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Chapter 1
The Nature of Economics
When Is It Rational to Learn a New Technology?
An important characteristic of young people is their eagerness to learn new things. This is especially true
for new electronic technologies or upgrades to new technologies such as cell phones with each new feature
that is added, for computers and interactive computer games, multimedia, and surfing the Internet. They not
only embrace these technologies, but they also invest a significant amount of time becoming very proficient
with them. Older people do not learn these new technologies as readily and when they do, they are not as
skilled at using them. Is it possible that both of these behaviors as rational?
Yes. If you are young and you learn a new skill, you will be able to gain returns from your investment in
learning over many decades. If you are in your 60s by contrast, and invest the same amount of time and effort
learning the same new skill, you will reap any returns for a much shorter time. Thus both young and older
peoples’ behavior is rational in the economist’s sense.
Student Printing in the University
Most universities allow students to use university network printers in student labs when they are working
on the university network as part of their tuition or computer use or technology fees charged to students
when they register for classes. The average school spends several thousand dollars per month for this service.
This service is expensive because students print personal jobs unrelated to academics such as downloads
from entertainment Web sites and photos of friends and family. Winthrop University in South Carolina
decided to charge students a $10 printing fee that allows them to print 250 pages per semester on University
network printers. After that the students are charged $0.04 for each additional page that they print. Assuming
students are rational, what do you predict happened to Winthrop’s printing costs after they implemented
this charge? Why?
Winthrop’s printing costs declined by about one-half. Students were printing some pages that had little
additional value to them because those pages were essentially free. Once each page cost something to print,
rational students printed those pages that were worth the price charged to them.
Chinese Smuggling
Recently, China’s leaders announced the formation of a new anti-smuggling police force to try to stop the
annual flow of tens of billions of dollars in contraband. One type of contraband is cigarettes. Taxes on
cigarettes are so high that many Chinese cigarette manufacturers export half of their output, which they
then smuggle back into China.
Why does China need an anti-smuggling police force when it already has an army of border guards and
customs inspectors? The answer is that the returns to smuggling are so high that many existing border
guards and customs inspectors have become smugglers themselves. Thus the government feels that new
police are needed in part to watch over the existing cadre of “law enforcers.”
What could the government do to end the incentives to smuggle cigarettes? (1) Significantly increase the
salaries of border guards and customs inspectors so that the opportunity costs of being caught and losing
their jobs is increased. (2) Lower taxes on cigarettes. (3) Increase the penalties of being caught smuggling.
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Are Economics Students Rational?
If you did a survey in your economics class, not all students would agree with the statement “I am rational.”
In an attempt to show that the rationality assumption is accurate nonetheless, an increasing number of
economists are doing the same kinds of experiments that are used in the physical sciences. One researcher,
David M. Grether, ran some experiments at the University of California at Los Angeles in the early 1980s.
His experiment involved separating students as volunteers into two groups. One group was paid the same,
$7, no matter how it performed. The second group was paid less for poor performance and more for better
performance. This group was paid either $5 or $25, depending on the level of performance. Performance
was measured by how well students were able to pick gambles that had the greatest probability of winning.
Students had to do some relatively complicated math calculations to make the best guess.
The results were consistent with the rationality assumption. One-third of the students in the group that
was paid regardless of performance picked all of the gambles correctly. In the second group, for which
performance was distinctly rewarded, two-thirds of the students had no errors in making their calculations.
Does the experiment prove that economics students are rational? Why or why not? The experiment does
not prove that economics students are rational, only that the rationality assumption predicts better than the
alphabetical one. Note that one-third of the students in the better-rewarded group did no better than did the
majority of the uniformly paid group.
Chapter 2
Scarcity and the World of Trade-Offs
Fast Lanes for a Fee
In recent years highway planners in most large urban areas have added high occupancy vehicle lanes or
HOV lanes. During rush hours only cars carrying two (or in some places three) persons are allowed to
use these lanes. In 1996 to the present San Diego has been allowing drivers to pay a fee to drive in the
HOV lanes during rush hours. The price was initially $50 per month. Currently it is possible to place
a transponder in your car and a fee is charged on a per trip basis.
Why would a person be willing to pay a fee to drive by him- or herself, when all that he/she needs to do
to drive in the HOV lane for free is to arrange to carpool with one or two other persons? (Hint: Is there
an opportunity cost of time?) A person who is willing to pay to drive alone in the HOV lanes will place
a high value on his/her time. The need to find and pick up a carpool companion or companions will take
more time just as driving in the regular traffic lanes at rush hour does. If the person values the time saved
by using the HOV lanes by more than the fee or the time spent picking up carpool companions, then he/she
will pay the fee.
