environmental offenders options with pollution allowances.
Case #1 addresses the negative externalities associated with acid rain (SO2 in rain water).
Cap and trade works because it allows firms to decide how it will reduce pollution emissions or purchase
pollution reduction from firms who find it less costly to reduce emissions.
Revising the Clean Air Act and allowing the act of polluting to be recognized and traded created a successful
marketplace and reduce pollution resulting from SO2 in rain water.
OSHA started in 1970 to assure safe and healthful working conditions by assisting states and providing
research, information, education, and training in the field of occupational safety and health.
The market failure was lack of information. Workers were not being compensated for the hazard of unsafe,
unhealthful workplaces because they were unaware of the hazards or lacked the ability to ask for safer
environments.
Most workers come under OSHA’s jurisdiction, a few examples of exceptions are miners, transportation
workers and the self employed.
The role of OSHA’s inspections is to point out problems and to educate and train the individual states and the
Department of Labor are the enforcers of the safety and health codes.
Chapter 19: Politics and Economics: The Case of Agricultural Markets
Questions for Thought and Review
1.
The good/bad paradox is the phenomenon of doing poorly because you're doing well. The increase in supply
as the result of a good harvest lowers the price and results in less income to the farmers. If demand were
perfectly elastic (a horizontal line) the shift in supply would have no effect on price. Thus the more elastic the
demand, the less the effect on price and the less likelihood of the paradox. It's important to emphasize that the
good/bad paradox refers to the entire market. The worst of all possible cases is where you have a poor year,
but other producers have a good year. In this case you receive a low price and have a low output.
2.
A price support system achieved through acreage restriction is
illustrated on the right. The graph shows that, under this system,
the farmers gain rectangle A as income from the government in the
form of payments not to grow wheat, and rectangle B from
consumers who pay more for the wheat the farmers do grow.
Price
Supply
$5
A
B
3.50
Demand
Q1
Q2
Quantity
Page 678, Answers to End-of-Chapter Questions
3.
The taxpayers' group would prefer the economic incentives for not producing because it costs less; in the
example in the text, buying the surplus means the government pays the farmers $5 a bushel, rather than $2.20
with the incentives program.
4.
As shown on the right, the method of price support that is
most costly to the taxpayer is the subsidies on sales to
keep prices down; taxpayers must finance the subsidy
payments on all subsidized farm products, represented by
areas A, B, and C.
Price
Supply
$5
B
A
3.50
C
1.75
Demand
Q1
Q2
Quantity
5.
As shown in the textbook, the method of price support that is least costly to the taxpayer is regulatory
measures, which have no direct cost to taxpayers other than the cost of enforcing and administering the
regulations.
6.
Tariffs and quotas generally accompany price support systems in order to prevent lower-priced foreign
products from competing in the domestic market.
7.
The elasticity of supply affects the cost of price supports in the four options illustrated in the text. When the
supply is elastic a small change in price causes a large change in quantity, and the hurt group is larger.
8.
Governments find grandfathering a good option when they institute price supports because it is the easiest way
of restricting supply. Existing suppliers retain their level of output, added or new entry is denied or limited,
and the policy is easy to enact and easy to enforce.
9.
This is false. This is an extremely broad statement. As the chapter points out in detail, all government
regulation has benefits and costs, and in some cases one can assess the net impact. It seems highly unlikely
that all government intervention would make society worse off. Whether society is worse off must be based on
judgments about historical experience, not on theory.
10.
The nonrecourse loan is a price support system in which government buys goods in the form of collateral on
defaulting loans. The land bank program is a price support in which the government supports prices by giving
farmers economic incentives to reduce supply.
Chapter 19: Problems and Exercises
1.
a.
The graphs below illustrate the effect of a supply increase in each of the four situations presented in the
question. When supply is inelastic and demand is elastic, the increase in supply causes a small change in price
and a larger change in quantity. When supply is elastic and demand is inelastic, there is a larger change in
price and a smaller change in quantity. When both are elastic, there is a small change in price and a larger
change in quantity. When both are inelastic, there is a large change in price and a smaller change in quantity.
Page 679, Answers to End-of-Chapter Questions
S0
Price
Price
S1
S1
D
Q0
(1)
D
Q1 Quantity
S1
Quantity
S0
D
Price
S0
Price
Q0 Q1
(2)
S1
D
Q0 Q1
(3)
Q0 Q1
(4)
Quantity
The effect of a government price guarantee in each case is illustrated in the graphs below. In each graph, A is
the increase in farmers' revenue, B and C is the decrease in their revenue, and C and D are the excess burden,
the loss to society that results.
S1
Price
S1
Price
b.
Quantity
D
A
C
A
D
C
B
D
B
(1)
S01
D
A
(2)
D
C
D
B
c.
2.
S1
A
C
(3)
Quantity
Price
Price
Quantity
D
B
Quantity
(4)
D
Quantity
Farmers prefer the situation with the inelastic demand and elastic supply. In each graph, A is the increase in
farmer's revenue, B and C is the decrease in revenue, C and D are the excess burden, and the loss to society.
The graph below shows an increase in demand sufficient to raise the market price to Ps. The market quantity is
also increased to Qs. The cost to the government is the shaded rectangle. If instead supply is restricted (shown
in the far right graph), the government must pay the farmers (Ps - P1) for every unit not grown at price Ps,
resulting in a cost equal to the area of the bolded rectangle. Therefore, assuming that you cannot use the corn,
the second policy is preferred.
Page 680, Answers to End-of-Chapter Questions
S1
S
S
Price
Price
S1
Ps
Pe
D1
Ps
Pe
P1
D
Qe Qs
(a)
Quantity
a.
b.
c.
4.
a.
b.
c.
d.
e.
(b)
Q1 Qe Qs
Quantity
The regulators under Dr. Wiley's Law have likely been subject to strong lobbying by the food industry to
protect their own interests from competition under the guise of consumer protection.
A skeptical economist would likely look at the effects of this law on prices and competition to determine the
motives behind passage of the law.
This is very significant because it suggests that it was the lobbying of existing producers that supported the
law to protect their interests from the new products that led to the law not the consumer's interest.
Consumers of peanuts pay more in higher prices—estimated at
between $190 and $369 million a year—and suffer from reduced
consumption.
See the graph on the right. Area B represents additional costs to
S
Ps
consumers, while areas D and E represent deadweight loss of the
program.
B
D
Pe
The land with peanut quotas is a government license to sell
E
millions of pounds of peanuts and thus is priced higher to include
D
the present value of the future returns to that license.
The government’s costs would likely rise enormously in the
Qs
0
Qe
attempt to keep supply constrained to maintain the 50 percent
Quantity
above competitive equilibrium price.
If the United States limited the guaranteed high price to U.S.
producers only, administrative procedures would have to be set up to see that imported peanuts are not passed
off as U.S.-produced peanuts.
Price
3.
D
5.
a.
b.
c.
Mr. A would be willing to spend up to $100,000 to stop passage of the law.
Mr. B would be willing to spend up to $100,000 to get the law passed.
The implications for social policy is that individuals are willing to spend lots of money to pass laws that
benefit them as individuals. A reduction in such rent seeking would benefit society if the ability of individuals
to affect laws is curtailed.
6.
a.
The reason the difference exists is mostly political. A small group of ranchers benefits greatly from the
reduced fee and is a strong lobby for the cause.
The advantage to getting a lower fee could be that the U.S. government could require more from ranchers in
their care of the land.
One would expect excess demand because at the price below equilibrium, the quantity of land owners are
willing to supply at $1.86 is lower than the quantity demanded.
b.
c.
Chapter 19: Web Questions
1.
a.
Using numbers from Spring 2003, raw sugar in the world market was 7.60 cents per pound. In the domestic
market, sugar was 22.30 cents.
Page 681, Answers to End-of-Chapter Questions
b.
c.
2.
a.
b.
c.
What accounts for the difference is that imported sugar is subjected to quotas, which along with U.S. Farm
program, helps to keep U.S. sugar prices higher than world sugar prices.
Prices are maintained with price tariff quotas, the Secretary of Agriculture establishes the tariff rate quota
amount and is authorized to increase the total quota amount (above the GATT minimum) if domestic supplies
of sugar may be inadequate to meet the domestic demand at reasonable prices.
Genetically engineered crops are crops that are the result of seeds that have been genetically altered to borrow
desirable traits from another crop that currently do not exist in that particular crop.
Genetic engineering has led to stronger crops resistant to a greater number of pests. This has lowered
operating costs and boosted yield for those farmers using genetically engineered seeds. In the short run this
has increased farm profits.
In the long run, because demand for crops is inelastic, this is likely to lead to greater farm production, but
lower farm income and lower profits.
Chapter 20: Microeconomic Policy, Economic Reasoning, and Beyond
Questions for Thought and Review
1.
A Pareto optimal policy is one that benefits some people and hurts no one. It's hard to object to such a policy,
although one could if one saw certain social values as inviolate. Such issues are, for the most part, academic,
since, in reality, no such policy can exist. All real world policies hurt someone.
2.
The problem with proposing only Pareto optimal policies would lie in developing them. As the text points out,
there are no examples of real-world policies that benefit some people without hurting anyone. If economists
seek to propose only Pareto optimal policies, they may end up proposing no policies. Focusing only on Pareto
optimality condemns them to irrelevancy in real-world affairs, and to focusing on abstract models rather than
on the real world.
3.
All economists are not likely to oppose any policy, price controls included. Economists will support or oppose
policies based in part on value judgments and in part on their reading of the political and social institutions
within which economic policies are instituted. Differences over these lead to differences in policy
recommendations. Most, but not all, economists, based on their reading of history, oppose price controls.
4.
The usual arguments against the buying and selling of body organs include the concern that people might seek
to make such sales for the money involved and exploit the poor, and that those with the ability to pay would
get needed organs sooner than those without means, again favoring the well-off over the poor. Some may
believe that it is immoral to sell body parts. Arguments for selling body parts include that both parties freely
enter the transaction, and that both sellers (since they decided they preferred the money to the body part) and
buyers benefit. Economic theory provides no answers to such questions.
5.
Some of this analysis will depend on whether or not the course is a requirement. If it is, taking it would have
more benefits than if it were optional (in which case the benefits would be the knowledge gained, getting to
know that professor, meeting other students you might not have met, etc.). The cost would be tuition expense,
book(s), supplies, any added cost of transportation or food (because of the effect on your schedule), and the
opportunity costs of courses not taken, professors not taken, students not met, etc.
6.
The textbook suggests a method for valuing one’s life. Your answer should consider what you would pay to
reduce their chance of dying by a certain amount. The value of life is that amount times the inverse of the
reduced probability of dying.
7.
Most people can (and many unknowingly do) function with only one kidney. Thus it can be argued that having
two kidneys means having one more than you need to live a perfectly normal life. Aside from the expense,
pain, etc., of having the kidney removed, selling one for a million dollars may sound like a good deal.
However, should the remaining kidney become diseased, the seller would be left with no choice but dialysis,
Page 682, Answers to End-of-Chapter Questions
or obtaining a transplant himself or herself. The question is whether the million dollars is worth the risk.
(There are also cultural and religious factors involved here.)
8.
An economist might propose a policy that has little chance of adoption because he or she might be removed
from the concerns that make policies unadoptable (i.e., political concerns). In so doing, economists put ideas
into the real world and may influence the way people think. The goal behind policy proposals is not always to
get them implemented.
9.
There is usually an inertia that makes any change difficult. This can explain the difference in attitudes. There
seems to be no reason why people today would value their lives more than in the 1970s. The introduction of
airbags also involved informational issues. People needed to be convinced that airbags save lives. In the 1990s
there is still some debate about the negative consequences for children with passenger side airbags.
10.
Most politicians say that they are out to do the public good, but in practice they often (in their quest to be
reelected) do things that just sound good.
11.
If the hourly wage is higher on welfare than in a job, rational individuals will choose welfare. The policy
recommendations from such information are many. One could call for a much higher minimum wage.
Alternatively, one could call for a reduction of welfare, or the establishment of subsidized day care as part of
the support if the welfare recipient works.
12.
Any decision about prisons involves complicated ethical and moral as well as economic considerations. In
reference to the economic issues alone, it would seem that it does make sense to build more prisons since,
assuming prisons are currently full, the marginal benefits of additional prisons are greater than the marginal
costs.
Chapter 20: Problems and Exercises
1.
a.
b.
2.
a.
b.
c.
3.
a.
The cost of the device is $12 per car (the benefit is .0005 x $8,000 = $4 per car). So, given the assumptions, it
seems cost ineffective.
The other costs of a car crash would be the costs of death or injury to the people involved (and perhaps costs
of other cars and their passengers too), as well as damages to public and private properties. This could raise
the costs considerably and make the device cost effective.
A higher percentage of births by C-section are done at for-profit hospitals, most likely because the profit
margin for C-sections is higher than that for vaginal births.
The implication that can be drawn is that goodwill cannot be relied on to lead to low-cost health programs.
Other mechanisms must be instituted to ensure efficiency.
In the case of fixed payment, the for-profit hospital would probably do more vaginal births, which cost less
than C-sections. The C-section rate would most likely rise at nonprofit institutions as necessary C-sections are
limited at for-profit hospitals and shift toward nonprofit hospitals.
Because the cost of using a road is now close to zero, excess demand results. In the accompanying graph,
excess demand is Qd - Qs. By charging a price of P1 to use the roads, excess demand could be reduced or
eliminated.
Page 683, Answers to End-of-Chapter Questions
Price
S
P1
D
Qs
Qd
Quantity
b.
c.
4.
a.
b.
c.
5.
a.
b.
c.
6.
a.
b.
c.
7.
a.
b.
8.
a.
Some will attempt to disable the readers. Other will share rides. Still others will shift to vehicles which don't
have readers, such as motorcycles. Still others will find out where the readers are and go around them, or if
prices are to rise at certain time, go right before.
Pre-peak load congestion might be avoided if the start of the peak load price is a lottery, say equally probable
between 4 and 5 o'clock, with the knowledge after what time it is not available.
Since the supply of teenage baby-sitters shifted to the left just as the demand for them shifted to the right, the
equilibrium wage probably rose dramatically, reducing the number of times parents go out without their
children.
The price of baby-sitters probably rose as described in a.
The average age of baby-sitters probably fell as parents loosened their requirements of babysitters in an
attempt to find substitutes for the reduced number of 14- to 17-year-olds.
The price of pigs will most probably rise, although nearly imperceptibly, as a new demand for pig organs
develops, shifting the demand for pigs to the right.
I doubt that it is Pareto optimal. Some people will be made better off, but individuals who feel that such use of
pigs is immoral will be hurt. The rise in the price of pigs will also hurt some people.
If this program were successful, it would significantly reduce the black market price of human organs since
the black market would be replaced by an open market for organs.
According to standard economic reasoning, the value of an additional dollar spent in preventing death is
(assuming the journal’s figures are correct) more valuable in the United States than in Sweden and in Portugal,
and thus more money should go to saving lives in the United States. However, there are moral issues that
complicate matters and make the answer unclear.
This is a complicated question. First, many Americans fly in Portugal and, second, it would be bad publicity
for an airline to value lives of people differently by national origin or to even acknowledge making such a
marginal cost/marginal benefit analysis with regard to safety precautions at all. Moreover, there are those
sticky moral issues, which lead one to value all life equally.
To the degree that the cost of the standard is the same, the standard economic answer is yes. If noneconomic
factors are included, the answer is not so clear-cut.
If the issues of liberty (freedom of choice and from government regulation) are removed, it would make more
sense to spend more on the improvement of car seat belt standards since its cost of saving a life is currently
significantly below that of landfill disposal bans. There is, however, a cost imposed on individuals when they
are required to wear a seat belt. When aggregated across all Americans, these costs could theoretically change
the cost/benefit ratio.
If these figures correctly value these regulations, then one should first look at other life saving expenditures to
see if their cost is lower. As a general rule, lower cost regulations (with the same marginal benefit) should be
imposed first.
The likely effect of that proposal would be a flood of criticism. Certain human rights such as the sanctity of
the human body are held in high regard regardless of societal status. A proposal that, on its face, seems
economically sound is not acceptable if it does not include issues of human rights.
Page 684, Answers to End-of-Chapter Questions
9.
b.
That was the effect because the economic model did not account for all issues. Morality issues provoke strong
political reactions.
a.
If 70 percent of families choose male offspring, monogamous heterosexual marriages will be difficult to
maintain as there will be too few women. Women might start having two husbands (as they do in a few
cultures). The average marriage age of women would likely decrease.
It will likely push down the female dowry since the quantity of demanded women significantly exceeds the
quantity supplied (assuming the distribution of individual sexual preferences does not change).
On supply/demand grounds, a family would be wise to have a daughter since their relative importance would
rise as their expected relative supply declines.
b.
c.
Chapter 20: Web Questions
1.
a.
b.
Assuming head of a household with two children. In this example the monthly budget was overspent by $158.
With a minimum wage budget, things like new clothing, eating out, trips, movies would become luxuries. It
may be prudent to give up owning a car and use public transportation and ride sharing.
2.
a.
According to the New Party, a living wage at an absolute minimum means that someone working full time
should never fall below the poverty line, the exact amount varies from state to state but at this time generally
between $6.50 and $7.50 an hour with health benefits.
At this time minimum wage is $5.15 per hour.
The New Party’s arguments for a living wage include: an honest day’s work should be rewarded with an
honest day’s pay; the economy is moving in the wrong direction, too many working Americans still cannot
make ends meet; and tax dollars do not fix problems but often make them worse—subsidies are not the
answer.
b.
c.
3.
a.
b.
c.
d.
Six of the rights granted by the Constitution include; freedom of speech, the right to bear arms, the right to
peaceable assembly, the right to a speedy and public trial, the right against unreasonable search and seizure,
and the right to petition the government for redress of grievances.
Yes, these rights are inalienable, nontransferable.
This is a normative question. You may be able to sell your silence but not your right to freedom of speech.
Though Libertarians believe in a totally free market, they also believe in individual freedom. There is no
market for something that is not transferable.
Chapter 21: International Trade Policy
Questions for Thought and Review
1.
A country does better producing that good for which it has a comparative advantage and importing and
exporting that good in exchange for goods for which other countries have a comparative advantage.
2.
If Widgetland produces only widgets, it can make 240 of them and the opportunity cost is 1/1. If Wadgetland
makes only wadgets could produce 720 of them at an opportunity cost of .25/1 (widgets to wadgets). Since
the opportunity costs differ, there is a basis for trade in production. Widgetland should produce only widgets
240, and trade 60 of the widgets for 120 wadgets. Wadgetland should produce only 720 wadgets and trade
120 wadgets for 60 widgets. Both countries will be better off.
3.
Traders get big gains from trade in newly opened markets. The more competition that exists in international
trade, the more of the gains pass to the citizens and less to the trader.
4.
Smaller countries tend to get more of the gains from trade because more opportunities are opened up for them.
This is true only under the condition that competition among traders prevails. International traders in small
countries often have little competition and so keep large shares of the gains from trade for themselves; hence
the small country may not get the gains from trade.
Page 685, Answers to End-of-Chapter Questions
5.
Countries producing goods with economies of scale get a larger gain from trade. Trade allows an increase in
production and if there are economies of scale, the increase can lower the average cost of production,
therefore, lower the price of the good in the producing country.
6.
An equitable method might be to tax those who gain from the trade liberalization and give the proceeds to
those who are hurt by it. Assuming the original distribution is equitable and the government is not trying to
redistribute income, this method is equitable because the combined policies make everyone better off. The
political problems with implementation includes: (1) Everyone will try to exaggerate the amount they are hurt
and minimize the amount they are helped. Thus actually finding a tax that accomplishes the goal will be
difficult. (2) Once the taxes and subsidies are in place, they may not be removed after the adjustment of
displaced workers is complete. Losers will be overcompensated and gainers will be taxed too much.
7.
The answer in part will depend on what advice is being given. Most economists would argue that some trade
restrictions might benefit a country, but almost no country can limit its restrictions to the beneficial ones.
Trade restrictions are additive; most economists would not recommend them, even in a recession.
8.
When the United States economy fell into a recession in 1991 income and imports fell and the trade balance
improved. This is consistent with predictions.
9.
Free trade can protect national security by increasing understanding of each other’s culture as countries import
and export each other’s goods. Increased trade also sets up a structure of interdependence that is compromised
during wars.
10.
Economists support free trade because it forces domestic producers to operate efficiently and it increases
consumer welfare.
11.
Tariffs and quotas have similar effects on limiting trade (both shift the supply curve to the left). The big
difference is who gets the revenue from the resulting increase in the price of imports. With a tariff the
government gets the revenue. With a quota, the revenues accrue to the producers. You can see this graphically
in the margin graph on page 467 of the text.
12.
Both increase the price of the import, helping the domestic producers. In the case of the voluntary restraint,
increases in price result in increased revenue to foreign firms and increased demand is met entirely by the
domestic market.
13.
This is a normative question. Some aspects to think about would be your concern about the health of American
consumer and how does the price competition affects American growers.
14.
With a price floor, there is a loss of consumer surplus, higher prices and lower quantities.
15.
The benefits are that there will be more internal competition among the four countries. The danger is that the
combination of countries might place stronger restrictions on outside goods, thereby decreasing international
competition.
16.
The WTO is the successor to GATT. Both work toward agreements to reduce trade. WTO includes
enforcement mechanisms that GATT did not have.
Chapter 21: Problems and Exercises
1.
a
b.
Since their opportunity costs differ, they can gain from specializing: Nebraska will produce only wheat, and
Iowa will produce only corn. If Iowa produces only corn, it can increase its production of corn by 60 million
to 180 million. Similarly Nebraska can increase its production of wheat to 180 million. There is now 180
million bushels of both to be divided in whatever way the states decide, making it possible to meet the
distribution given in the question.
If the countries were willing to remain at their initial consumption combinations the trader would end up with
40 million bushels of wheat and 40 million bushels of corn.
Page 686, Answers to End-of-Chapter Questions
a.
b.
3.
a.
b.
c.
d.
No. Both countries’ opportunity cost of producing pickles is 2/1 (they must give up 2 olives to get 1 pickle).
Neither has a comparative advantage, so there is no basis for trade.
If there are economies of scale, it definitely pays for both countries to specialize since doing so would lower
total costs. Which one should specialize is an open question since neither has a comparative advantage.
The gains to domestic producers is shown in the graph to the
right. Domestic producers now produce B at Pt instead of A at
Pw. Domestic producers gain additional revenue shown by areas
FHKG and ABKE.
The revenue to the government is the quantity supplied by
foreign producers, BC, multiplied by the tariff. This is shown in
the graph on the right as HIJK.
The cost to domestic producers to produce additional units is
shown by area ABKHE.
The gain to domestic producers is greater than the cost to
domestic producers by area FHEG.
S
Price
2.
Pt
F
Pw
G
H
E
I
K
J
D
A
B
C
D
Quantity
4.
a.
b.
c.
5.
a.
b.
6.
a.
b.
c.
Firms may produce in Germany, because (1) transportation costs in the other countries may be very high, so
that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas
for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be
so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led
to production in Germany and the cost of moving production may exceed potential gains.
Yes, one would expect some movement from Greece and Italy into Germany, but this is limited by the
minimum wage laws in Germany. Also, social restrictions such as language and culture will limit labor
mobility. With such high unemployment in Germany already, one would not expect much short-run
movement. Movement in the long run, however, may be substantial.
I would need to know how stable the political system is, what the worker productivity rates are, how sound the
infrastructure (such as roads) is, and what the tax differences are between the two countries.
He most likely means that around election time, government officials offer to impose tariffs and quotas to
protect industry and "buy" the votes of those who benefit at the cost of increased prices to consumers. This can
be done because the small group who will reap large gains will be better organized than the larger group with
similar losses but lower per person costs. The larger group will more likely not vote based on this issue, but
the smaller group will.
It would most likely impose quotas since it eliminates foreign competition while a tariff allows some
competition. The protected industry will benefit more from a quota by reducing competition, and it is the votes
from this industry that government is most likely targeting.
Three assumptions are that the good is tradable, that transportation costs are minimal, and that taxes between
the two countries do not differ significantly.
To the degree that production facilities and labor can move easily, the law of one price should hold for labor,
too. Given the wage differentials that exist among countries with seemingly equivalent productivities, it seems
that these conditions do not hold for labor.
Since capital is more mobile than labor, the law of one price should have a greater tendency to hold for capital.
Financial capital is a great example. Interest rates among countries tend to equate much faster than wages.
Chapter 21: Web Questions
1.
a.
b.
c.
WTO uses a multilateral system of consultants and panels of experts through a set procedure to settle disputes.
The timetable for the settlement procedure is to complete it within one year, 15 months if there is an appeal.
If a country chooses not to abide the dispute agreement the penalty can be trade sanctions, if possible in the
sector of the dispute.
Page 687, Answers to End-of-Chapter Questions
2.
a.
b.
c.
3.
a.
b.
c.
d.
4.
Three trade barriers listed are biotechnology bans, quotas on lumber, and export control licensing.
The biotechnology bans are implemented because of perceived health risks to genetically modified food. The
lumber quotas are to save American jobs in the timber industry. Export control licensing of satellites has
shifted from the Commerce Department for security reasons. The time to get a license has risen 30 percent.
The ban on gmo’s is hurting the U.S. agriculture market. The import quota on lumber has led to a 35 percent
increase in the price of U.S. lumber. We are losing business from China from the change in license control.
The members of ASEAN are: Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei Darussalam,
Cambodia, Laos, Myanmar, and Vietnam. The members of Mercosur are: Argentina, Paraguay, Uruguay, and
Brazil.
Asean was established in 1967 with the first five countries. Mercosur was established in 1991.
Asean states that the aims of the association are 1) to accelerate the economic growth, social progress and
culture development in the region through joint endeavors in the spirit of equality, and 2) to promote regional
peace and stability.
Mercosur’s stated objectives are: 1) Free transit of production goods, services and factors between the
member states, the elimination of customs rights and lifting of nontariff restrictions; 2) Fixing of a common
external tariff (TEC) and adopting of a common trade policy with regard to nonmember states; 3)
Coordination of macroeconomic and sectoral policies of member states relating to foreign trade, agriculture,
industry, taxes, monetary system, exchange and capital, services, customs, transport and communications, and
any others they may agree on, in order to ensure free competition between member states; and 4) The
commitment by the member states to make the necessary adjustments to their laws in pertinent areas to allow
for the strengthening of the integration process.
Combined GDP in Mercosur countries was $715 billion in 1993. Combined GDP in Asian countries was $737
billion in the late 1990s.
The answer to this question depends on the country chosen.
Chapter 21: Appendix A
a.
b.
c.
d.
2.
a.
b.
The countries can move to those points through specialization and trade. Machineland has the comparative
advantage in machines and should specialize in them and trade them for food from Farmland. If Machineland
produces 200 machines and Farmland produces 200 of food, then they can trade on a 1 to 1 basis to reach
points B and D.
At points A and C the total production of machines is 110 and of food is 170. By specialization the total
production of each would increase to 200.
Your share should compensate you and still allow for the two nations to gain from trade. Eventually the
above-normal returns will be competed away.
Economies of scale would mean that the production possibilities curves would not be straight lines, and would
be a further argument in favor of specialization.
The opportunity cost for Greece of making 1 million olives
is 1,000 pounds of cheese. The opportunity cost for France
of making 1 million olives is 250 pounds of cheese. The
opportunity cost for Greece of making 1,000 pounds of
cheese is 1 million olives. The opportunity cost for France
of making 1,000 pounds of cheese is 4 million olives.
They are worse off since France has a comparative
advantage in producing olives and Greece has a comparative
advantage in producing cheese. Under the new law France
produces 50,000 pounds of cheese and Greece produces 500
million olives—point A. They could have had a greater
combination: 100,000 pounds of cheese produced by Greece
and 600 million olives (200 million by France and 400
million by Greece)—point B. Their combined possibility
curve if they were able to trade is the outermost production
possibility curve shown.
Thousands of pounds of
Roquefort cheese
1.
700
600
500
400
300
200
100
0
Gre e ce
Spe cialization
& trade
France
A
B
0 0 0 0 0 0 0
10 20 30 40 50 60 70
Page 688, Answers to End-of-Chapter Questions
Millions of olives
See the accompanying graph. All the points in the shaded area were unattainable without specialization and
trade.
a.
The production possibility curve is shown in the graph on the
right.
60
Since Busytown can produce more cars when all of its
50
bus ytow n
resources are devoted to producing cars, Busytown has an
40
absolute advantage in producing cars. Neither has an absolute
30
advantage in producing gourmet meals since if each devotes
20
all of its resources to producing meals, each can produce 50.
lazyas iw annabe
10
Lazyasiwannabe has a comparative advantage in gourmet
0
meals. It must give up 1 cars for each gourmet meal while
Busytown must give up 1.2 cars for each gourmet meal.
20
50
10
30
40
60
Therefore, Lazyasiwannabe has a comparative advantage in
Meals in thousands
making gourmet meals.
Busytown should produce 60 thousand cars and Lazyasiwannabe should produce 50 thousand meals.
Lazyasiwannabe then offers Busytown 22 thousand meals for 24 thousand cars. Since Busytown must give up
only 24 thousand cars for 22 thousand meals (instead of the 26.4 thousand cars it would have to if it made 22
thousand meals itself) it accepts this offer. Lazyasiwannabe ends up with 28 thousand meals and 24 thousand
cars while Busytown ends up with 22 thousand meals and 36 thousand cars.
b.
c.
d.
Cars in thousands
3.
c.
Chapter 22: Economic Growth, Business Cycles, Unemployment, and Inflation
Questions for Thought and Review
1.
Economic growth is measured by increases in total output and increases in output per person.
2.
The U.S. per capita growth rate of 1.5 to 2.0 percent per year is lower than those of Japan (4.8 percent per
year) and China (3.4 percent per year), close to those of Western Europe (2.5 percent per year) and Latin
America (1.4 percent per year), and higher than those of Eastern Europe (1.0 percent per year) and Africa (0.8
percent per year).
3.
Real output is a measure of the total goods and services an economy actually produces stated in constant
prices. Potential output is a measure of the total goods and services an economy is capable of producing given
its resources and institutions.
4.
A representative business cycle is shown on the
right. Each of the four phases—peak, downturn,
trough, and upturn—is clearly labeled.
rn
tu
Do
Up
Total Output
Peak
wn
tu
rn
Trough
Time
5.
Besides predicting the recessions that did occur, the index has also predicted many recessions that did not
occur. So the predictions have not been especially accurate. Predicting recessions is difficult because business
cycles have varying durations and intensities. The leading indicators are called indicators and not predictors
because they're only rough approximations of what's likely to happen in the future.
6.
Reducing unemployment to 1.2 percent today is not likely for several reasons. One is that a low inflation rate
seems to be incompatible with low unemployment. Another is that today’s economy differs from that of the
Page 689, Answers to End-of-Chapter Questions
World War II period, when there was an enormous ideological commitment to the war effort and an
acceptance of strong wage and price controls.
7.
Structural unemployment results from changes in the economy itself, while cyclical unemployment results
from fluctuations in economic activity.
8.
Structural unemployment, because it results from changes in the structure of the economy, is best studied in
the long-run framework. Cyclical unemployment, which results from fluctuations in economic activity, is best
studied in the short-run framework.
9.
Some economists argue that the unemployment rate undercounts unemployment because people who have
stopped trying to find jobs are considered voluntarily idle and are not counted as unemployed. Others point out
that, because of unemployment insurance, people often say they are looking for work when they really aren't,
and therefore unemployment is overstated. So there are tendencies both to overestimate and underestimate the
problem.
10.
Okun’s rule of thumb states that a 1 percentage point change in the unemployment rate will cause income to
change in the opposite direction by 2 percent. Thus, a 2 percentage point rise in unemployment will likely
cause income to decrease by 4 percent.
11.
Expectations are central to understanding inflation because the relative price increase people want must be
tacked onto the inflation they expect. Expectations of inflation play an important role in any ongoing inflation.
Expectations can snowball a small inflationary pressure into accelerating inflation.
12.
False. While inflation doesn’t make the nation any poorer on average, it does have costs. Its costs include
capricious distributional effects, the destruction of the informational value of prices, and the breaking down of
the institutional structure within which markets work.
13.
Solving inflation often worsens unemployment and slows growth. Similarly, reducing unemployment by
stimulating growth tends to increase inflation. So, in the short run, there will likely be a relationship. However,
once expectations of inflation are built in, there can be high inflation with high unemployment, so the answer
to the question is no.
Chapter 22: Problems and Exercises
1.
a.
b.
c.
2.
a.
b.
c.
d.
3.
The labor force participation rate is the total number of people employed and/or looking for work (or the labor
force) as a fraction of the population over 16 years old. In this instance it is 142,542/214,967 X 100 = 66
percent.
The unemployment rate is the total number of unemployed as a fraction of the labor force. In this instance it is
8,590/142,542 X 100 = 6 percent.
The employment rate is the total number of unemployed as a fraction of the labor force. Since the labor force
equals the unemployed plus the employed, we know that in this instance it is (142,542,000 –
8,590,000)/142,542,000 X 100, or 94 percent.
The index in 2003 is 68/64 X 100 = 106.25.
Real output is Nominal output/Price index X 100 = $300 billion/115 X 100 = $260.9 billion.
Percent change in nominal output = Percent change in real output + Percent change in the price level. Thus,
change in nominal output = 5 percent + 2 percent = 7 percent.
Percent change in nominal output = Percent change in real output + Percent change in the price level. Thus,
inflation = percent change in nominal output – percent change in real output= 7 percent - 3 percent = 4
percent.
The purpose of life and therefore a desired lifestyle is a complicated issue. To the extent that work provides a
sense of self-worth and identity, complete idleness is not desirable. This, however, is a normative question.
Unemployment within our culture and set of institutions is a measure of aggregate well-being to the extent that
employment provides a sense of well-being and sufficient income to support a desired lifestyle. The Eloi are
Page 690, Answers to End-of-Chapter Questions
all unemployed, but if they can support their desired lifestyle with the work of machines, unemployment is not
so bad. This example shows that unemployment must be understood within this broader framework-its
meaning is specific to a set of institutions and a culture.
4.
a.
b.
c.
5.
a.
Possible explanations include Japanese cultural emphases on tradition, honor, and loyalty. In Japan, firms are
less willing to lay off workers in times of excess supply and workers are less likely to change employers in
search of higher compensation. Another explanation is the nature of Japanese production. One could suggest
that Japanese production does not rely on a changing base of skills so that the skills of workers always match
the skills demanded of a particular firm.
It is impossible to say which is better. Each needs to be judged within the broader system of the economy.
This requires far more knowledge than is required for this book.
The answer to this question depends on the distribution of layoffs and hires in each of the economies. If
layoffs in Japan were unavoidable and occurred among lower-ranking employees, the average tenure of
Japanese employees would rise. If instead the elderly were asked to retire, the average tenure would decline.
In the United States, assuming that new hires came from those just entering the labor force, the average tenure
would most likely decline.
4%
b. 5%
c. fell $.12 billion
d. -1%
e. 4%
Chapter 22: Web Questions
1.
a.
b.
c.
The unemployment rate was 5.8% in February 2003 was and CPI inflation rate was 3 percent.
The consensus forecast for unemployment in 2003 was 5.8% and for inflation in 2003 was 2.6 percent.
These appear to be reasonable predictions, though the outcome of the Iraqi War provides additional
uncertainty.
2.
a.
The answers to this question will depend upon the
current state of the economy. The graph is shown
on the right. The copy of the Economic Report of
the President for Spring 2003 did not include
quarterly data back to 1989, so we looked on
BEA’s web site at www.bea.doc.gov to find it. The
peak and trough are marked.
The economy is currently in an expansion.
It has been in an expansion for just a few quarters.
The last recession was in 2000/01.
Real GDP
Billions of 1996 Dollars
b.
c.
d.
10000
peak
9500
9000
trough
8500
8000
7500
7000
6500
89
91
94
97
0
2000
Year
Chapter 23: National Income Accounting
Questions for Thought and Review
1.
It depends on whether more foreign businesses and individuals conduct business in the country relative to
domestic businesses and individuals. If more foreign businesses and individuals conduct business in the
country relative to domestic businesses and individuals, then GNP will be greater than GDP.
2.
If you add up all transactions, you will include intermediate goods—so the amount will far exceed GDP,
which is the measure of final output within a country.
3.
A stock concept is the amount of something at a given point in time. A flow concept has a time period
associated with it. A stock is the amount of water in a reservoir; a flow is the amount of water that flows over
Niagara Falls every hour.