The Saving Rate in the U.S.
From late 2005 through 2006 the saving rate of the household sector of the U.S. was negative. At the same
time foreigners, especially Asians were lending funds to the U.S. largely as a result of large surpluses of
U.S. dollars earned from selling more goods to the U.S. than they purchased from the U.S. The U.S.
economy and investment continued to grow during this period. At the time there was a talk among
economists and others of a glut of savings in the global economy. Yet the trend of saving a percent of
world GDP has been declining since about 1970, according to the World Bank.
Assuming that the U.S. saving rate remained unchanged from 2006, what would happen to the U.S. production
possibilities curve if foreigners decided to use their savings to finance investment in their own countries
instead of lending them to the U.S.? Why? If the U.S. saving rate was negative, then investment would be
negative and the capital stock would decrease. The production possibilities curve would shift to the left.
How is it possible for a country such as the U.S. to consume more than it produces which is what a negative
saving rate means? The U.S. would have to purchase goods produced by foreigners.
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Drilling in the Arctic National Wildlife Refuge (ANWR)
From 2001 to 2003 there was a proposal by the Bush administration to open up the ANWR to oil exploration
as part of the president’s energy policy to promote less dependence on imported oil. Environmentalists
argued that opening up the refuge to oil exploration and drilling would damage the fragile arctic environment
and possibly injure the diversity of arctic species. The administration argued that there were an estimated
5.7 to 16 billion barrels of oil in the ANWR and that only a small amount of land in the reserve would
be used for drilling and damage to the environment and wildlife would be very small. In early 2003 the
Congress defeated a bill that would have permitted oil exploration and development in the ANWR.
What is the opportunity cost to the economy of the decision to prohibit development of oil reserves in the
ANWR? The opportunity cost to the economy is the 5.7 to 16 billion barrels of oil.
Continued Life versus the Environment
In the 1990s it was discovered that taxol, a chemical found in the bark of Pacific yew trees in the Pacific
Northwest, was effective in treating ovarian cancer, which afflicts an additional 10,000 women each year.
It takes the bark of about 150,000 yew trees per year to extract enough taxol to treat these women, many of
whom would otherwise die. The problem is that yew trees are slow growing and are mostly in old growth
forests that have taken hundreds of years to develop. Taxol has recently been found to be effective on a
number of other cancers such as lung cancer. This has increased the demand for it and thus results in more
trees being required. Even the development of a semi-synthetic version of taxol does not completely solve
the problem. Complete synthesis is not yet economic. Environmentalists point out that heavy logging of
old growth forests can damage other trees and the environment generally. Until scientists develop new
sources of taxol, there will continue to be a trade-off: saving women with ovarian cancer and persons with
other types of cancer or saving Pacific yew trees.
What is the opportunity cost of saving yew trees? What is the opportunity cost of saving the lives of the
women suffering from ovarian cancer who could be treated with taxol? The opportunity cost of saving
yew trees is the costs associated with the early death of women from ovarian cancer. The opportunity cost
of saving those lives is the loss of yew trees and damage to old growth forests. Since the number of Pacific
yew trees is finite and limited to a small area, the yew trees could become extinct.
Do all environmentalist attempts at saving plants or animals involve an opportunity cost? Yes, all
environmental attempts to save plants and animals involve an opportunity cost because resources must
be used to save them or some resources may not be used if the plant or animal is to be saved. In all cases
resources have alternative uses. Those that are used to save a plant or animal cannot be used for something
else. If a resource cannot be used so that a plant or animal can be preserved, then we must give up the
highest valued alternative thing for which it could have been used.
The Opportunity Cost of Going to College
What is the cost of going to college? The obvious costs are the costs of tuition, fees, and textbooks. The
obvious costs of going to college do not include room and board because these costs will be incurred no
matter what you do—go to work or go to school. The biggest cost of going to college is forgone income.
This is to say that going to college usually means sacrificing a full-time salary. In the case of a typical
18-year-old, the opportunity cost of going to college may be $15,000 to $20,000 per year. The cost to a
performer such as Eminem last year would have been over $19 million. For Britney Spears it would have
been $9.1 million. For the successful musician, actor, or model, the old saw “Get all the education you
can get” doesn’t make much sense.