Page 691, Answers to End-of-Chapter Questions
4.
The aggregate value added at each stage of production is, by definition, precisely equal to the value of final
sales. Thus, the value-added rate should also be 15 percent. (Technical note: This is assuming the value-added
tax is an income-based rather than consumption-based.)
5.
If the United States introduced universal child care, GDP should increase because some child care provided at
home would then become market transactions. The welfare implications of that rise will depend on how
society views this change. For example, would the quality and amount of child care increase? Would there be
fewer neglected and abused children? Would an increase in the number of well-cared-for children eventually
mean lower unemployment, more productive workers, and higher wages?
6.
NDP is actually preferable to GDP as the expression of a country’s domestic output because NDP takes
depreciation into account. Depreciation is a cost of producing goods. However, measuring true depreciation is
difficult because asset values fluctuate, and so GDP rather than NDP is generally used in discussions of
economic activity.
7.
Employee compensation is the largest component of national income for most countries.
8.
Transfer payments are not included in national income, so nothing directly would happen to it.
9.
Personal income differs from national income because it measures the income actually received by households
as opposed to the income they earned. Thus, unearned income (transfer payments) is added to personal
income, and earned income not received (corporate retained earnings, and social security taxes) is subtracted
from personal income to arrive at national income. In addition, because non-business interest is not included in
national income, but received by households, non-business interest must be added.
10.
The difference between domestic personal income and national personal income is the addition of net foreign
factor income to domestic personal income.
11.
GDP does not measure happiness nor does it measure economic welfare. GDP measures economic activity.
Economists talk about GDP because it is measurable and they need something to talk about. Moreover, GDP
figures are used to make comparisons of one country's production with another country's and of one year's
production with another year's. Besides, GDP does have some relation to happiness.
Chapter 23: Problems and Exercises
1.
a.
b.
c.
d.
GDP is the sum of the value added by the three firms: 550 + 1850 + 950 = 3350.
A 10 percent value-added tax would generate (.10)(3350) = $335 of revenue.
A 10 percent income tax would generate the same revenue.
A 10 percent sales tax on final output would generate (.10)(1000 + 2100 + 1000) = $410 of revenue.
2.
a.
b.
c.
d.
e.
f.
GDP should fall as nonmarket transactions increase.
GDP would not change.
GDP would rise by the broker’s commission.
GDP would not change.
GDP would not change.
GDP would rise.
3.
Students can search on the Internet or call the embassies of each country to find this information.
4.
GDP = C + I + G + (X - M) = 500 + 185 + 195 + 4 = 884.
GNP = GDP + Net foreign factor income = 884 + 2 = 886.
NNP = GNP - Depreciation = 886 - 59 = 827.
NDP = GDP - Depreciation = 884 - 59 = 825.
NI = NNP - Indirect business taxes = 827 - 47 = 780.
PI = NI + Transfers from government + Nonbusiness interest income - Corporate retained earnings - Social
Security taxes = 780 + 72 + 10 - 51 - 35 = 678.
Page 692, Answers to End-of-Chapter Questions
DPI = PI - Personal taxes = 702 - 91 = 611.
5.
a.
b.
c.
d.
6.
a.
b.
c.
7.
a.
b.
c.
The expenditure approach:
GDP = C + I + G + (X - M) = 700 + 500 + 300 + 275 = 1775
GNP = C + I + G + (X - M) + net foreign factor income = 700 + 500 + 300 + 275 + (-3) = 1772.
The income approach:
National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 500 = 1,647.
GNP = NI + indirect business taxes + depreciation = 1,647 + 100 + 25 = 1772.
GDP = GNP - net foreign factor income = 1775.
NDP = GDP - depreciation = 1775 - 25 = 1750.
NNP = GNP - depreciation = 1772 - 25 = 1747.
National income = wages + rents + interest + profits + proprietor's income: 972 + 25 + 150 + 500 = 1,647.
PI = NI + transfers + net non-business interest income – corporate retained earnings - social security contrib. =
1647 + 0 +20 - 60 - 0 = 1607.
DPI = PI - personal taxes = 1607 - 165 = 1442.
GDP = C + I + G + (X - M) = 485.
GNP = GDP + Net foreign factor income = 488.
NI = Compensation + Rent + Profits + Net interest = 448.
NNP = NI + Indirect business taxes = 475.
NNP = NDP + Net foreign factor income: NDP = 472.
Depreciation = GDP - NDP = 13.
GDP C + I + G + (X - M) = 480.
GNP = GDP + Net foreign factor income = 483.
NI = Compensation + Rent + Profits + Net interest = 459.
NNP = NI + Indirect business taxes = 486.
NNP = NDP + Net foreign factor income: NDP = 483.
Depreciation = GDP - NDP = 23.
1998: 8509.7 1999: 8857.7; 2000: 9190.8; 2001: 92157.2.
Since inflation was positive in every year, nominal GDP growth always exceeded real GDP growth in each of
the last three years.
It is impossible to say in which year society's welfare increased the most. GDP measures market activity, not
welfare.
Chapter 23: Web Questions
1.
a.
b.
c.
d.
2.
a.
b.
c.
3.
a.
b.
These data are for 2002.
Consumption: $7303.7 billion; Investment: $1,593.2 billion; Government expenditures: $1,972.9 billion; Net
exports: -$423.6 billion.
Nominal GDP was $10446.2 billion; real GDP was $9,439.9 billion.
GDP increased 3.6 percent. 1.2 percentage points was due to a rising price level.
Increases in consumption contributed the most to GDP growth. Net exports detracted from GDP growth.
The economic contributions of household and volunteer work.
Crime, depletion of nonrenewable resources, family breakdown and loss of leisure time. The depletion of
nonrenewable resources is the largest of these categories.
The GDP has been going up while the GPI has been falling in recent years.
We found the answers at http://hdr.undp.org/statistics/faq.cfm
The following are used to construct the HDI: Longevity is measured by life expectancy at birth; knowledge is
measured by a combination of the adult literacy rate and the combined gross primary, secondary, and tertiary
enrollment ratio; and standard of living, as measured by GDP per capita (PPP US$).
The countries with the highest HDIs are Norway, Sweden, Canada, Belgium, and Australia. Although these
countries have relatively high GDP per capita, the country with the highest GDP per capita, the United States,
is number 6 because it doesn’t score as well on life expectancy at birth and adult literacy.
Page 693, Answers to End-of-Chapter Questions
c.
Equatorial Guinea had the highest rank disparity. The difference was -73, meaning that its rank by GDP was
73 places lower than its HDI ranking. Evidently it measures better by longevity and knowledge than by
standard of living. This information was found at http://www.undp.org/hdr2002/indicator/indic_284_1_1.html
Chapter 24: Growth, Productivity, and the Wealth of Nations
Questions for Thought and Review
1.
a.
b.
Answers will vary. Students can do some research about developing countries either at the library or on the
Internet to find out about what it is like to live in a developing country.
Answers will vary. Answers will mention the lack of some products such as cars, air-conditioning,
dishwashers, TVs, the Internet as well as the need to work longer hours to provide for the goods that did exist.
Figure 24-1 supports this.
2.
A person living in 1910 is most likely to work more to buy a dozen eggs than the person living in 1990. The
reason is that, since 1910, the United States income has been rising, on average, by more than the growth in
the population. This means that the income per person has gone up since 1910. Thus, the person living in 1990
has a higher income than the person living in 1910 and so is likely to work less to buy the dozen eggs.
3.
The answer to this question is more complicated than comparing increases in relative income. In terms of real
income, the poor are doing relatively better than the rich because growth has made everyday goods available
to the poor that weren’t available previously. To the extent that growth has lengthened life expectancy, growth
has increased the life expectancy of the poor more than the rich because it has improved the basic diet of the
poor more.
4.
Specialization and division of labor allow a country to take advantage of its comparative advantage. Thus, the
individual country can specialize in the production of goods in which it has a comparative advantage and trade
them with the goods for which it does not have a comparative advantage. Hence, free trade will, in general,
benefit the participating countries.
5.
An increase in savings in the United States can lead to an increase in investment. As investment in the
economy increases, total output in the economy will increase and this would raise people’s income. As a
result, the standard of living will be higher. But if a politician is to implement policies to encourage savings, it
might inhibit aggregate spending in the economy and so income would not increase and so the policy would
not be able to meet its objective of raising the standard of living.
6.
The three types of capital are physical capital, human capital, and social capital. Physical capital includes the
buildings and machines that are available for the production process. Human capital includes the workers’
skills that are embodied in them through education, experience, and on-the-job training (i.e., through people’s
knowledge). Social capital includes the habitual way of doing things that guides people in how they approach
production in the economy.
7.
Two ways in which growth through technology differs from growth through the accumulation of physical
capital are: (1) Accumulation of physical capital increases output by simply increasing the amount of the
capital available for production whereas technology increases output by making the existing capital more
efficient and thereby increasing the return per available capital. (2) Technology can also change the types of
goods people buy in an economy by introducing new types of product whereas accumulation of physical
capital does not make such a change.
8.
The two actions governments can take to promote the development of new technologies are (a) to create
patents and protect property rights, and (b) to implement policies to provide funding for research.
9.
Thomas Malthus based his prediction that population growth would exceed the growth in goods and services
on the law of diminishing marginal productivity of labor. But his prediction did not come true because labor
Page 694, Answers to End-of-Chapter Questions
has become more efficient as a result of education and technological progress, which has increased the output
per worker.
10.
If individuals suddenly needed more
food to subsist, the subsistence line
would rotate to the left. Population
would decrease and output would fall,
as is shown in the graph on the right.
Subsistence level of
output
Output
Production
function
L1
L*
Labor
11.
Network externalities are when the use of a good by one individual makes that technology more useful to
other people. Because of these spillover effects, the effect of the technological change is magnified.
12.
The following are three ways in which growth can be undesirable: (1) Growth may contribute to increased
pollution. (2) Growth changes traditional cultures with beautiful handiwork, music, and dance into cultures of
modern gadgets. (3) Some argue that the number of average working hours has increased because of growth in
the economy.
13.
Credentialism can lead to the employment of workers who have the necessary degree but do not have the
required skills for the job. Thus the average return from the person as a worker would be less and so the
production process he or she is involved would become less efficient.
14.
To compete with the others, the producer has an incentive to innovate (i.e., to invest in technological advance
so that he can increase his efficiency and so take a lead among his competitors). But technological innovation
is usually associated with a high cost initially, and the producer who has advanced his production process
cannot afford to impose a high price on his product due to competition in the industry and so he cannot sustain
his technological improvement.
15.
The answer may vary depending on the students’ perceptions. I would say yes if it wants to attract Western
businesses in whose interest it is to maintain their property rights. I would say yes if it wants avoid possible
retaliatory measures by Western countries. I would say no if it thinks that copying other’s patents would lead
to greater growth without much cost. The downside to not adopting Western patent laws is that doing so would
limit the benefits for Pakistanis themselves to innovate, thereby lowering potential growth.
16.
Communities are willing to give tax relief to new-technology firms to help them survive during the initial
stages, when the start-up costs are very high. If these companies survive, they will be able to provide
employment opportunities to the community members and thereby play a role in increasing the community’s
total income and standard of living.
Chapter 24: Problems and Exercises
1.
Using the Rule of 72, we know that it would double in 36 years.
2.
Constant returns to scale refers to the relationship between increases in all inputs and output. In this case, only
one input rose, so we cannot make any conclusion about returns to scale.
3.
Nepal: 65.5 years; Kenya: 42.4 years; Singapore: 10 years; Egypt: 18.5 years.
Page 695, Answers to End-of-Chapter Questions
4.
a.
b.
c.
d.
-4.8%
4.6%
4%
2.0%
5.
a.
While developing an educational system for a developing country, one might emphasize on technical
education especially in high school level. The reason for this is that most students in the underdeveloped
countries cannot afford to pursue higher education and stop at the high school level. Therefore, if high schools
focus a little more on the technical aspect, then these students would be able to garner some technical
knowledge to be efficient in this world of rapid technological change.
Because the United States is a rich country, it can afford a more eclectic educational system that teaches less
directly relevant aspects of knowledge.
b.
6.
a.
b.
c.
7.
a.
b.
The borrowing circle probably would not work in the United States, because the strong social forces in
Bangladesh that eliminate the need for collateral do not exist in the United States. Perhaps there are some
minority groups that do not have the necessary collateral to get loans in the traditional way but whose culture
could provide the social forces to make repayment of loans more certain.
A possible modification of the program would be to require proof that the “traditional” methods of financing
are not open. This would limit the program to those who have few options but do have a good business plan
and intention to repay. Another modification would be to require that the business be maintained in the
neighborhood where the cosigners live. This would maintain the social forces that ensure repayment.
Minorities often face the same problems because they do not have adequate assets for collateral necessary to
gain traditional financing. They also may face discrimination by banks and venture capitalists. Nevertheless,
they may have good business plans and an intention to repay.
It exhibits decreasing marginal productivity.
If the population is at L1, it will grow. The surplus food is shown by Q1 – S1.
Subsistence level of
output
Output
Production
function
Q*
Q1
S1
L1
c.
d.
L*
L2
Labor
At L2 population is declining because there is not enough food to go around.
The intersection of the two curves gives the level of population, L*, at which the economy is in a steady state.
It is a steady state because there is no surplus or shortage—there is just enough to keep people at their
subsistence level.
Chapter 24: Web Questions
1.
This information was found in the World Development Indicators files.
a. Students have to subtract the population growth from the average annual growth in output. Kenya = 0.1 %;
Mexico = -0.1% – 1.6; United States = 2.1; Japan = 2.7;
b. Kenya = 3.1%; Mexico = 1.9%; United States = 1.0%; Japan = 0.4;
c. Kenya = 19.7%; Mexico = 23.1%; United States = ; Japan = 32.3%.
Page 696, Answers to End-of-Chapter Questions
2.
a.
b.
3.
a.
b.
This question was answered according to the Index of Economic Freedom, 2002. The ratings for the top two
are Hong Kong = 1.3; Singapore = 1.45. The ratings for the bottom two are North Korea = 5.0 and Iraq = 4.90.
The top two are countries where there is the greatest absence of government coercion or constraint in the
following spheres beyond what is necessary for the citizens’ protection: production, consumption and
distribution.
Using figures from 1998, the GDP per capita growth rates were as follows: Singapore = 0.4 %; Hong Kong = 7.9% ; North Korea = -6.8% ; Iraq = not available. As can be seen, there does not seem to be a definite
relationship between the two factors. Even if one compares these GDP per capita growth rates with the Index
of Economic Freedom for 1998, one cannot make any definite conclusions. The relationship between
economic freedom and growth may be more visible over longer time comparisons.
The term of a patent is 20 years although exceptions can be made for, say pharmaceuticals.
Shortening the length of patents means that the new product or the technological innovation will become
“common knowledge” soon. As such, it will be available to other sectors of production that might use it or
might develop new ideas from it.
If the length of the patent if shortened, then there is reduced incentive to spend on R&D and technology since
your funds are indirectly being used to provide new technologies to other sectors.
Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics
Questions for Thought and Review
1.
The central difference between activist and laissez-faire economists is their differing views about whether the
economy is self-regulating. Laissez-faire economists (Classicals) believe the pricing mechanism will bring the
economy to an equilibrium (potential output and full employment) while activist economists (Keynesians) do
not share that belief.
2.
Classicals felt that if the wage was lowered, the Depression would end. They saw unions as preventing the fall
in wages, and they saw the government lacking the political will to break up unions.
3.
Five factors that shift the AD curve are: changes in foreign income, changes in expectations, changes in
exchange rates, changes in the distribution of income, and changes in government aggregate demand policy.
4.
Say there is a rise in the price level. That would make the holders of money poorer (the wealth effect). It
would also reduce the real money supply, increasing the interest rate (the interest rate effect). Assuming fixed
exchange rates, it would also make goods less internationally competitive (the international effect). All three
account for the quantity of aggregate demand decreasing—decreasing spending as the price level rises. These
initial increases are then multiplied by the multiplier effect as the initial spending reverberates through the
economy.
5.
Two factors that shift the SAS curve are changes in productivity and changes in input prices.
6.
If the economy is in short-run equilibrium below potential output, there will be downward pressures on the
price level. The short-run aggregate supply curve will shift down and the price level will fall. This will set the
wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and
thereby bringing the economy into long-run equilibrium at potential output.
7.
This implies that productivity is increasing significantly. If computers are a large portion of the economy, and
wages do not rise by the full amount of the productivity increase, the result will be to lower the SAS curve. It
can also shift out the potential output curve to the right, increasing equilibrium potential output and lowering
the price level.
8.
Yes, they would emphasize the inherent value of the program rather than discussing the program’s effect on
aggregate demand. This is because programs that increase aggregate demand when the economy is close to
potential will ultimately lead to inflation and little increase in real output.
Page 697, Answers to End-of-Chapter Questions
9.
Countercyclical fiscal policy is difficult to implement because politically it is difficult to raise taxes when the
economy is doing well (or at any time). Politics, not the needs of the economy guide tax and spending
decisions.
10.
To design an appropriate fiscal policy, it is important to know the level of potential income because where the
economy is relative to potential income tells you whether you want expansionary or contractionary policy.
Conducting fiscal policy without having an estimate of potential income would be like driving without being
able to see the road.
11.
As can be seen in the following diagram, a large increase in
potential output (shifting the LAS curve to the right) would
cause downward pressure on the price level from P 0 to P1. As
the price level shifts down the output level increases from Y 0
to Y1. This is the argument some economists used to suggest
policymakers didn’t need to worry about inflation.
LAS0
Price
Leve l
P0
LAS1
SAS 0
E
SAS
1
D
P
1
AD
12. The simple model abstracts from a number of important issues
such as the problem of estimating potential income. Without
knowing potential income, we cannot know whether
expansionary or contractionary policy is called for.
Y0
Y
1
0
Real Output
Chapter 25: Problems and Exercises
1.
a.
b.
c.
d.
The SAS curve will shift up since wages rise by more than the rise in productivity.
The SAS curve will shift down since productivity rises by more than the rise in wages.
The SAS curve will shift up since wages rise and productivity declines.
The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.
2.
a.
Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw
economic models as an engine of analysis, not an end in themselves.
It fits in nicely with the “other things constant” assumption since the policy relevance follows only when one
has eliminated that assumption and taken into account all the things held at the back of one’s mind.
It definitely was primarily in the art of economics since the above method is the method used in the art of
economics.
b.
c.
3.
a.
b.
c.
d.
e.
f.
4.
a.
b.
The AD curve will be steeper because a change in the price level will be offset by a change in the exchange
rate eliminating the international effect on the AD curve.
The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in
the price will not cause them to increase their expenditures. This is an example of the wealth effect not
working.
The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level
(it may even be backward bending) since the fall in the price level will cause people to shift expenditures
further out into the future.
Assuming poor people consume more than rich people, the AD curve will shift to the right.
The AD curve will shift to the right by a multiple of 20.
The AD curve will shift to the left by a multiple of 10.
An increase in the availability of inputs will shift the LAS curve to the right.
A civil war will presumably destroy productive capacity or otherwise halt production and cause a shift in the
LAS curve to the left.
Page 698, Answers to End-of-Chapter Questions
c.
d.
5.
a
b.
c.
6.
a.
To the degree that the rise in oil prices results in an overall rise in the price level, this will shift the SAS curve
up. Otherwise, other relative prices will decline to offset the rise in oil prices and the SAS curve will not shift
at all.
If wages that were fixed become flexible and aggregate demand increases, the SAS curve will shift up as
wages rise.
We would suggest that the rise in oil prices will shift
SAS 1
LAS
the SAS curve up and the drop in world income will
Price
shift the AD curve in, causing equilibrium income to
Level
fall even more below potential (to point B in the
graph on the right).
SAS 0
B
We might suggest expansionary fiscal and monetary
P
1
policy to shift the AD curve out (from AD0 to AD2)
A
and bring equilibrium income to its potential. We
P
0
would caution the government about the possible
AD 2
inflationary consequences, but since the economy is
AD
0
significantly below potential, we would argue that it
AD
1
is a risk worth taking.
A real business cycle economists would say that the
actual level of the economy is the best estimate of its
Y0
Y
Real Output
1
potential income. He would suggest that the policy
would be inflationary because it is not affecting the
real supply-side issues. If the economy were left on its own, the SAS curve will shift down below SAS 0 until
output reached its potential .
The slowing of foreign economies will reduce
exports, shifting the AD curve to the left by a
multiple of the initial decline in exports (from AD0
to AD1 in the graph below). I would recommend
that the government increase expenditures by an
amount equal to the initial decline in exports. This
will shift the AD curve back to its initial position,
as shown in the graph.
LAS
Price
Leve l
SAS
AD
0
AD
1
Real Output
b.
An economy operating above potential is shown by
point A in the graph on the right. To keep the
inflation from rising (the SAS curve from shifting
up), the government should reduce expenditures
enough (shifting the AD curve from AD0 to AD1)
to bring the economy back to long-run equilibrium
at potential output, YP, and the price level, P1, as
shown below.
LAS
Price
Le ve l
SAS
A
P
0
P
1
AD
0
AD
1
Y
P
Page 699, Answers to End-of-Chapter Questions
Y
0
Re al Output
c.
A new technology that increases potential output
will shift the LAS curve (from LAS0 to LAS1),
creating excess capacity and downward pressure on
factor prices. If left alone, the price level will fall
and real output will rise. If the government wants
to keep the price level constant, it can increase
expenditures enough to increase output to the new
potential (shifting the AD curve from AD0 to AD1).
LAS 0
Price
Le vel
LAS
1
SAS 0
P
SAS 1
0
P
1
AD 1
AD
Y
Chapter 25: Web Questions
a.
b.
2.
0
0
Re al Output
The CPI has been relatively low in the past year or so. This would suggest that the economy is at or below
potential output.
The fact that inflation is low suggests government should do nothing. If it follows expansionary fiscal policy,
it risks igniting inflation. It is possible that the war with Iraq will push the economy below potential, in which
case the government could run expansionary fiscal policy.
a-b. The level of output and price level is shown on the right.
c. Since the curve involves shifts in both the SAS curve and AD
curves, all we can say is that these are points of equilibrium
given certain assumptions. It is neither an AD nor an SAS curve.
In order to draw one or the other simplifying assumptions must
be made regarding what is held constant.
112
110
Price level
1.
P
Y
108
106
104
102
100
98
96
94
00 00 00 00 00 00 00 00 00
65 70 75 80 85 90 95 100 105
Real output
(billions of real dollars)
3.
The Consumer Confidence index fell in March 2003 after falling the previous month as well. This suggests
that the AD curve will shift to the left. Equilibrium output will likely be lower than otherwise and inflation
pressures will be weakened.
Chapter 26: The Multiplier Model
Questions for Thought and Review
1.
If planned expenditures are below actual production, income will decline. Here’s how: when planned
expenditures are below actual production, firms will see that their inventories are building up faster than
they’d like. In response, they cut production. As production falls, so does income. Consumption falls by a
fraction of the decline in income leading to a further decline in planned expenditures. This process continues
until planned expenditure equals actual production.
2.
At levels of output above equilibrium inventories are building up because planned expenditures are below
actual production. People are not buying all that is produced.
3.
The aggregate expenditures curve shifts down by the decline in autonomous expenditures.
Page 700, Answers to End-of-Chapter Questions
4.
The AE curve becomes steeper when the marginal propensity to expend increases. Equilibrium income rises.
5.
If savings were immediately translated into investment, the size of the multiplier would be infinite since
leakages from the economy would be zero. However, autonomous expenditures would no longer exist. In
short, under these conditions the multiplier model would break down.
6.
Shocks to aggregate expenditures are any sudden changes in factors that affect C, I, G, X, or M. This includes
consumer sentiment, business optimism, foreign income, and government policy. It is possible that people
could change their marginal propensities to consume and save, and this could also have an effect on the
economy.
7.
In late 2002, the government budget was in deficit and the state of fiscal policy was expansionary (lower taxes
and higher expenditures). Although taxes were lowered because of the administrations’ ideological beliefs in
lower taxes and expenditures were raised to increase national security, the policy made economic sense
because the economy had slowed and inflation was not believed to be a threat. (This answer may change as
the economy progresses.)
8.
If the mpe is 0.5, the multiplier is 2. Every $1 increase in autonomous expenditures will raise income by $2.
To close a recessionary gap of $200 the government needs to generate $100 of additional autonomous
spending. It can accomplish this by increasing government expenditures by $100.
9.
Cutting taxes by $100 has a smaller effect on GDP than increasing expenditures by the same amount because
people don’t spend the entire amount of the tax cut. The multiplier begins with the increased individual
spending resulting from the tax cut, or the mpc times the tax cut.
10.
The effects of this invention on the economy would be manifold and in many ways unpredictable because such
major shocks have social, institutional, and political effects, as well as economic effects. The obvious effect is
that the demand for the pill would likely be tremendous (after people were sure it was safe), and so production
of the pill would gear up to meet the demand. Market structure and pricing decisions will play a big role in
determining the new effect of the change. Alternative forms of transportation would suffer decreases in
demand (cars, mass transit, airplanes, etc.), and levels of production of those goods and services would adjust,
as would employment in those industries and related industries. Measured GDP might actually fall.
11.
The circular flow diagram of the economy that would more accurately describe the multiplier model would
include leakages of savings to investment that cause the diagram to pulsate as the economy continually
overshoots equilibrium in response to shocks to the economy.
12.
A mechanistic model states the equilibrium independent of where the economy has been or of what people
wanted. A mechanistic model is used as a direct guide for policy prescriptions. An interpretive model is used
as a guide that highlights dynamic interdependencies that is suggestive of the direction of the response of
aggregate output to various policy initiatives.
13.
If there is a delay, it will mean that the initial multiplier effects can be small or non-existent, and then,
suddenly, they become large and fast. Uncertain, changing, expectations can add to the ambiguity of the
model’s result.
Page 701, Answers to End-of-Chapter Questions
Chapter 26: Problems and Exercises
If the mpe is .8, then the value of the multiplier is (1/.2) or 5. If
autonomous expenditures are $4,200, the equilibrium level of
income in the economy is 5 x 4200 = $21,000. This is
demonstrated in the graph on the right.
Real expenditures
1.
AP
AE
$4,200
$21,000
a.
b.
3.
a.
b.
c.
d.
If the mpe is .66, the value of the multiplier is 3. A decrease in
autonomous expenditures of $20 will likely result in a
decrease in income of $60. This is demonstrated in the graph
on the right.
The analysis in a is graphed on the right.
Real expenditures
2.
Real income
AP
AE0
AE1
Given the mpe is 0.8 and autonomous investment has risen by
20,
Income will increase by 100 (the multiplier is 1/.2 or 5, and 5
D 20
X 20 is 100).
The multiplier is now only 2 (1/.5), and so the change in
investment causes income to change by 40.
Real income
D 60
The decrease in exports and increase in investment cancel
each other out so that autonomous expenditures in the
aggregate are unchanged.
See the graphs below. The graph on the left corresponds to (a) and the graph on the right corresponds to (b).
The graph to (c) would show the AE curve not moving at all.
AP
AE0
20
E0
100
Re al income
4.
a.
b.
c.
AP
AE1
Real expenditures
Real expenditures
E1
AE1
E1
AE0
20
E0
40
Real income
Given that the mpe is .6, I0 = 1,000; G0 = 8,000; C0 = 10,000; and (X0 - M0) = 1,000, then:
Y = 10,000 + .6Y + 1,000 + 8,000 + 1,000.
Y - .6Y = 20,000; 0.4Y = 20,000; Y = 50,000.
Thus, the level of income in the country is $50,000. (Note that Examland seems to be on a U.S. dollar
currency standard.)
If net exports increase by $2,000, income will increase by $5,000 (the multiplier is 2.5, or 1/.4).
According to Okun’s law, a one-percentage-point change in unemployment will cause a 2 percent change in
income in the opposite direction. Thus, if income has increased by $5,000, which is a 10 percent increase, then
unemployment should drop by 5 percentage points.
Page 702, Answers to End-of-Chapter Questions
If the mpe falls from 0.6 to 0.5, the multiplier decreases from 2.5 to 2. The answer to part a would now be
$40,000; the answer to part b would be $4,000; and the answer to part c is that unemployment should fall by 5
percentage points.
a.
A likely culprit was a decline in investment spending, partly due to
AP
increased bank regulation and Federal Resolution Trust Corporation
scrutiny of loans in the wake of the failed S&Ls and liquidity problems
AE0
of commercial banks in the late 1980s and early 1990s. This was
AE2
commonly known as the credit crunch, where lower interest rates failed
AE1
to increase investment spending in the early 1990s. This is shown as a
shift down of the AE curve from AE0 to AE1 and a decline in real
income.
An improvement would be graphically represented by a shift up of the
AE curve shown in the graph as the shift from AE1 to AE2 and a rise in
Real income
real income. The improvement occurred most likely as a result of
expectations of an improving economy and further reductions in
interest rates increasing consumption and investment expenditures. Government expenditures did not change
much in this period and probably did not contribute to the economic improvement.
President Bush would have had to increase government expenditures significantly to stop the slowdown, but
given the political atmosphere regarding the high deficit, and debt, it is unlikely he could have done so.
President Clinton faced the same political imperatives to decrease the size of the deficit, so he implemented
some policies designed to affect potential output (the supply side). He lowered some taxes, calling them
supply enhancing tax cuts, changed the composition of government spending calling them supply-enhancing
changes, and raised other taxes (discounting their effects on the economy).
b.
c.
d.
6.
a.
b.
c.
7.
a.
b.
c.
d.
8.
a.
b.
c.
Real expenditures
5.
d.
Given that income is $50,000, the mpe is .75:
To reduce unemployment by 2 percentage points (again, by Okun’s rule of thumb) requires a 4 percent
increase in income, which in this case is $2,000. The multiplier is 4.0, calculated as [1/(1 - mpe)]. To generate
a $2,000 increase in income, increase government spending by $500.
If the mpe is .66, the multiplier is 2.94, which means that to generate a $2,000 increase in income, government
spending would have to increase by $680.27.
If the mpe is .5, then the multiplier is 2.0, which means that to generate a $2,000 increase in income,
government spending would have to increase by $1,000.
If the mpe is .5, the multiplier is 2, because there is a recessionary gap of $800, government spending would
have to increase by $400 to bring the economy back to long-run equilibrium.
If the mpe is .8, the multiplier is 5, because there is an inflationary gap of $1500, government spending would
have to decrease by $300 to bring the economy back to long-run equilibrium.
If the mpe is .2, the multiplier is 1.25. Because there is an inflationary gap of $1,200, the government will
want to reduce expenditures by $960.
If the mpe is .7, the multiplier is 3.33. Because there is an recessionary gap of $1,500, the government will
want to reduce expenditures by $450.
If the mpe is .5, the multiplier is 2. To eliminate the inflationary gap, the government should undertake a
contractionary fiscal policy. Since the economy is $36,000 above potential, we would advise decreasing
government spending by $18,000.
Using Okun’s rule of thumb, since income falls by 6 percent, we would expect unemployment to rise by 3
percentage points to 8 percent.
The multiplier now becomes 5, so we would advise decreasing spending by $7,200. We would not change our
answer to b.
Chapter 26: Web Questions
1.
a.
b.
Consumer confidence slipped in March 2003, after having already declined in February 2003. It is now at 62.5
(1985=100) down from 64.8 in February.
Falling consumer confidence means that consumption expenditures, and hence aggregate demand will fall.
The multiplier model says that the decline in national output will be greater than the fall in aggregate demand.
Page 703, Answers to End-of-Chapter Questions
c.
d.
2.
a.
b.
Business confidence fell in the 3rd quarter of 2002 to 61. (A reading of more than 50 reflects more positive
than negative responses).
They match somewhat. Both are falling. We would therefore expect the economy to remain weak. It is unclear
what will happen to inventories. If business confidence rises before consumer confidence, inventories will rise.
On the other hand, consumption expenditures haven’t been following consumer confidence well. If consumer
spending remains strong while business cut back production, inventories will fall.
Inventories were down 0.2 percent in January 2003 from the previous month following a 0.8 rise the previous
month. Inventories are 0.1 above levels a year ago.
Falling inventories either means that consumer expenditures, and therefore aggregate demand is rising, or
production is declining (or a combination of the two). At least expenditures are outpacing output. However,
inventories are at about the same level as a year ago, suggesting production and expenditures are about equal.
It is unclear without additional data (such as sales) what this means for the direction of the economy.
Chapter 26: Appendix A
1.
We would suggest a decrease in taxes. To determine precisely how much we would need to determine what
the multiplier is. Assuming all other marginal propensities are zero, the multiplier is 5. The tax cut would
initially affect the economy by only .8 times the tax cut, so to increase output by 400, we would decrease taxes
by 100 (.8 X 100 X 5 = 400).
2.
We would recommend increasing expenditures by 80.
3.
This makes the multiplier 3.57. This means that we would increase expenditures by about 112, or cut taxes by
about 140.
4.
This makes the multiplier 2.08. This means that we would increase expenditures by about 192 or cut taxes by
about 213.
5.
Making taxes and imports endogenous reduces the size of the multiplier because they increase the leakages
from the expenditure flow. Because of taxes and imports, increases in income will lead to lower increases in
expenditures than otherwise.
This would make the multiplier = 1/(1 - c + ct + m - mt). It would be a slightly higher multiplier. (The
difference between the two assumptions is whether we are assuming government imports.)
6.
Chapter 26: Appendix B
b.
As shown in the left-hand graph below, an increase in autonomous expenditures shifts the AE curve up and
causes a movement along the AP curve to the right and results in a higher equilibrium income level twice the
shift in the AE curve.
As shown in the right-hand graph below an increase in autonomous expenditures shifts the AD curve to the
right by twice the increase in autonomous expenditures. Since the price level is fixed, Real output increases by
twice the rise in autonomous expenditures as well.
AP
AE1
AE0
Price level
a.
Real expenditures
1.
SAS curve
AD1
AD0
Re al income
Re al output
Page 704, Answers to End-of-Chapter Questions
Since prices are somewhat flexible, the rise in
expenditures is split between a rise in prices
causing a downward shift of the AE curve that is
smaller than the initial upward shift. The rise in
income is less than twice the initial shock. This is
shown in the graph an the right
.
AP
AE1
AE2
AE0
P1
P0
Y0 Y1
Re al output
Price level
In the AS/AD model, a flexible price means that
the shift in the AD curve is split between increases
in the price level and increases in real output. Real
output rises by less than the multiplier times the
increase in autonomous expenditures.
Real expenditures
c.
SAS
P1
P0
AD0
Y0
2.
a.
b.
c.
d.
Y2 Y1
AD1
Re al output
The AD curve will become steeper.
An increase in the size of the multiplier makes the AD curve flatter because the effect of changes in the price
level on aggregate demand will be augmented even more by the multiplier.
An increase of $20 in autonomous expenditures has no effect on the slope of the AD curve; it only affects its
position.
A decline in the price level disrupting the financial market will make the AD curve steeper because it
eliminates the price-level interest rate effect.
Chapter 27: Money, Banking, and the Financial Sector
Questions for Thought and Review
1.
Although financial institutions don't produce any tangible real assets, they are nonetheless considered a vital
part of the economy because of their central role in transferring savings into investment and in making the real
economy more efficient.
2. .
Money is to the economy as oil is to an engine because money is a financial asset that makes the real economy
function smoothly by serving as a medium of exchange, a unit of account, and a store of wealth. Without it,
the economy comes to a screeching halt.
3.
The three functions of money are: (1) it serves as a medium of exchange; (2) it serves as a unit of account; and
(3) it serves as a store of wealth.
4.
In order to maintain money’s usefulness and to prevent large fluctuations in the price level, the money issuer,
which in the United States is the Federal Reserve Bank, must issue neither too much nor too little money. To issue money without restraint would destroy the social convention that gives money its value.
5.
Two components of M2 that are not components of M1 are savings deposits and small denomination time
deposits.
Page 705, Answers to End-of-Chapter Questions
6.
The equation for the simple money multiplier is 1/r; the equation for the approximate real-world multiplier is
1/(r + c). Since c is positive, the simple multiplier is larger.
7.
Money doesn't have to have any inherent value to function as a medium of exchange. All that's necessary is
that everyone believes that other people will accept it in exchange for their goods. This is the social
convention that gives money value.
8.
If the U.S. government were to raise the reserve requirement to 100 percent, the interest rates banks pay to
depositors would decrease and possibly even become negative (you’d have to pay to have the bank handle
your money), because significant opportunities for profitable loans would be lost.
9.