Opportunity cost has something to do with the decision by Britney Spears and Eminem to not attend
college while they are under 25. Between the ages of 17 or 18 and 25 the opportunity cost of going to
college for stars in the popular music industry is very high.
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What is the opportunity cost of leaving college early for student athletes who join professional teams prior
to graduation? The opportunity cost of leaving college early is the forgone education. If at the end of a
professional career the athlete does not have a degree, then his or her best income alternatives will usually
be much lower than for an athlete who did get a degree.
Chapter 3 Demand and Supply
Congestion Pricing for San Francisco
San Francisco, among other cities, is examining congestion pricing as a way to reduce traffic congestion
that has been successfully used in European and Asian cities. In London for example drivers were initially
charged an $8 fee that has since increased to $14 every time they enter London’s central business district.
Before the congestion fee was implemented, traffic congestion was a major problem in central London.
The effect of the congestion fee was to reduce traffic congestion by nearly a third in three years as measured
by traffic speeds. Traffic speed has nearly doubled from about 5 mph during business and rush hours to
about 10 mph as a result of a decrease in the number of motor vehicles entering central London. Use of
public transportation into the area increased significantly after the fee went into effect.
Does the decrease in the number of vehicles entering central London represent a decrease in demand or
a decrease in quantity demanded for the use of central London’s streets? It is a decrease in the quantity
demanded because the price of using the streets has risen from $0 to $14. Thus there has been a movement
along the demand curve for the use of the streets for driving in a motor vehicle.
U.S. Agricultural Subsidies and Globalization
The U.S. government began subsidizing U.S. cotton farmers in the 20th century to allow them to stay in
business. The purpose was to insulate them from fluctuating market prices that could bankrupt cotton
farmers as a result of world market conditions beyond their control. The farm lobby has made sure that
cotton remains a subsidized product protecting to some extent cotton farmer income.
U.S. (and other developed countries) cotton subsidies are alleged to be a major reason why cotton farmers
in India are experiencing declining income and many are being forced out of farming. The world price of
cotton has fallen by more than 33 percent since the mid-1990s. The Indians blame the U.S. and other
developed countries’ subsidies for these lower prices. Thus a program aimed at helping U.S. farmers is
driving Indian farmers out of business.
Are the Indian farmers right to blame the cotton subsidies for their plight? Yes. U.S. and developed
country subsidies increase the world supply of cotton and decrease its price other things constant.
Is Dental Care Becoming an Inferior Good?
A British health minister once claimed that the demand for health care is infinite because everyone is in
a losing battle against death. This is not so for American dentistry, however. As aggregate U.S. income
levels have risen during the last 25 years, overall spending on dental care services has declined.
It isn’t that fewer Americans are seeing dentists each year. They just do not require as many fillings or
extractions. As incomes rose, people purchased more expensive and effective toothpastes. More towns,
cities, and counties began to fluoridate their water as the relative price of this anticavity agent declined,
so changing relative prices have played a role. The higher incomes of their residents have permitted more
municipalities to purchase fluoridation systems. At every age, the average American now has two more
teeth than 25 years ago.
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Many fledgling dentists have begun specializing in “cosmetic dentistry” desired by clients with healthy but
less than beautiful teeth. Compared to traditional dental care services, is cosmetic dentistry more or less
likely to be a normal good? Cosmetic dentistry is more likely to be a normal good. As incomes rise, people
are likely to wish to improve their appearance because they can afford the expense.
Is Dental Care Becoming an Inferior Good?
A British health minister once claimed that the demand for health care is infinite because everyone is in a
losing battle against death. This is not so for American dentistry, however. As aggregate U.S. income levels
have risen during the last 25 years, overall spending on dental care services has declined.
It isn’t that fewer Americans are seeing dentists each year. They just do not require as many fillings or
extractions. As incomes rose, people purchased more expensive and effective toothpastes. More towns,
cities, and counties began to fluoridate their water as the relative price of this anticavity agent declined,
so changing relative prices have played a role. The higher incomes of their residents have permitted more
municipalities to purchase fluoridation systems. At every age, the average American now has two more
teeth than 25 years ago.
Many fledgling dentists have begun specializing in “cosmetic dentistry” desired by clients with healthy but
less than beautiful teeth. Compared to traditional dental care services, is cosmetic dentistry more or less
likely to be a normal good? Cosmetic dentistry is more likely to be a normal good. As incomes rise, people
are likely to wish to improve their appearance because they can afford the expense.