A benefit of government guarantees is that it prevents inappropriate panic about a bank’s ability to pay back
its obligations; a cost of government guarantees is that it prevents appropriate panic about a bank’s ability to
pay back its obligations.
10.
What brought the S&Ls down were bad loans, particularly in real estate. The reasons that S&Ls made those
bad loans are complex. Government deregulation in the 1980s expanded the kinds of loans S&Ls could make
and the ways they could compete for deposits. Due to moral hazard and perverse incentives (government, not
the bank managers, would have to pay if the S&L went down), S&Ls made risky loans and paid high interest
on their deposits. When the real estate market soured, the S&Ls’ net worth crumbled and the government had
to step in to bail out depositors.
11.
Panics occur when depositors lose faith in a bank and all try to take their funds out at once. The U.S. banking
system is less susceptible to panics because the government guarantees the obligations of various financial
institutions. Panics may still occur if the government is perceived as unwilling or unable to live up to those
guarantees.
12.
To be considered money, the currencies would have to fulfill the functions of money. They only partially
fulfill those functions since they have only limited acceptability as a medium of exchange, store of value, and
unit of account. Thus, while they are partial moneys, we would not consider them full moneys.
Chapter 27: Problems and Exercises
1.
a.
b.
2.
If individuals hold no cash, the simple money multiplier is the reciprocal of the reserve requirement. Thus for
the following reserve requirements the simple multiplier is found by dividing the requirement percentage into
1: 5%, 20; 10%, 10; 20%, 5; 25%, 4; 50%, 2; 75%, 1.33; 100%, 1.
If individuals hold 20% of their money in the form of cash, the multiplier becomes (1)/(r + c) and so for the
following reserve ratios their multipliers are now: 5%, 4.0; 10%, 3.33; 20%, 2.5; 25%, 2.22; 50%, 1.43; 75%,
1.05; 100%, 0.83.
a.
b.
c.
d.
For a deposit of $100 and a reserve ratio of 5 percent,
The bank can lend out $95.
There is now $195 of money.
The multiplier is 20.
John’s $100 will ultimately turn into $2,000.
3.
a.
Neither
4.
a. money b. not money
g. not money
5.
a.
b.
c.
b. Both
c. M2
d. Both
c. not money
e. Neither
d. not money
f. Neither
e. money
g. Both
f. not money
Nothing happens to M2. M1 declines by $200
Nothing happens to M1 or M2
Nothing happens to M2, M1 rises by $50
Page 706, Answers to End-of-Chapter Questions
d.
Nothing happens to M1 or M2.
Chapter 27: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
d.
e.
Evocash is an alternative to money that aims to become globally acceptable. Its main purpose is to facilitate
Internet transactions. You must purchase evocash at a rate of $1 = 1 evo. You spend evo by selecting
“evocash” as payment for the purchase of a good at Internet vendors.
Currently, evocash is not as liquid as dollars. It will take time before it can be used as a generally acceptable
medium of exchange. However, it does fulfill the three functions of money as far as the websites where
evocash is accepted are concerned.
Evocash is money in the sense that it has the potential to fulfill the functions of money if people start believing
that others will accept it in exchange for their goods.
There is about $575 billion of U.S. currency in circulation today but most of it resides outside of the U.S.
Assuming that the world population is about 6 billion, this means that there is approximately $95 per person in
the world.
People typically withdraw cash at ATMs over the weekend, so there is more cash in circulation on Monday
than on Friday.
1.5 years.
Most of this is in the form of U.S. Government Securities owned by the Federal Reserve System. Some of it
also consists of gold certificates, special drawing rights, and “eligible” paper such as bills of exchange or
promissory notes.
Bureau of Engraving and Printing.
Chapter 27: Appendix A
1.
Students gain a financial asset and the government incurs a financial liability.
2.
It is a financial asset because it has value due to an offsetting liability of the Federal Reserve Bank.
3.
No. In economic terminology he is saving. Investing is the act of spending the money on real investment
goods in economic terminology.
4.
No, she is not correct. While a loan is a loan, that loan is a financial asset to the one issuing the loan because it
has value just as a bond does.
5.
$4.35.
6.
$0.50
7.
$2,000 five years from now is worth $1568 today. Take the $2,000 five years from now.
8.
9.
a.
b.
c.
Market rates are above 10 percent because its price is below face value.
Its yield is 12.24 percent.
Its price will rise.
As interest rates rise, it would take less money now to invest to get a return that would equal $100 10 years
from now.
10.
Substituting into the present value formula PV = $1,060/1.1, we find that the bond is worth $964 now.
11.
Using the annuity table, we find that a dollar a year for 40 years with a 6 percent interest rate is worth $15.05 now.
Thus $100 would be worth $1,505.
12.
Using the present-value table, we see that at a 3 percent interest rate, $1 30 years from now would be worth
$0.41; $200 would be worth $82 now.
Page 707, Answers to End-of-Chapter Questions
13.
Since we're not sure how long your expected lifetime is, we can use the annuity rule which says that the
present value of an annuity is the flow of income divided by the interest rate, which in this case would be
$200/.09 = $2,222.22. You should be willing to pay no more than $2,222.22 for that annuity. The amount you
are willing to pay does depend on your expectations about future changes in the interest rate; if you expected
the interest rate to decline in the future, you would be willing to pay more than $2,222.22.
14.
If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 10 years can be calculated using the
annuity table in Table A27-1. You should be willing to pay $20,000 X 0.42, or about $8,400 for this offer.
15.
To find the present value of a perpetuity of $100 per year, use the annuity rule, which says that the present
value is equal to the amount of the cash flow divided by the interest rate. Thus the present value will be: $1000
if the interest rate is 10 percent; $2000 if the interest rate is 5 percent; $500 if the interest rate is 20 percent.
Using the same interest rates, the future values of $100 are: $110 in one year, and $121 in two years at 10
percent $105 in one year, and $110.25 in two years at 5 percent $120 in one year, and $144 in two years at 20
percent
Using the rule of 72, your money will double in: about 7.2 years at 10 percent, about 14.4 years at 5 percent,
about 3.6 years at 20 percent.
a.
b.
16.
An investment bank facilitates borrowing. It does not take in deposits and often does not make loans. A
commercial bank takes in deposits and makes loans.
17.
False. The difference has nothing to do with which is more important. The difference is that in primary
markets new issues are sold and in secondary markets existing stocks and bonds are resold. The secondary
market is much larger.
18.
The prospects must not be very good, or the interest rate must be extremely high. Generally, stocks sell for a
minimum of multiples of 10 or 12 times earnings. This multiple can be roughly determined by dividing the
expected earnings (the annuity) by the interest rate. More recently, the average price/earnings ratio has been
30, a historically high figure.
19.
On the surface it might seem that the primary market contributes more to the production of tangible real assets
because it is here that new firms find the financing for their ideas. A secondary financial market only transfers
existing financial assets from one saver to another, and such a transaction does not represent any new savings.
However, the existence of a secondary market plays an important role in enticing people to buy in the primary
market because it makes their financial asset more liquid, and, hence, more valuable. Thus on a deeper level it
is hard to say which contributes more.
20.
Money market assets usually pay lower interest rates than do longer-term capital assets because they offer the
buyer more liquidity and less risk of asset value fluctuation.
21.
a.
b.
c.
d.
e.
f.
Asset
Liability
Market
Lamar
Credit Union
money
Pension USA
Sandra
capital
First bank initially held the asset, but then FNMA held it. Finally, Pension USA held it as owner of share in
FNMA mortgage fund. All along it was a liability to Sandra.
Asset
Liability
Market
First Bank
Sean
money
residents of
Providence
Providence
capital
Lanier
the firm
capital
No financial asset has been created, it has just changed hands.
Asset
Lanier
Liability
the firm
Market
capital
Page 708, Answers to End-of-Chapter Questions
22. a.
b.
c.
d.
e.
Technically, a rise in stock prices does not imply a richer economy. If, however, the rise in stock prices
reflects underlying real economic improvement such as finding the cure for cancer or a technological advance,
society will be richer not because of the rise in stock prices, but because of the underlying cause of their rise.
We disagree with this statement. If both the real and financial asset are worth $1 million, then they have the
same value as long as they are valued at market prices. Just as financial assets bear a risk of no repayment, real
assets bear a risk of a fluctuation in prices.
Although financial assets have a corresponding liability, they facilitate trades that could not otherwise have
taken place and thus have enormous value to society.
This is false. The value of an asset depends not only on the quantity but also on its price per unit. The price of
land per acre in Japan exceeds that in the United States by so much that the total value of land in Japan also
exceeds that in the United States.
This is false. The stock market valuation depends on the supply and demand for existing stock. There is,
however, a relationship between relative growth in GDP and the rise in stock prices to the extent that growth
in stock prices and GDP growth both reflect economic well-being in a country. Also, many of the companies
are multinational companies, and where the company is based may not reflect where its value added is
generated.
Chapter 27: Appendix B
1.
2.
Starting with the initial balance sheet:
Assets
Cash
20,000
Loans
225,000
Phys assets
105,000
Total
350,000
Liabilities & Net Worth
Demand dep 200,000
Net worth 150,000
Total 350,000
a.
If an immigrant enters the country and deposits $10,000 in a bank the result is:
Assets
Liabilities & Net Worth
Cash
30,000
Demand dep
210,000
Loans
225,000
Net worth
150,000
Phys assets
105,000
Total
360,000
Total
360,000
b.
If the bank keeps 10% of this deposit and lends the rest, the result is:
Assets
Liabilities & Net Worth
Cash
21,000
Demand dep
210,000
Loans
234,000
Net worth
150,000
Phys assets
105,000
Total
360,000
Total
360,000
c.
80% of the loan amount ($9000) gets deposited back in the bank, and the result is:
Assets
Liabilities & Net Worth
Cash
28,200
Demand dep
217,200
Loans
234,000
Net worth
150,000
Phys assets
105,000
Total
367,200
Total
367,200
d.
After the money multiplier is all through multiplying, the initial $10,000 will have become $40,000 (if
everyone deposits 80% of what they receive back into the bank), and the final balance sheet will be:
a.
The effect on the balance sheet is shown below:
Assets
Liabilities
Cash $
10,000
Demand deposits
-1,000
9,000
Loans
100,000
Net worth
$50,000
-1,000
49,000
110,000
Page 709, Answers to End-of-Chapter Questions
Physical assets 50,000
Total assets $159,000
b.
3.
Total liabilities and
net worth
$159,000
c.
d.
The reserve ratio is now 18 percent. This is less than the required 20 percent. The bank must decrease loans by
$800 to meet the reserve requirement. But this shows up as $800 less in demand deposits and $800 less in
cash. The bank must again reduce loans, but this time by $640. Demand deposits once again decline. This
continues until the final position indicated by the following T-account:
Assets
Liabilities
Cash
$ 9,000
Demand deposits
$ 45,000
Loans
96,000
Net worth
110,000
Physical assets 50,000
Total assets $155,000
Total liabilities and
net worth
$155,000
The money multiplier is 5.
Total money supply declined by $5,000.
a.
b.
The bank is holding $7500 in excess reserves.
$50,000 new money would be created: (1/0.15) * 7,500.The final T-account is shown below:
Assets
Cash
Loans
Phys. assets
Total Assets
30,000
370,000
350,000
750,000
Liabilities
Demand deposits
Net worth
200,000
550,000
Total Liabilities and net worth
750,000
Chapter 28: Monetary Policy and the Debate about Macro Policy
Questions for Thought and Review
1.
The Fed is a semi-autonomous agency of the federal government. Although it is owned by member banks, its
officials are appointed by government. It is a creation of Congress, but has much more independence than do
most public agencies.
2.
There are few regional Fed banks in the western part of the United States because in 1913, when the Fed was established, the West and South were less populated and less important economically than the rest of the
country. As these regions grew, the original structure remained because no one wanted to go through the
political wrangling that restructuring would bring about.
3.
Six explicit functions of the Fed include: 1) conducting monetary policy; 2) supervising financial institutions;
3) serving as a lender of last resort; 4) providing banking services to the U.S. government; 5) issuing coin and
currency; and 6) providing financial services to commercial banks.
4.
Three tools by which the Fed can affect the money supply are: (1) changing the reserve requirement, which
changes the amount of reserves banks keep and thereby changes the money supply; (2) changing the discount
rate, which changes the cost of borrowing by banks from the Fed and thereby changes the money supply
(actually, it works more as a signal); and (3) open market operations, which change reserves as the Fed buys
and sells bonds, and thereby changes the money supply.
5.
When the Fed buys bonds the price of bonds rises and the interest rate falls.
6.
The Fed funds rate is the interest rate that banks charge one another for Fed funds or reserves. As the Fed buys
and sells bonds, it changes reserves and thereby directly affects this short-term overnight interest rate. Other,
longer-term interest rates, such as the Treasury bill rate, are only indirectly affected.
Page 710, Answers to End-of-Chapter Questions
7.
Defensive policies are simply changes to offset fluctuations in the demand for money. Therefore a change in
the direction of monetary policy would be an offensive action.
8.
When the Fed takes money out of the economy, banks are in violation of Fed regulations and have no choice
but to contract their loans in order to meet their reserve requirements. When the Fed puts money into the
economy, banks have excess reserves but there is no regulation that they are violating. Although they may
have a financial incentive to make loans, they are not required to do so. Since they are not required to make
loans, the saying “You can lead a horse to water, but you can’t make it drink” is relevant.
9.
To increase income by 240, investment should increase by 80 (the income multiplier is 3). To increase
investment by 80 requires decreasing the interest rate by 4 percentage points (investment increases by 20 for
every 1 percentage point drop in interest). To change the interest rate by 4 requires a change of 20 in the
money supply (each change of 5 in the money supply changes the interest rate by 1 percent). Since the money
multiplier is 4, reserves should increase by 5. Thus the recommended policy is an open market purchase that
would increase reserves by 5.
10.
The nominal interest rate is equal to the real interest rate plus the expected inflation rate. If the nominal
interest rate is 6 percent and the expected inflation rate is 5 percent, the real interest rate is 1 percent.
11.
If we consider the example of an open market sale by the Fed, the initial transaction or "splash" would be that
a person writes a check to the Fed, and the Fed presents it to the person's bank for payment. The bank now
must adjust to this change, and the "ripples" will show up on its balance sheet. The loss of cash to the Fed
means that the bank's reserves are too low, and the bank must figure out a way to meet its reserve requirement.
It may call in loans to do so, but that in turn could mean that someone paid the loan from a checking account,
which has further balance sheet implications.
12.
Treasury bills pay interest; cash does not.
13.
From 1999 to 2000 the Fed tightened slightly. The Fed loosened monetary policy considerably from 2000 to
2002.
14.
The Taylor rule suggests that the Fed will target a Fed funds rate of 5.5 percent [2 + 3 + .5(1) + .5(0)].
15.
The tools of monetary policy are those things over which the Fed has direct control such as the open market
operations. These tools have a direct effect on operating targets such as the Fed funds. These operating targets,
in term will affect intermediate targets such as consumer confidence. It is these intermediate targets that then
impact the Fed’s ultimate targets—prices, growth and employment. Because the Fed cannot directly control its
ultimate targets, Fed must rely on adjusting its tools to try to achieve its ultimate targets.
Chapter 28: Problems and Exercises
1.
In each case, expansionary monetary policy shifts the AD curve to the right. The difference is whether the
shift results in an increase in real output, an increase in the price level, or a combination of the two.
Page 711, Answers to End-of-Chapter Questions
a.
In the short run, when the economy is significantly below
potential, the shift of AD curve to the right from AD0 to AD1
will increase both real output and the price level. Because the
economy is below potential, there are no cost pressures to shift
the SAS curve up. The economy moves from point A to point
B (output rises to Y1 and the price level rises to P1) in the
graph on the right.
LAS
Price
Level
SAS
B
P
1
A
P0
AD1
AD 0
Y0
b.
When the economy is significantly above potential, the effect
of the shift of the AD curve to the right is entirely on the price
level, not real output. As the AD curve shift to the right, cost
pressures rise immediately, shifting the SAS curve up so that
real output doesn’t change at all, only the price level rises.
Graphically this can be shown as an economy moving from
point B to point C in the graph below. The AD curve shifts
from AD0 to 1, but the SAS curve shifts up from SAS0 to
SAS1 so that output remains at Y0 while the price level rises to
P 1.
Price
Leve l
C
a.
b.
c.
3.
a.
b.
4.
a.
b.
c.
5.
a.
b.
c.
d.
6.
a.
Real Output
1
SAS 1
SAS
0
P
1
P0
AD
A
1
AD 0
Y0
2.
Y
LAS
Real Output
If people hold no cash, the money multiplier is 1/r. If this is equal to 3, then the current reserve requirement is
33 percent. To increase the money supply by 200, the Fed should lower the reserve requirement to 32 percent.
Lowering the discount rate will encourage banks to borrow. This will increase the amount of reserves in the
system so that the money supply increases. If the Fed wishes to increase the money supply by 200, and the
multiplier is 3, reserves must be increased by 66.67. If banks will borrow an additional 20 for every point the
discount rate is lowered, the Fed should lower the rate by 3.33 percentage points.
To increase the money supply by using open market operations, the Fed should buy bonds, thus increasing the
level of reserves in the banking system. To achieve an increase of 200 (if the multiplier is 3) the Fed should
buy 66.67 worth of bonds.
Decreasing the reserve requirement from 20 percent will provide banks with excess reserves and will increase
the multiplier. To calculate exactly how much we would need to know the current money supply.
The Fed would buy $400,000 worth of bonds, increasing reserves, and so increase the money supply.
Increasing the reserve requirement would lower the multiplier, calculated as [l/(r + c)]. To calculate exactly
how much, we would need to know the current money supply.
The money multiplier is [l/(r + c)] = 2.5. If the Fed sold $800,000 worth of bonds it would decrease reserves
and so decrease the money supply by
$2 million.
This part of the question requires information from a local bank. Reevaluate a and b in view of this information.
The money multiplier, assuming no cash holding, would be one.
The money supply would decrease enormously.
This could be offset by the Federal government buying up Treasury bills, directly increasing the money supply
or by the Federal government making loans directly.
Since this eliminates a significant role of banks as lenders, eliminating a market within which they receive at
least a normal profit they would most likely oppose it.
This would increase excess reserves enormously.
Page 712, Answers to End-of-Chapter Questions
b.
c.
d.
7.
a.
b.
c.
8.
a.
b.
c.
Banks would most likely favor this proposal because they would now earn interest on their assets held at the
Fed.
Central banks would likely oppose this because it would reduce their superiority and may require that they ask
Congress for appropriation to pay the interest, reducing their political independence.
This would increase the interest rate paid by banks because the additional interest would increase their profit
margin. The initial increased profit margin would shift the demand for depositors out as new banks entered the
market and as existing banks competed for more deposits. This would increase the interest paid to depositors
until the normal profits are once again earned.
The Taylor rule is that the Fed funds target is 2 + current inflation + ½(inflation target-actual inflation) +
½(percent output deviates from potential output).
Fed funds rate target will be 3.5 percent [2 + 2 + ½ (1) + ½ (-2)].
Fed funds rate target will be 7.5 percent [2 + 4 + ½ (2) + ½ (3)].
Fed funds rate target will be 5.5 percent [2 + 4 + ½ (1) + ½ (-2)].
Since the money multiplier is 2.5, we would issue a directive for the Fed open market window to buy 24 worth
of government bonds.
We could have also reduced the discount rate and lowered the reserve requirement, although by how much
cannot be determined with the information given.
Using the quantity theory, we would predict that the price level would rise because of the increase in the
money supply.
Chapter 28: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
Alan Greenspan is chairman. He has been the chairman since August 11, 1987.
The seven members are Alan Greenspan, Roger W. Ferguson, Jr., Edward M. Gramlich, Susan Schmidt Bies,
Mark W. Olson, Ben S. Bernanke, and Donald L. Kohn.
All of them have an economics bachelor’s degree, a Ph.D. in economics and/or a MBA degree. Some of them
have held posts in private consulting firms, and most of the have had prior experience in public economics
related commissions and committees.
According to the Beige Book of November 2002, the economy grew slowly—retail sales were slightly higher
and manufacturing was soft. Inflation has been non-existent.
The most recent FOMC action was a reduction in the Fed funds rate by 50 basis points on November 6, 2002.
Because the economy shows signs of recovery, the Fed will likely keep the Fed funds rate at 1.25 percent in
the near term, but will stand ready to raise rates if inflationary pressures build.
Chapter 28: Appendix A
1.
Since the question does not indicate an initial bank balance sheet, let’s assume an initial bank balance sheet
shown below.
Assets
Reserves
T-bill holdings
Loans
Total Assets
Initial Bank Balance Sheet
Liabilities
100,000,000
Demand deposits
0
Net worth
905,000,000
1,005,000,000
Total Liabilities
1,000,000,000
5,000,000
1,005,000,000
First, individuals buy $1 million T-bills from the Fed, by withdrawing $1,000,000 from the bank leaving the
bank with no reserves.
Page 713, Answers to End-of-Chapter Questions
Assets
Reserves
T-bill holdings
Loans
Total Assets
99,000,000
0
905,000,000
1,004,000,000
Liabilities
Demand deposits
Net worth
Total Liabilities
999,000,000
5,000,000
1,004,000,000
To meet its reserve requirement the bank must call in $900,000 in loans. These loans are repaid by individual
withdrawals of demand deposits of $900,000.
Assets
Reserves
loans repaid
deposits withdrawn
T-bill holdings
Loans
Total Assets
99,000,000
+900,000
-900,000
0
904,000,000
1,003,000,000
Liabilities
Demand deposits
Net worth
Total Liabilities
998,000,000
5,000,000
1,003,000,000
Again the bank calls in loans to meet reserve requirements. Each round, the amount called in gets smaller and
smaller until the bank arrives at its final position with money supply having fallen by 10,000,000.
2.
Let’s assume the following initial bank balance sheet:
Initial Bank Balance Sheet
Assets
Liabilities
Reserves
$100,000,000
Demand deposits
T-bill holdings
0
Net worth
Loans
905,000,000
Total assets
$1,005,000,000
Total liabilities
$1,000,000,000
5,000,000
$1,005,000,000
First, individuals sell $2 million in T-bills to the Fed, and deposit the $2 million in the bank. The bank now
has more reserves than is required:
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,002,000,000
T-bill holdings
0
Loans
905,000,000
Net worth
5,000,000
Total liabilities
$1,007,000,000
Total assets
$1,007,000,000
It has excess reserves of $1.8 million, which it lends out. These loans are redeposited at the bank as demand
deposits:
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,002,000,000
Loans given
-1,800,000
New deposits
+1,800,000
New deposits
+1,800,000
T-bill holdings
0
Net worth
5,000,000
Loans
906,800,000
Total assets
$1,008,800,000
Total liabilities
$1,008,800,000
It still has excess reserves of 1.62 million, which it lends out. Each round, the amount called in gets smaller
and smaller until the bank arrives at its final position with money supply having risen by $20 million.
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,020,000,000
T-bill holdings
0
Net worth
5,000,000
Loans
923,000,000
Total assets
$1,025,000,000
Total liabilities
$1,025,000,000
Page 714, Answers to End-of-Chapter Questions
Chapter 29: Inflation and Its Relationship to Unemployment and Growth
Questions for Thought and Review
1.
Lenders lose out because they are paid a fixed nominal interest rate. They would not lose out if the interest rate
were indexed to inflation or if the lender was able to adjust the interest rate periodically.
2.
Adaptive or extrapolative expectations.
3.
2 percent.
4.
The real interest rate is 5 percent: Real interest rate = Nominal interest rate - Inflation.
5.
The Fed cannot target nominal interest rates less than 0, so a deflation will set a floor on real interest rates, in
this case 2 percent.
6.
The three assumptions are that velocity is constant, real income is independent of the money supply, and the
direction of causation is from money to prices.
7.
Inflation will be 10 percent.
8.
Financial institutions have changed enormously and financial markets have become increasingly connected
internationally, increasing the flow of money among countries.
9.
Developing countries. In those countries the money supply is growing so quickly it dominates any other
factors that might affect the relationship.
10.
Governments and central banks sometimes increase money supply even when they know the consequences
because sometimes the political ramifications of not increasing the money supply (which can include a
collapse of government) are thought to be worse.
11.
An inflation tax is an implicit tax on the holders of cash and the holders of any obligations specified in
nominal terms. The holders of cash and the holders of any obligations specified in nominal terms pay the tax.
12.
Quantity theorists are more likely to support rules because they have less trust in government undertaking
beneficial actions. Rules limit those actions.
13.
From right to left. (Money to the price level.)
14.
The insider/outsider theory of inflation divides workers into insiders and outsiders. It is an example of an institutionalist theory of inflation, which says that social pressures prevent economic pressures from working. In it,
insiders push up wages and outsiders find themselves experiencing unemployment. So there is little pressure
on insiders not to raise wages. It is an institutionalist theory.
15.
The quantity theory emphasizes control of the money supply; institutionalist theories also require control of
the money supply, but they have other methods such as labor market structural changes or income policies that
are used in conjunction with control of the money supply.
16.
Alfred Marshall would say that it is impossible to separate the roles of supply and demand in influencing price
and that therefore we cannot distinguish between cost-push and demand-pull inflation.
17.
The short-run Phillips curve is illustrated on page 696 of the text in Figure 29-3(a). The short-run curve shows
the trade-off between inflation and unemployment when expectations of inflation are constant. The long run
Phillips curve is shown in Figure 29-4(b) as the vertical curve. The long-run curve shows the trade-off (or lack
thereof) when expectations of inflation equal actual inflation.
Page 715, Answers to End-of-Chapter Questions
18.
No, as long as expectations of inflation are constant, the economy will stay on the same short-run Phillips
curve.
19.
It depends. With short-run, long-run, and shifting curves, just about any combination of inflation and
unemployment rates can fit some Phillips curve. So, yes, the Phillips curve is a figment of economists'
imaginations. But then again, aren't all models simply structures imposed on reality and doesn't reality only get
interpreted through imaginary imposed structures? If so, to suggest that the Phillips curve is "nothing but a
figment" is incorrect. Reality is itself a figment of imagination. (If you follow this answer, you might consider
shifting to a philosophy major.)
20.
Economists see a trade-off between inflation and growth because low inflation reduces price uncertainty and
thereby encourages investment, increasing the efficiency of the market system.
Chapter 29: Problems and Exercises
a.
b.
c.
d.
e.
2.
a.
b.
c.
3.
a.
b.
c.
d.
Use the equation, MV = PQ. Real output is $2,000.
Nominal output is $4,000.
If the money supply rises from 500 to 600, the price level will rise from 2 to 2.4.
If the government established price controls, either shortages would result if the economy were perfectly
competitive, or real output would rise if the economy had monopolistic elements.
We would look at the empirical evidence, and see whether it has remained constant in the past when similar
circumstances have prevailed.
The economy is at point A on short-run and
LP
long-run Phillips curve on the graph on the
right.
B
C
The answer to this question really hinges on
what kind of change would be popular. Should
you try to cut unemployment further? If so,
A
5%
then we would recommend increasing
SP (Pe > 5%)
government expenditures, moving the
SP (Pe = 5%)
economy to a point such as B in the graph on
the right. Or would a better strategy be cutting
5%
inflation? If so, then we would recommend
reducing government expenditures, which will
Une mployme nt rate
increase unemployment while reducing
inflation.
We have chosen the “lower unemployment” option. An increase in aggregate expenditures will cause a
movement up along the short-run Phillips curve. Unemployment will fall, but inflation will rise. In the long
run, as expectations of inflation adjust to actual inflation, the short-run Phillips curve shifts up. Unemployment
returns to its target rate of 5 percent, but inflation is higher than before, as shown as point C on the graph.
Inflation
1.
Stopping inflation tends to transfer money from debtors to creditors. Creditors are generally rich, and can golf
regardless of their wealth. Debtors, faced with a decrease in their wealth, must cut back on discretionary
expenditures, of which golf is one.
Since the exchange rate was fixed, any differential in inflation rates between the two countries could not be
offset a change in the exchange rate. The fact that goods in dollar equivalent pesos in Argentina were higher
than in NYC suggests that the Argentinean inflation rate remained greater than in the U.S. and the high prices
of goods were serving as an anchor on the economy.
In an inflation (with interest rates falling behind inflation), people look for real assets to buy to protect their
wealth. This increases the demand for goods relative to services increasing their price. When the inflation is
stopped, the opposite occurs.
One reason why luxury auto dealers were shutting down was the same as the argument given in (a). A second
reason is equivalent to that given in (c). A third reason is that wealthy Argentineans who would most likely
purchase such a car also probably had foreign bank accounts denominated in dollars. The car in dollars was
Page 716, Answers to End-of-Chapter Questions
cheaper because the peso was overvalued at the fixed exchange rate. The demand for luxury cars fell as
Argentineans substituted dollar-denominated luxury cars for peso-denominated cars.
The advantage of indexing grades is that it provides a benchmark with which to measure a student’s performance in his or her class. It would distinguish between an A received in a difficult class in which many did
not receive A’s and an A earned in an easy class in which A’s were plenty. The disadvantage is that it would
not distinguish between an A earned among A’s in a class where A’s were given generously without work and
an A earned among A’s in a class of geniuses. It might result in professors making distinctions among bright
students whose abilities are virtually the same just to make a given distribution of grades.
4.
5.
a.
b.
c.
One would expect real output to decline.
One would expect unemployment to rise.
One would expect inflation to fall.
6.
a.
He would likely be a quantity theorist since quantity theorists see inflation most connected to long-term
growth because low inflation means that the informational job of prices is working better and more investment
will take place.
Inflation can affect household decisions in a number of ways. It can add uncertainty about the future, leading
them to save less. Alternatively, it could lead them to temporarily supply more labor than they would
otherwise, causing a temporary spurt in growth and then a fall in growth once they recognize their mistakes.
b.
7.
a.
b.
c.
Answers may differ. Five goods we buy frequently are newspapers, soda, gas, shirts, and coffee.
This requires research by the student. Answers will depend on goods chosen.
Answer will depend on good chosen.
Chapter 29: Web Questions
1.
Year
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
M1 billions
140.38
140.31
143.05
146.48
150.93
156.80
163.47
170.96
177.67
190.13
201.42
209.12
223.17
239.05
256.35
269.20
281.44
297.19
319.98
346.31
372.71
395.75
424.88
453.00
503.17
538.65
587.00
666.51
GNP billions
507.43
527.38
545.63
586.53
618.68
664.38
720.10
789.30
834.08
911.45
985.35
1039.68
1128.60
1240.43
1385.55
1501.00
1635.18
1823.93
2031.40
2295.88
2566.38
2795.55
3131.35
3259.23
3534.95
3932.75
4213.00
4452.85
Velocity
3.61
3.76
3.81
4.00
4.10
4.24
4.41
4.62
4.69
4.79
4.89
4.97
5.06
5.19
5.41
5.58
5.81
6.14
6.35
6.63
6.89
7.06
7.37
7.19
7.03
7.30
7.18
6.68
Page 717, Answers to End-of-Chapter Questions
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
b.
c.
d.
2.
a.
b.
c.
d.
743.63
774.98
782.47
811.07
859.53
966.36
1079.00
1145.48
1143.10
1106.32
1069.88
1080.71
1102.44
1104.05
1136.98
1185.18
4742.48
5108.33
5489.05
5803.25
5986.23
6318.95
6642.33
7054.30
7400.55
7813.18
8300.73
8759.95
9256.15
9824.60
10082.20
10387.5
6.38
6.59
7.01
7.16
6.96
6.54
6.16
6.16
6.47
7.06
7.76
8.11
8.40
8.90
8.87
8.76
One dollar in 1960 supported approximately $3.8 in total income. This rose to about $5.0 in 1970, and $7.1 in
1980. By 1990, one dollar circulated enough to support approximately $7.2 in total income and in 2000 it
supported $8.9 in total income.
As can be seen the velocity of money has on average been rising over the last couple of decades.
The quantity theory of money assumes that the velocity of money is constant. This is obviously not the case as
can be seen by the above chart. Thus, this theory will not be able to predict accurately the growth in nominal
GDP due to the growth of the money supply.
The article suggests that there is an inverse relationship between the two (i.e. as interest rates rise, inflation
falls).
The article emphasizes the quantity theory viewpoint since it says that changes in interest rates (due to changes
in money supply) will lead to changes in the inflation rate.
The Fed has to estimate the state of the economy and then make decisions regarding interest rates.
The terrain could include variables like production, employment, consumer expenditures and their
expectations etc.
Chapter 30: Aggregate Demand Policy in Perspective
Questions for Thought and Review
1.
Franklin D. Roosevelt's statement was made during the Depression of the 1930s, which was partly caused by
people getting scared and cutting back their spending. The multiplier then took over and turned that decrease
into a much larger decrease. To get the multiplier working in reverse, and so countershock the economy, the
government would have had to get people to spend more than they wanted to; hence Roosevelt's attempt to
calm people's fears and to encourage them to spend.
2.
If the economy has a recessionary gap, the following trade policies can be adopted: (1) An export-led growth
policy in which the country lobbies to remove other countries’ restrictions on its exports. (2) Allowing its
currency to depreciate, which means that the exchange rate of its currency relative to other currencies should
fall.
3.
To offset a cut in taxes, the U.S. government should implement a policy that reduces net exports by the mpe
times the tax cut such as instituting new or higher tariffs.
4.
The budget process begins a year and a half before the budget is implemented, making it difficult to know
what type of fiscal policy will be needed. In addition, many budget decisions are made for political reasons
(few politicians would vote for a tax increase in an election year even if such an increase were needed).
Finally, nearly two-thirds of the budget is mandated by federal programs and cannot be easily changed.
Page 718, Answers to End-of-Chapter Questions
5.
State balanced budget requirements are procyclical because during downturns, tax revenue generally fall,
making it necessary for state governments to raise tax rates and cut expenditures in order to maintain a
balanced budget. Such actions slow the economy even further. The opposite is true during expansions: tax
revenues rise so that states accumulate surpluses. They cut tax rates and increase expenditures, contributing
even to a greater expansion.
6.
Automatic stabilizers work to reduce taxes and raise expenditures during contractions (and do the opposite
during expansions) without additional government action. They therefore act to offset contractions. Likewise,
however, during recoveries, automatic stabilizers increase taxes and reduce expenditures, which act to slow
the recovery.
7.
Three alternatives to monetary and fiscal policy are directed investment policies, autonomous consumption
policy, and trade policy.
8.
If interest rates have no effect on investment, there would be no crowding out. Crowding out occurs when the
government’s sale of bonds to finance expansionary fiscal policy causes interest rates to rise, choking off
private investment.
9.
Increasing government spending shifts out aggregate demand and thereby increases income. This makes
people better off in the short run and more likely to vote for them. The exception would be if the economy is
beyond potential income and there is a significant inflation threat.
10.
Increasing taxes shifts the aggregate demand curve in to the left, decreasing income and making people less
likely to vote for them. The maxim holds because people tend to have short memories.
11.
Monetary policy is considered the more effective tool since politically fiscal policy has proven almost
impossible to use due to the time lag.
12.
Policies followed now affect expectations of future policies, and those expectations can affect how the
economy operates. By thinking about policy as a process, not a one-time event, policymakers can take these
effects into account.
13.
A policy regime is a contingent rule about how policy makers will respond to different events; a policy is a
one-time action that does not consider policy as a process.
Chapter 30: Problems and Exercises
1.
a.
b.
c.
d.
e.
If the mpe is .8, the multiplier is 5. Every one-dollar increase in autonomous expenditures will raise income by
five dollars. To close a recessionary gap of $400 the government needs to generate $80 of additional
autonomous spending. It can accomplish this by increasing government expenditures by $80.
If the government wishes to achieve the same end by changing taxes, it should decrease taxes by $100. This
will generate $80 of additional autonomous spending. Again, with a multiplier of 5, this will cause a $400
increase in aggregate income.
If there is a marginal tax rate of 0.2 (instead of taxes being exogenous), the multiplier is [1/(1 - c + (c ( t))] or
[1/(1 - .8 + (.8)(.2))], which is equal to 2.77. With regard to your answers to parts a and b, the government
must generate added expenditures of $144.40 to close the recessionary gap, either through an increase in
government spending of that amount (part a) or a decrease in taxes of $180.50 (part b).
With a marginal propensity to import of .2 the multiplier changes to [1/(1 - c + ct + m)] or [1/(1 - .8 +.16 +.2)]
which is equal to [1/.56] or 1.79. With this multiplier, to close a recessionary gap of $400 the government
would have to generate $224 in new expenditures, either through an increase in government spending of that
amount or a cut in taxes of $280.