Garth Brooks, Used CDs, and the Law of Demand
In 1993 country singer Garth Brooks tried to prevent his latest CD from being sold to any chain or store
that also sells used CDs. His argument was that the used-CD market deprived labels and artists of earnings.
His announcement came after Wherehouse Entertainment, Inc., a 339-store retailer, started selling used
CDs side-by-side with new releases. Brooks, along with the distribution arms of Sony, Warner Music,
Capitol-EMI, and MCA, was trying to quash the used-CD market. By doing so, it appears that none of
these parties understands the law of demand.
Let’s say that the price of a new CD is $15. The existence of a secondary used-CD market means that to
people who choose to resell their CDs for $5, the cost of a new CD is, in fact, only $10. Because quantity
demanded is inversely related to price, we know that more units of a new CD will be sold at a price of $10
than at a price of $15. Taking only this force into account, eliminating the used-CD market tends to reduce
the sales of new CDs. But there is another force at work here, too. Used CDs are substitutes for new CDs.
If used CDs are not available, some people who would have purchased them will instead purchase new
CDs. If this second effect outweighs the first, then Brook’s argument was correct.
Can you apply this analysis to the used-book market in which both authors and publishers have long argued
that used books are “killing” them? The analysis should apply to the textbook market. Without a secondary
market for textbooks the net price of a text would be much higher. As a consequence some students will
copy their friends’ books (at 10 cents per page on many university copiers a 500 page book would only
cost $50.00 as opposed to the $80.00 to $120.00 for a new text). Some students would choose to share a
book, and some students would simply choose to take better class notes and not buy a book at all. While
this part of the analysis is the same, the nature of the textbook market is somewhat different than that of
the CD market. In the textbook market many if not most texts are sold to students who have no intention of
keeping them. Students do not choose a text based on their tastes and preferences. Their professors choose
the books. Thus a very high percentage of textbooks are sold in the secondary market. CDs are purchased
because the buyer likes the artist or band. One would predict that a much smaller proportion of CDs would
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be sold in the secondary market. Thus the impact on total sales of CDs would be expected to be less than
the impact on total new book sales.
Changing Age Distribution in the Population
Changing population is certainly a determinant of the demand for many goods. So is the change in the
age distribution in the population for such goods as housing. The demand for housing jumps between
20 and 30. It is relatively nonexistent before age 20, and it starts declining after age 40 by about 1 percent
per year. That means that if the age distribution of the population changes, so will the demand for housing.
In 1960 about 13 percent of the population was between ages 20 and 30. In 1980, it had increased to
20 percent. Not surprisingly, the demand for housing did increase more than the population between 1960
and 1980. The proportion of the population between 20 and 30 has steadily decreased, reaching 13.6% in
the year 2000.
What would you predict would have happened to the demand for housing? What other goods and services
may be facing declining demand because of the aging of the American population? The demand for
housing should decrease. In addition there would be decreases in demand for products for infants since
most women have children prior to their 40th birthday. The demand for appliances would decrease since a
large share of the market for appliances is for installation in new housing.
Chapter 4 Extensions of Demand and Supply Analysis
Of Oranges and Hurricanes
As a result of four hurricanes in 2004 and 2005 in Florida, large numbers of orange trees were either
damaged or destroyed. In addition disease affected the trees during the same period. As a result of these
factors many orange farmers sold their farms to developers for housing construction and got out of farming
altogether. At the same time demand for orange juice was decreasing. The end result was that the price of
orange juice concentrate rose more than 250 percent between January and December 2005.
Explain in terms of the supply and demand model why the price of concentrate increased. Supply decreased
as a result of the hurricanes, disease, and the sale of orange groves to developers for housing. Demand also
decreased. Supply must have decreased by more than demand decreased for price to have risen.
Jamaica’s Sugar Industry Takes a Hit
Sugar production in Jamaica amounts to a little over a third of the country’s exports. The country was one
that could sell its sugar in the European Union (EU) at a price three times higher than the world market
price. Under an agreement reached with the World Trade Organization the EU agreed to cut the sugar
subsidy by 36 percent over the next 4 years. The result is an expected price is that would seriously harm
Jamaican sugar producers who are not competitive at the world market price of sugar.
Using the supply and demand model explain how the reduction in the EU sugar subsidy would affect the
price of sugar paid to the Jamaicans. The effect of the subsidy is to increase the supply of sugar produced
by Jamaican producers. The EU would decrease the subsidy paid to Jamaican producers and the effect
would be the same as a decrease in the price received by them for their sugar. The supply of Jamaican
produced sugar would decrease and the price would decrease other things constant.