The graph on the left below shows the shift in the AE curve resulting from an increase in government
expenditures of $80 or a reduction of taxes of $100 when the mpe and mpc are .8. The graph on the right
shows the shift in the AE curve necessary to close the recessionary gap when the marginal tax rate is .2.
Notice that the slope of the AE curve is smaller (.64). The AE curve must shift up by more to achieve the same
Page 719, Answers to End-of-Chapter Questions
increase in output. Finally, the AE curve for part d has an even smaller slope (.44) shown below the first two
graphs. Here the AE curve must shift up by even more.
Real expenditures
AP
Real expenditures
AP
AE1
AE0
AE1
AE0
144.4
80
400
Real income
400
Real income
Real expenditures
AP
AE1
AE0
224
400
Real income
2.
a.
In the standard AS/AD model, a tax cut will shift the AD
curve to the right, leading to an increase in the price level and
real output, as shown in the graph on the right. Congressman
Stable’s views fit this model well.
Price
Le ve l
SAS
P
1
A
P0
AD1
AD 0
b.
c.
d.
If Congressman Growth is correct, the tax cut will shift the
LAS curve to the right. If the economy had previously been in
long-run equilibrium, the economy will now be below
potential and there will be pressures for factor prices to
decline. Assuming nothing else happens in the meantime, the
SAS curve will shift down, leading to a lower price level and
higher real output, as shown in the graph in the next column.
In the short run, Congressman Stable is likely to be correct.
If there is significant crowding out, the tax cut will require
government to finance a higher budget deficit. This would
lead to higher interest rates and lower investment. If there is
perfect crowding out, the decline in investment will
Y0
LAS
Price
Leve l
Y
Re al Output
1
0
LAS
1
SAS 0
SAS1
P
1
P0
AD 0
Y0
Page 720, Answers to End-of-Chapter Questions
Y
1
Real Output
completely offset the expansionary effect of the tax cut. In this case, the tax cut will have no effect on either
the price level or real output.
3.
a.
b.
c.
4.
a.
b.
c.
5.
a.
b.
c.
d.
In the standard model, an increase in the tax rate will shift the
Price
AD curve to the left as shown in the graph on the right. This will
Le ve l
lead to a lower price level and lower real output.
If there were partial crowding out, the increase in taxes will
SAS
require government to finance a lower budget deficit. This
P
would lead to lower interest rates and higher investment. If there
0
P1
were partial crowding out, the AD curve would shift to the left
AD
0
by an amount that is less than shown in a. The price level and
AD1
real output will not decline by as much as shown in the answer
to a.
If there is perfect crowding out, the rise in investment will
Y1
Y
Re al Output
0
completely offset the contractionary effect of the tax increase
and the tax increase will have no effect on either the price level or real output. The AD curve will shift right
back to its original position.
In 1995 the unemployment rate fell below the target rate of 6 percent without generating inflationary
pressures. He was probably changing his estimates to reflect that reality.
It would shift the LAS curve out.
Using Okun’s rule of thumb—which says that for every 1 percentage point rise in the unemployment rate,
income falls by 2 percent—a 0.5 percentage point decline in the target unemployment rate would imply a rise
in potential income of 1 percent, or $100 billion.
President Clinton's policy does not fit well with the multiplier model because with that model the two goals
are inconsistent with one another in the
short run. To increase output and
Price
employment using stimulative fiscal tools
Le vel
requires an increase in the deficit.
His policy might have the desired effect if
a reduction in government expenditures to
reduce the deficit reduces the interest rate
Aggregate
so much and affects expectations
Supply
positively to such a degree that their effect
P
0
on
investment
and
consumption
F
expenditures offsets the decline in
AD
2
government spending.
AD 0
The reduction in the deficit shifts the AD
AD 1
curve to the left, but the increase in
investment expenditures resulting from
Y1 Y Y
Re al Output
the reduction in interest rates shifts the
0
2
AD curve to the right by so much that, on
net, output rises as shown in the graph on the right.
I would look at interest rates and investment expenditures to see if the explanation is correct.
Chapter 30: Web Questions
1.
a.
b.
The four key economic targets are: low inflation, low level of unemployment, high and stable level of
economic growth, and external balance between imports and exports.
The main policy tools are: Income tax (rates and allowances): This is the key variable of the fiscal policy and
can be used to alter consumer expenditures. VAT and other indirect taxes: This indirect tax works like the
income tax and can be used to alter expenditures. It is also an important source of government revenue.
Page 721, Answers to End-of-Chapter Questions
c.
d.
2.
a.
b.
c.
Government expenditure: This is also a part of the fiscal policy. It includes expenditures on things like defense
and highways etc. Interest rate: This is a part of the government’s monetary policy and can be used to control
variables like the inflation rate.
Assuming that the economy is in equilibrium below the potential output, if income taxes are increased, the
resulting fall in aggregate demand will lead to a fall in output at the same level of prices. Thus there will be
lower economic growth, greater unemployment, but no change in the inflation rate. The model also predicts
imports to decrease.
Assuming that the economy is in equilibrium below potential output, the model predicts that the increase in
government spending will lead to greater output and hence greater economic growth. There will also be less
unemployment and more imports though the inflation rate would remain the same.
The process starts off by the formulation of the President’s budget for a fiscal year. The budget documents are
then prepared and transmitted to the Congress. The Congress after reviewing this budget develops its own
budget and accepts the expenditure and revenue bills. The agency managers then execute the budget in the
fiscal year after which information for the actual spending and receipts becomes available.
It takes about two years. For example, for Fiscal Year 2001 (begins October 1, 2000) the President formulated
the budget between February-December 1999, and the data on the expenditures and receipts became available
in October-November 2001.
The President and the Congress have to decide upon the discretionary spending, which accounts for one-third
of all federal spending. The remaining two-thirds of all federal spending, called mandatory spending, is
authorized by permanent laws.
Chapter 31: Politics, Deficits, and Debt
Questions for Thought and Review
1.
It follows from the long-run framework. The long-run framework directs one to avoid deficits; in the short-run
framework deficits are useful if the economy is significantly below potential.
2.
The government can finance a deficit in either of two ways: by selling bonds or by printing money.
3.
It depends. Your cash flow budget is in deficit since your expenditures exceed your income. However, if you
consider your tuition expense an investment in your future and separate it out as part of your capital budget,
then your current account budget will have a surplus.
4.
There are technical aspects of the deficit that must be understood in order to undertake a meaningful
discussion of the problems deficits and debts pose for society. Since a deficit is defined as a shortfall of
revenues compared to expenditures, these technical aspects include what you define as revenue and what you
define as expenditure.
The structural deficit is greater than the actual deficit because the economy is above its potential. Assuming
expenditures do not change with income, tax revenues are $50 billion dollars higher than they would be if the
economy were at its potential, so the structural deficit is $150 billion. The passive surplus is $50 billion
because tax revenues are $50 billion higher because the economy is operating above potential. The structural
and the passive deficit add up to the actual deficit.
5.
6.
A structural deficit would exist even if the economy were at its potential level of income, which would be at
full employment, or at where the unemployment rate is equal to the normal rate of unemployment. If an
economist believed that the normal rate of unemployment was 4 percent instead of 6 percent, then the portion
of the deficit considered to be structural would be smaller. Thus, it is Mr. A who should also say that the
structural deficit is $20 billion.
7.
Given that the nominal deficit is $300 billion, the inflation rate is 20 percent, and the debt is $2 trillion, the
real deficit is calculated as the difference between the nominal deficit and the product of the inflation rate and
the total debt, or 300 billion - (.20 )( 2 trillion) = (-100) billion. There is a real surplus of $100 billion.
8.
It would not differ; expected inflation does not enter into the determination of the real deficit.
Page 722, Answers to End-of-Chapter Questions
9.
Debt is defined as accumulated deficits, and is also a summary measure of a country's financial situation. Debt
must be viewed in relation to a country's assets, but, like income and revenues, assets and debts are subject to
varying definitions. There's no unique answer to how assets and debts should be valued, and there are different
types of debt.
10.
Three ways individual debt can be said to differ from government debt are: (a) government is ongoing and
therefore never needs to pay back the debt; (b) government can pay off the debt by creating money; and (c)
much of the government debt is internal debt.
11.
No. Financing internal debt causes redistribution; it does not make the society poorer.
12.
Deficits are only a summary measure of the economy. A government can undertake significant future
obligations and therefore get itself into trouble even if it is not running a deficit.
13.
Debt service is a good measure of whether debt is a problem because interest payments do not result in
additional productive expenditures. Interest payments are the result of past expenditures.
14.
The Budget Enforcement Act changed the politics of spending and taxing. It forced Congress to figure out
how the government would pay for a program at the same time it instituted the program.
15.
The Economic Growth and Tax Relief Reconciliation Act of 2001 cut taxes and increased spending. This Act
along with the economic slowdown contributed to the return to deficits in 2002.
16.
Because of the baby boom, there were many people working and relatively few collecting Social Security in
the late 1990s. This caused a surplus in the Social Security Trust Fund. Since that Trust Fund is part of the
government budget, the Social Security system is a primary reason for the surplus.
17.
Two real solutions are increasing the retirement age and cutting benefits when baby boomers retire.
18.
It depends. Clearly, there is some tendency for the deficit to raise the interest rate, thereby decreasing
investment and hence future growth. However, to the degree that the government spending is itself productive,
not having the deficit could also decrease future growth. The ultimate effect depends on the relative size of the
two effects.
Chapter 31: Problem and Exercises
1.
2.
The completed table is shown below:
Revenues
Expenditures
1997
$141
$150
1998
$153
$150
1999
$156
$153
2000
$171
$153
2001
$179
$162
a.
b.
c.
d.
e.
Debt
$583
$580
$583
$565
$548
The passive deficit must be zero since it is defined as zero at potential output.
The structural deficit is $200 billion.
Now $60 billion of that deficit is passive and $140 is structural since revenue would increase by $60 billion if
output rose to potential.
Now there is a passive surplus of $30 billion, and a structural deficit of $230 billion because revenue would
decline by $30 billion if output declined to potential.
The structural deficit is likely of more concern to policymakers because normal stabilization policies will not
remove it.
Page 723, Answers to End-of-Chapter Questions
3.
a.
b.
c.
d.
4.
a.
b.
c.
5.
The real deficit is calculated as the nominal deficit less the product of the inflation rate and the total debt.
Therefore,
Real deficit = 220 billion - (.10 X 3 trillion) = (-80) billion
50 billion - (.02 X 1 trillion) = 30 billion
30 billion - (-.04 X 500 billion) = 50 billion
$100 billion surplus + $60 billion = $160 billion surplus.
Debt service payments are 0.06 times $360 billion = $21.6 billion.
The nominal deficit is 160 - ($21.6 + 145) = $6.6 billion.
The real deficit equals the nominal deficit
($6.6 billion) less .03 3 $360 = $4.2 billion surplus.
Since the real deficit is rising at a faster rate than real growth in the economy, the deficit/GDP ratio is rising. It
can only continue to do so as long as it can sell the bonds, but at some point the debt/GDP ratio will become
so large that creditors will begin to doubt the country's ability to repay the debt. Then, selling bonds will
become more difficult and eventually impossible.
6.
a.
b.
c.
d.
e.
To make the deficit look as small as possible, we would do the following:
Enter government pensions when they become payable, not on an accrual basis.
Treat the sale of land as current income rather than spreading it out with the sale of an asset.
Include Social Security taxes as a current revenue because at this time revenue from Social Security exceeds
payment.
Count prepayment of taxes as current income instead of reserves for future taxes.
Count expenditures on F-52 bombers as capital expenditures and introduce another cost item of depreciation
and allow the F-52 to depreciate as little as possible.
Chapter 31: Web Questions
1.
a.
b.
c.
2.
a.
b.
c.
Among other things, Social Security is nearly universal, saves many retirees from poverty, provides benefits
that would be difficult for workers to match through private policies, and enjoys broad public support.
Among other things, the Social Security trust fund will be depleted in 2029, benefits for future retirees will
likely be cut, the payroll tax is regressive, it may depress national savings, and it may encourage early
retirement.
Reform proposals include increasing the number of years of work used to calculate the benefit, changing the
way benefits are taxed, extending coverage to state and local government workers, increasing the age of
eligibility, and adjusting the CPI.
28 percent is held as bills, 49 percent as notes, and 19 percent as bonds. 3 percent are held as inflation indexed
notes and an additional 1 percent as inflation indexed bonds.
Intra-governmental holdings are securities held by Government trust funds, revolving funds, and special funds.
The debt will decline during a year in which there is a budget surplus.
Chapter 32: Macro Policies in Developing Countries
Questions for Thought and Review
1.
Students can use the list in the text for some examples of the kinds of things they would have to give up, as
well as for examples of some of the things they would have to do.
2.
You can’t just judge an economy; you must judge the entire culture. Some developing countries have cultures
that, in some people’s view, are preferable to ours.
3.
Suicide rates are lower in developing countries because there is little ambiguity and few questions about the
meaning of life. Americans could learn a great deal from an experience of living in a developing country,
especially some Americans who do not truly appreciate what they have. But learning this lesson would require
hardship; thus it would be hard to say that Americans would be better off living in such a country.
Page 724, Answers to End-of-Chapter Questions
4.
The exchange rate method uses current exchange rates to compare relative incomes while the purchasing
power parity method compares incomes by looking at the domestic purchasing power of money in different
countries. Because many developing countries’ currencies are undervalued, the current exchange rate
overstates the income disparity between developed and developing countries.
5.
Development refers to an increase in productive capacity and output brought about by a change in underlying
institutions; growth refers to an increase in output brought about by an increase in inputs.
6.
Three ways in which institutions differ in developing countries are that (a) basic market institutions with welldefined property rights do not, in many cases, exist; (b) there is often a dual nature to the economy; and (c)
fiscal structures with which to adequately implement fiscal policy often do not exist.
7.
Governments in developing countries often seem more arbitrary and oppressive than governments in
developed countries because of their lack of stable, well-developed fiscal, financial, and political institutions.
Rules change quickly creating uncertainty and making the rates seem arbitrary.
8.
An economist might favor activist policies in developed countries and laissez-faire policies in developing
countries because the policies one favors depends on the desire and the ability of government to work for and
achieve the goals of its policies. Different views of government can lead to different views of policy. Since
many economists have a serious concern about the political structure in developing countries, but less concern
about it in developed countries, they can favor one set of policies for developing countries and another set for
developed countries.
9.
The dual economy refers to the existence of a traditional, less developed, often barter economy and a second
internationally oriented modern market sector which is highly developed.
10.
A regime change is a change in the entire structure within which the government and economy interact,
whereas a policy change is a change in one aspect of government action.
11.
An inflation tax is the transfer of wealth from the holders of IOUs denominated in the unit of account, such as
cash or bonds, to the issuers of those IOUs when there is inflation (cash) or when inflationary expectations are
not fully adjusted (bonds).
12.
The alternative to the inflation tax, possible breakdown of government and the economy, may be worse than
the inflation tax, which may buy a bit more time before the difficult decisions must be made.
13.
Conditionality is the making of loans that are subject to conditions by the IMF. Often, countries will ask the
IMF for loans to cover balance of payments deficits, but the IMF will in turn place conditions on those loans
which often include running a balance of payments surplus.
14.
Investment and savings are low in developing countries because income is low, and poor people don’t have a
whole lot left over to save. The rich often put their savings abroad due to the fear of political instability. As for
the middle class, the underdeveloped financial sector leaves them with few opportunities to invest their
savings.
15.
Even though developing countries may be unstable and offer a risky environment for investing, if a country
has a motivated, cheap work force, a relatively stable government supportive of business, and sufficient
infrastructure investment, multinational companies will have a strong motivation to invest in the country.
16.
An investor thinking of making an investment in a developing country should be concerned about the country’s political stability and its economic condition (inflation, etc.). The existing amount of debt may also
be a matter of concern.
17.
The right education is a necessary component of any successful development strategy. The wrong education is
an enormous burden. Developing countries tend to have too much of the wrong education and too little of the
Page 725, Answers to End-of-Chapter Questions
right education. But when students from such countries study abroad, they are often faced with a hard choice
at the end of their education, and many choose not to return home, resulting in a brain drain.
18.
Corruption limits investment and growth because knowing that payments of graft must be made prevents
many people from undertaking actions that might lead to growth. Tax revenues are often diverted to those in
power instead of going into legitimate productive investment, and the same is sometimes true of foreign aid
money from abroad. But that does not answer the issue, since one must deal with the political reasons why the
government increases the money supply.
19.
While a country's population can never be higher than its natural resources can support, overpopulation can be
an obstacle to development. Whether a country should control the size and the makeup of its population is a
matter of considerable debate. Individuals differ substantially in their assessment of the morality of these
programs, but even if one believes that population control is an appropriate government concern, it does not
seem that such programs will be successful, by themselves, in limiting population growth.
20.
The UN could encourage the development of microcredit banks, like the Grameen Bank, which provide a lowcost alternative to money lenders. There are also significant social and cultural limitations in many areas that
limit women entrepreneurs.
Chapter 32: Problems and Exercises
1.
This exercise has students interview a foreign student in their school or class about the obstacles to economic
development.
2.
This exercise asks you to spend a day living like someone in a developing country, and then to read this
chapter and contemplate the degree to which someone in such a situation can pull himself or herself up by the
bootstraps.
3.
a.
b.
c.
4.
a.
b.
c.
5.
If the cost of the recycling is the opportunity costs, this program should be accepted for plastics but not for
glass. Even this, though, may not be right since the $400 per ton does not include the cost of the negative
publicity of Germany sending its trash to a developing country.
Whether this will benefit the developing country depends upon the opportunity costs of the alternative uses of
the resources that will be devoted to the program and the long-term consequences of dumping on the land. If
the present value of the future stream of income minus the damage to the land exceeds the value of the land,
the program would be beneficial. The distribution of the costs and benefits, however, must also be considered.
The income will most likely go to a few, but the damage to the land will most likely affect many. The country
must weight the marginal social cost and the marginal social benefits.
Alternatives include monitoring of waste to include least-environmentally damaging waste, assurances that the
revenue be used to improve the lives of the majority in the country who are those most likely to be hurt by the
program and that the proposal be ratified by referendum so that the populace decide whether to accept the
trash.
I would want to emphasize those skills which have the highest per-dollar return—those that would lead to
development. These would probably be the basic reading, writing, and problem-solving skills that fit the
indigenous culture.