Ticket Scalping Goes Legit
Rather than let ticket scalpers obtain economic rents, certain professional sports franchises are now going
to the Web to “out scalp” the scalpers. An increasing number of professional teams, such as the Seattle
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Mariners and the New York Jets, use an online site called StubHub.com to sell unused seats for seasonticket holders. StubHub.com claims to have sold about $100 million in ticket sales in 2004. The average
ticket sale price was about a third higher than its face value. Those teams take about a 10 percent
commission of whatever “the market will bear.”
Ticketmaster has started auctioning off certain tickets for important sporting events. In addition, about
20 teams use Ticketmaster to sell tickets put up by season ticket holders. These teams obtain around an
8 percent commission. While fans decry this legitimate “scalping,” economists know that it is no different
from so-called yield maximization that airlines use virtually every minute of every day as they adjust
their prices to equate anticipated quantity demanded with anticipated quantity supplied.
Movements in Supply and Demand
It’s not often that a doubling of demand leads to a 25 percent reduction in price. That is exactly what
happened in the underwater fiber-optic cable business. This is a perfect classroom example.
Demand doubled in 2003 and continued to grow in 2004 and 2005. In contrast, rates of capacity utilization
in the undersea fiber-optic business have hovered around 10 to 15 percent during the first half of the 2000s.
Consequently, fiber optic cable owners were willing to reduce prices quite substantially in order to “light up”
some “dark” fiber-optic cable capacity. That is to say, supply could move out to the right almost at will in
that industry.
This is a good example of showing the supply curve moving outward faster than the demand curve moved
outward. Given that the demand doubled and prices fell by 25 percent, you can demonstrate this with a
relatively large shift in the supply of undersea fiber-optic cable utilization.
Paying to Drive Fast
According to the Federal Highway Administration, between 1980 and the year 2000, road and street mileage
increased only 2.0%. During the same time period, the number of vehicle-miles traveled increased by 80%.
The results? Increased traffic jams and certainly more road-rage. The solution, well known to economists
since Vickers wrote about peak period pricing decades ago is to start charging for highway use according
to shifts in usage. Technologically, this is more feasible now than ever before. Dashboard-mounted
electronic toll tags (windshield mounted) are easy to use and virtually fail-proof. They allow drivers to
be charged automatically even when riding at 65 miles an hour. Drivers using such tags put funds into a
prepaid account.
If people want to drive in the fast lane during rush hour and are willing to pay for it, they can be charged
whatever is necessary to equate the quantity demanded with quantity supplied.
Empirical evidence shows that drivers are willing to pay up to $6.00 just to go ten miles in the fast lane
during rush hour. Let’s say that the driver saves 30 minutes by paying $6.00. His or her opportunity cost
has to be greater than $12.00 per hour to justify the “splurge” on getting from one location to another
faster than without paying.
What is nice about the system, already in use in Orange County and San Diego, California, is that drivers
can consider it an insurance policy. When they don’t want to pay the extra fee for going faster, they can
stay in regular (slower-moving) traffic.
Price Controls in Sierra Leone
Lisa Walker spent a year in Sierra Leone, West Africa, as a Peace Corps volunteer, and she kept a diary of
her experiences. One thing she wrote about was what happened when the government imposed price controls
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on many common items. “For the past 5 days,” she wrote, “nobody has sold cigarettes, kerosene, Maggi
(bouillon) cubes, or rice here . . . This is the result of the government’s new order. The government says
the Maggi cubes have to be sold for 30 cents, but the sellers bought them for 50 cents, so when military
men enter the village to enforce the government price, those with Maggi’s hide them. Same story for
cigarettes and kerosene. The rice supplies are hidden because of government prices. Unless one is willing
to pay an outrageous price, it is impossible to buy rice in the marketplace. The only way to get rice legally
is to buy it from the government. This means standing in long lines for many hours to get a rationed amount.
I don’t know how Sierra Leoneans are managing or how long this artificial shortage will last.”
How would you graphically illustrate the market for rice in Sierra Leone in the presence of price controls?
The supply of rice would become vertical at the price ceiling and quantity supplied by the government.
There would be a shortage at the legal price. The equilibrium price would occur at the intersection of the
demand curve and the vertical portion of the supply curve.
Should the Legal Quantity of Cigarettes Be Set at Zero?