This differs from the ideal educational system in the United States because the U.S. culture is different and
U.S. economic problems are different. Thus, in the United States the focus would be more abstract analysis,
while in developing countries the focus would be agricultural science and basic skills.
This is an open-ended question. The relevant question would be: How much would individuals be willing to
pay for courses that do not result in a credential compared to how much they would be willing to pay for a
credential without the coursework?
This is a student research question.
Page 726, Answers to End-of-Chapter Questions
6.
a.
b.
I agree with this statement because of the differing importance of institutions. A detailed knowledge of a
country’s institutions and culture is necessary to make prescriptions for development. I disagree with this
statement to the degree that the lessons learned from a general theory say that development requires stability
of political structures and of economic environment and the need for savings applies across countries. The
solutions are specific to the countries but fall within a general framework.
This argument is made for developing countries because culture and traditional institutions play a larger role
in the growth in these economies.
Chapter 32: Web Questions
1.
a.
b.
c.
d.
2.
a.
b.
Three social challenges are disease, lack of sufficient education, and inadequate nutrition.
Three economic challenges are government-owned businesses, lack of infrastructure and military conflict.
Three environmental challenges are destruction of natural habitat, lack of sufficient sanitation, and lack of
sufficient drinkable water.
An additional challenge not listed is a well-developed market with rule of law.
Criticisms about the World Bank and IMF focus on conditions placed on borrowing countries for access to
funding (which may include loss of local economic authority), its dominance by industrialized nations as well
as projects that it has funded that may harm the environment.
One recent criticism is the disregard for indigenous people’s right to self determination. See
http://forestpeoples.gn.apc.org/index.htm. Another criticism is of human rights violation at a World Bank
supported gold mine. http://www.leat.or.tz/active/buly
Chapter 33: International Finance
Questions for Thought and Review
1.
If a country is running a balance of trade deficit, the amount of goods it is exporting is less than the amount of
goods it is importing. This is only one part of the current account, which is the part of the balance of payments
that lists all short-term flows of payments. A deficit in merchandise could be offset by a surplus in other areas
of the account.
2.
When someone sends 100 British pounds to a friend in the United States, the transaction will show up in the
component of the current account called net transfers, which include foreign aid, gifts, and other payments to
individuals not exchanged for goods or services. It will also appear on the capital account as a receipt of
foreign currency just like the purchase of a British stock or bond.
3.
The capital account measures the flow of payments between countries for assets such as stocks, bonds, and
real estate, and a surplus means that capital inflows were more than capital outflows. To buy United States
assets, foreigners need dollars, so the net capital inflows represent a demand for dollars that can balance the
excess supply of dollars due to a current account deficit. In the short run, a current account deficit balanced by
a capital account surplus is nice because current expenditures, which include the trade balance, give society
immediate pleasure.
4.
A capital account deficit means that capital outflows are more than capital inflows. The excess supply of
dollars is balanced by a current account surplus, which means Americans are producing more than they are
consuming. In the long run, capital account deficits are nice because you are building up holdings of foreign
assets, which will provide a future stream of income.
5.
Holding the exchange rate above the equilibrium market exchange rate will make a country's exports more
expensive and its imports cheaper than they otherwise would have been. It will also require the country to
finance the deficit using official reserves or borrowing to do so. It can allow the government to temporarily not
make the contractionary macro adjustments that otherwise would be necessary to bring the economy into
equilibrium.
Page 727, Answers to End-of-Chapter Questions
6.
We would use a combination of purchasing power parity, current exchange rates, and estimates of foreign
exchange traders to determine the long-run exchange rate of the Neverback. This combination approach can be
justified only by the “that’s all we have to go on” defense. Since no one really knows what the long-run
equilibrium exchange rate is, and since that exchange rate can be significantly influenced by other countries’
policies, the result we arrive at could well be wrong.
7.
Both fixed and flexible exchange rate systems have advantages and disadvantages. While fixed exchange rates
provide international monetary stability and force governments to make adjustments to meet their international
problems, they have some disadvantages as well: they can become unfixed, creating enormous instability; and
their effect of forcing governments to make adjustments to meet their international problems can be a
disadvantage as well as an advantage. Flexible rates provide for orderly incremental adjustment of exchange
rates and allow governments to be flexible in conducting domestic monetary and fiscal policies, but also allow
speculation to cause large jumps in exchange rates (and, as before, the government flexibility may be a
disadvantage too). Given the pluses and minuses of both systems, most policymakers have opted for a policy
in between-partially flexible exchange rates.
8.
He will more likely prefer fixed exchange rates. They provide an anchor, which restricts government
temptations to use expansionary monetary policy.
9.
They will sell that currency, which will force the government to use reserves to protect the currency.
10.
If a country eliminates tariffs, the demand for imports will likely increase. To buy more imports residents of
the country will have to supply more of their own currency, depressing their currency’s value.
11.
Argentina had fixed the value of the peso to the dollar—say
at P0 in the graph on the right. As its trading partners
economies slowed, exports declined, shifting the demand for
pesos to the left, placing downward pressure on the value of
the peso. As international investors expected the value of
the peso to decline, they sold pesos, shifting the supply of
pesos to the right, depressing its value even further. Because
Argentina did not have sufficient dollars to purchase the
excess supply of pesos and had to abandon its fixed
exchange rate.
Price of peso
S0
S1
P0
P1
P2
D0
D1
Quantity of pesos
12.
A common currency would tie these countries together much more closely, create a larger common market,
and make price comparisons among Canada, the United States, and Mexico easier. It would be politically
difficult since each country would have to give up its own currency, which is a source of national identity.
Since the U.S. dollar would likely predominate, this would be especially problematic for Canada and Mexico.
These countries would also have to give up their independent monetary policy. Since the economic conditions
in the three countries can differ substantially, doing so would likely be unacceptable for Canada and Mexico.
13.
He was advocating significant trade restrictions. These trade restrictions would have likely provoked
retaliation by our trading partners, hurting international cooperation, and hurting the world economy.
14.
No. It is extremely difficult to affect exchange rates. Since we don’t know what the correct exchange rates are,
it is probably best not to try to significantly change the exchange rates determined by the market by foreign exchange intervention. If one is going to change exchange rates, one must change one’s domestic monetary
and fiscal policies.
15.
The U.S. would want to hold up the value of the dollar to help prevent the surge in prices that would result
from the fall in exchange rates, and to keep foreigners from buying our assets cheaply. Other countries would
want a higher value of the dollar in order to keep their goods competitive with U.S. goods.
Page 728, Answers to End-of-Chapter Questions
Chapter 33: Problems and Exercises
a.
b.
c.
d.
2.
a.
b.
The graph to the right shows the fundamental
S0
analysis of the supply and demand for British
S1
pounds sterling in terms of dollars, and the effect of
the following changes:
P1
A rise in the UK price level causes foreign goods to
become cheaper. British demand for foreign
P0
currencies will tend to increase, and foreign demand
D1
P2
for pounds will tend to decrease. Thus supply of
pounds shifts outward from S0 to S1 and the
D0
demand for the pound shifts inward from D1 to D0.
Q0 Q1 Q2
The exchange rate value of the pound falls from P1
to P2.
Quantity of pounds
A reduction in U.S. tariffs would tend to shift the
demand for pounds to the right from D0 to D1 as Americans buy more imports from the UK. The exchange
rate value of the pound rises from P2 to P0.
A boom in the UK economy means an increase in its income, causing an increased demand for imports and an
increase in the demand for the foreign currency to buy those imports, thus resulting in an increase in the
supply of pounds. (This may also set off an expectations effect.) Thus, the supply of pounds shifts outward
from S0 to S1. If demand is at D0, the exchange rate value of the pound falls from P0 to P2.
If interest rates in the UK rise, there will be an increased demand for its assets, so the demand for pounds will
increase from D0 to D1 and the supply of pounds will decrease from S1 to S0 as fewer British investors sell
their pounds to buy foreign assets. The exchange rate value of the pound rises from P2 to P1.
Price of pounds in
dollars per pound
1.
This is an enormous change. In order to bring it about, the Never-Never government would have to run an
enormously expansionary monetary policy, reducing the real interest rate possibly to negative amounts and
probably generating significant inflation.
Holders of Neverbacks will demand foreign currencies (increase supply of Neverbacks) since the return on
Neverback assets has declined. This is shown as a rightward shift in the supply of Neverbacks. Likewise,
potential foreign investors will demand fewer Neverbacks for the same reason. This is shown as a leftward
shift in the demand for Neverbacks. The effect is to reduce the exchange rate value of the Neverback to $10
per Neverback.
3.
a.
Supplier
4.
a.
b.
We would suggest buying U.S. dollars and selling currencies of the EU.
We would suggest buying U.S. dollars since U.S. interest rates are expected to be higher, the quantity of U.S.
assets demanded will rise, and thus the demand for dollars will increase.
Since the market will likely already have responded to the higher expected interest rates, the rise will likely
have the same effect as a fall in interest rates. Thus, we would suggest selling U.S. dollars.
We suggest selling U.S. dollars by reasoning opposite to that in b.
We would suggest selling U.S. dollars in the expectation of a decrease in demand for U.S. dollars as U.S.
goods become more expensive. Also U.S.-denominated assets such as bonds will be worth less with greater
inflation making foreign assets more attractive to investors.
We would suggest buying because, if the U.S. government imposed new tariffs, the demand for imports would
decline, shifting the supply of dollars to the left. This would lead to a higher value of the dollar.
c.
d.
e.
f.
b. Supplier
c. Supplier
e. Demander
f. Demander.
5.
a.
d.
Current account
Current account
6.
a.
Three assumptions of the law of one price are that (1) there are zero transportation costs, (2) the goods are
tradable, and (3) there are no barriers to trade. (There are many others.)
For it to apply directly, labor would have to be completely mobile. Thus, it does not apply directly. However,
assuming capital is flexible, there will be significant indirect pressure toward an equalization of wage rates.
b.
b. Current account
e. Capital account
d. Demander
c. Current and capital accounts
Page 729, Answers to End-of-Chapter Questions
c.
Since capital is more mobile than labor, we would expect that the law of one price would hold more for capital
than for labor.
Chapter 33: Web Questions
1. a. Country
Australia
Britain
Israel
Malaysia
Russia
b.
c.
d.
2.
a.
b.
c.
3.
a.
b.
c.
Implied PPP of the Dollar
1.03
1.32
5.78
1.8
15.7
Exchange Rate
1.68
1.58
4.05
3.8
28.5
All the currencies are overvalued except the Isreali shekel, which is undervalued.
The Big Mac Index is limited because it measures purchasing power parity only in terms of Big Macs. People
don’t just consume Big Macs. Including more goods in a purchasing power parity index would make the index
more accurate.
In designing an index it would be important to include a wide variety of goods in order to measure overall
changes in purchasing power parity, everything from food and clothing to tires and light bulbs.
You could check the validity of the Big Mac index by comparing its implied purchasing power parities in U.S.
dollars to actual exchange rates.
The answer to this question depends on the country chosen. We chose Thailand.
The Thai currency is the baht.
The currency remained virtually unchanged from 2002 to 2003.
After falling 10 percent in 1998, real GDP growth has stabilized at between about 2 and 4 percent a year and
the unemployment rate has fallen somewhat. The budget balance hasn’t changed much. The economy appears
to be in good health, which may be contributing to a stable currency.
The problem facing this country is a chronic trade deficit without sufficient funds to pay for the deficit. Part of
the cause is rising inflation.
We recommended negotiating with unions to cut wages.
Negotiations were a failure. The country is on the brink of defaulting on international debt. So, instead we
devalued the country’s currency. The IMF lent the country money to help the economy adjust to the
devaluation. Imports became more expensive, making consumers unhappy, but the country’s exports were
more competitive. The IMF loan helped mediate the effects of the increased import prices by providing funds
for businesses to buy imports.
Chapter 34: Monetary and Fiscal Policy in a Global Setting
Questions for Thought and Review
1.
At the time that this was written, the dollar had fallen against the yen. This makes U.S. exports cheaper to
foreigners, but may signal weaker investor confidence in the U.S. economy. This may mean foreign investors
are pulling out of U.S. assets, which will also lead to lower stock prices and perhaps higher interest rates. A
lower dollar also means imports are more expensive, which puts upward pressure on domestic inflation.
Whether the dollar should be higher or lower depends on who you are. Manufacturers whose sales depend on
exports want a lower dollar. Investors likely want a higher dollar.
2.
At the time that this was written, the U.S. trade deficit had risen to record highs. Still, it is unclear whether we
should want to lower the U.S. trade deficit. The trade deficit was in part due to the fact that the economy has
been growing for nine consecutive years. As long as the United States can borrow or sell assets, it can have a
trade deficit. On the other hand, the more the United States borrows, the more U.S. assets foreigners own.
Eventually, the United States will have to run a trade surplus.
Page 730, Answers to End-of-Chapter Questions
3.
If Japan ran an expansionary monetary policy, it would increase Japanese imports of U.S. goods and thereby
decrease the U.S. trade deficit. The U.S. dollar would rise relative to the Japanese yen.
4.
A contractionary fiscal policy by Japan would have an ambiguous effect on the value of the U.S. dollar
because the effect via the interest rate and income paths oppose one another, and the effect through the price
level is a long-run effect. Contractionary fiscal policy in Japan will lower income and imports in Japan and
therefore lead to a higher U.S. trade deficit.
5.
Since the effect of monetary policy is to push the exchange rate down in all effects, this will not change the
effect presented in the chapter, other than to eliminate the effect through income and replace it with the effect
through prices.
6.
The effect of expansionary fiscal policy on the exchange rate is ambiguous, while contractionary monetary
policy has the effect of increasing exchange rates. The net effect will depend on which influence is stronger.
7.
The answer to this question hinges on what is meant by "justified." If that means that the United States is
complaining about the actual negative consequences it experiences because of this policy, as a matter of fact,
one can say the complaint is justified. If the argument centers on fairness, the issue is clearly complicated by
the question of whether a nation should put its goals ahead of or secondary to international goals.
8.
If the recession was caused by a fall in domestic expenditures, we would expect that its trade balance was
moving toward surplus. If, however, the recession was caused by a fall in exports, we would expect that its
trade balance was moving toward deficit. The G-8 countries were trying to get Japan to boost its economy by
increasing aggregate expenditures with expansionary monetary policy.
9.
When the U.S. debt in internationalized, there is a capital inflow into the U.S. Thus the U.S. can consume
more than it produces. Domestic borrowing would cause crowding out but when foreigners make the loans
that does not happen.
10.
The costs of internationalizing the debt are that interest and profits must be paid on the capital owned by
foreigners. Future consumption must be reduced to pay that amount.
Chapter 34: Problems and Exercises
1.
See page 805 in the textbook.
2.
increased money => increased income => increased imports => trade increased deficit .
3.
a.
b.
c.
4.
a.
b.
c.
A decrease in a country's competitiveness and an increase in the trade deficit are probably due to expansionary
fiscal policy which would increase inflation, reducing competitiveness, and increase income, increasing
imports and increasing the trade deficit. Expansionary monetary policy would make the trade deficit larger,
but its effect on competitiveness through the exchange rate is ambiguous.
If interest rates have risen steadily along with a rise in the exchange rate, it is likely that fiscal policy has been
very expansionary.
Running more contractionary fiscal policy and expansionary monetary policy would reduce the interest rate
and thereby push down the exchange rate making the country more competitive, while maintaining a constant
domestic macro policy.
We would suggest that the IMF require a contractionary policy for both monetary and fiscal policy. I would,
however, suggest a relatively more contractionary fiscal policy so that the exchange rate would also fall, while
inflation falls, boosting exports.
This would tend to slow inflation, after an initial burst due to a fall in the exchange rate. The policy, however,
would hinder growth and push the economy into a recession.
We suspect that the country would not be happy about the proposal because its adoption might lead to a deep
recession, which is politically unpopular.
Page 731, Answers to End-of-Chapter Questions
5.
a.
b.
c.
d.
The first advice I would give would be to explain that at most, I can talk about tendencies rather than
achieving goals. Not all goals are simultaneously achievable. That advice given, I would provide the following
recommendations:
We would suggest a contractionary fiscal policy, which lowers inflation and the interest rate directly and
reduces the trade deficit by lowering income. It will also increase the capital inflow, which will tend to allow
an increase in the trade deficit.
This would require a combination of monetary and fiscal policies—contractionary monetary policy to head off
inflation and increase interest rates and increase the value of the dollar to encourage imports and discourage
exports to reduce the trade deficit. To further decrease the trade deficit, a slight expansionary fiscal policy
could be implemented, but that will have a tendency to push the interest rate up.
An expansionary monetary policy will reduce interest rates, depressing the dollars, which will tend to reduce
the trade deficit. This will tend to reduce unemployment too. However, the increase in income and prices will
tend to increase the trade deficit.
This combination of goals is difficult to achieve. Expansionary fiscal policy will tend to reduce unemployment
and increase interest rates. But to offset the effect of higher income on increasing the trade deficit, an
expansionary monetary policy will have to be implemented to depress the dollar and spur exports to lower the
trade deficit. Reducing employment and the interest rate, this works in the opposite direction from
expansionary fiscal policy by reducing employment and the interest rate. Life is tough.
Chapter 34: Web Questions
1.
a.
b.
c.
d.
Canada, Mexico, Japan, Federal Republic of Germany, China.
Canada, Mexico, Japan, Federal Republic of Germany, China.
We would encourage them to follow expansionary monetary and fiscal policies.
Netherlands, Belgium, Australia, Dominican Republic, and Hong Kong.
2.
a.
Conditionality is the requirement by the IMF that its aid recipients follow certain policies, or conditions, in
order to receive aid.
Typical IMF financing preconditions include reducing government spending, budget deficits, and foreign
(external) debt, reducing the rate of money growth to control inflation, raising real interest rates to market
levels and removing barriers to export growth. When implemented, these conditions lead in the short term to
(a) a devaluation of local currency, (b) a lower trade deficit and (c) domestic problems including slower
growth and unemployment.
Mexico, Russia, Pakistan, Thailand and South Korea are examples of countries that have received IMF
financing over the past five years.
Mission creep is the term used to describe the increasing influence of the IMF on domestic policies of its aid
recipients. In addition to the enforcement of financial reform in exchange for aid, the IMF has been accused of
advocating an agenda in relation to geopolitics and international security, social safety nets, government
corruption, the environment and human rights.
b.
c.
d.
Page 732, Answers to End-of-Chapter Questions