Nicotine has been used as a psychoactive drug by the native peoples of the Americas for approximately
8,000 years. Five hundred years ago, Christopher Columbus introduced tobacco to Europeans, who
discovered, once they overcame the nausea and dizziness produced by snorting, chewing, and smoking
it, they simply could not get along without it. Nicotine rapidly joined alcohol and caffeine as one of the
world’s most popular psychoactive drugs. In the century after Columbus returned from the Americas with
tobacco consumption and addiction to nicotine spread rapidly around the world. There followed numerous
attempts by governments to quash what had come to be called the “evil weed.” None were successful,
even in Russia where a smoker could be executed for using it. A few years ago the head of the Food and
Drug Administration announced that his agency had concluded that nicotine is addictive and should be
classified with marijuana, heroin, and cocaine.
What can we predict if tobacco is ever completely prohibited? Because tobacco is now legal, the supply of
illegal tobacco is zero. If the use of tobacco were prohibited, the legal supply in the U.S. would become
zero. Even if all of those who had been producing tobacco legally went out of business, firms in foreign
countries would increase production to meet U.S. demand. The supply curve of illegal tobacco products
would shift to the right. There would be an illegal tobacco demand curve from U.S. users of tobacco. The
price people would pay would go up.
What other goods or services follow the same analysis as the ones presented here? The psychoactive drugs
such as marijuana and cocaine were all legal around the turn of the century. The illegal supply was zero.
When these drugs were outlawed, i.e., the legal supply was set at zero, illegal demand developed and the
illegal supply increased. The price of these psychoactive drugs increased. The same analysis can be
applied to prostitution and gambling services.
Chapter 5
The Public Sector and Public Choice
Trying to Lay Claim to Trees that Sop Up Pollution
American Electric Power (AEP) owns power plants around the U.S. that together release about 3 percent
of U.S. CO2 emissions every year. The company has entered into a voluntary agreement with the U.S.
government to cut its CO2 emissions by one percent every year. AEP has determined that it would cost
between $50 and $75 per ton of eliminated emissions to build cleaner power plants. In contrast planting
a sufficient number of CO2 absorbing trees would cost only $1 to $2 per ton of emissions.
AEP faces two problems in utilizing trees to reduce the polluting effects of its power plants. One is
uncertainty about how much CO2 trees absorb from the air. The company has already spent more than
17 million to reforest nearly 60,000 acres of land near its U.S. power plants and paid more than $7 million
to protect a 4 million-acre forest in Bolivia. AEP projects that over several decades the new U.S. trees alone
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will sop up 11 million tons of CO2 or the amount that its power plants release in 16 months. Independent
and government scientists disagree, however, about whether these estimates are accurate.
The second problem is that property rights to CO2 tree absorptions are poorly defined. It is unclear, for
instance, how much pollution reducing credit AEP will be able to claim from its investment in Bolivian
forests if Bolivian polluters try to also lay claim to the pollution abatement benefits those forests provide.
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Under what circumstances could society come out ahead if AEP and other polluters planted trees instead
of cleaning up any of their power plants? If companies could have ownership rights to the trees they planted,
they would plant the trees because fewer resources would be used to clean up air pollution. These resources
could instead be used to produce other goods and services. The external costs of pollution could be
internalized at minimum cost. Also there would be an increase in the quantity of wood produced.
Threat of Inflation Returns
From late 2001 until early 2004 the inflation rate hovered between 1 and 2 percent. The inflation rate
began to increase by mid-2004 to between 2.5 and 4.7 percent. In response the Federal Reserve began
using monetary policy and raised short-term interest rates from 1 percent to 5.25 percent between June
2004 and June 2006 in an attempt to prevent inflation from increasing. The Fed raised interest rates for
17 straight months. The inflation rate stopped rising and settled into a 2–3 percent range. At this point the
Fed stopped increasing interest rates and has left them unchanged even though the inflation rate remained
between 2 and 3 percent in most months since then.
Which function of government was the Fed performing? The Fed was performing the function of ensuring
economywide stability which includes ensuring price stability.
Hydrogen-Based Fuel Cells
In his State of the Union address in 2003 President Bush supported the idea of changing from the use of
internal combustion engines to fuel cells based on hydrogen as a way of reducing air pollution and the
emission of greenhouse gases. Fuel cells are nonpolluting because they only emit water vapor. President
Bush proposed having the government subsidize research and development of hydrogen fuel and fuel cell
technology. The president did not propose raising taxes on gasoline as a way of encouraging the use of
fuel cells and reducing greenhouse gases. Currently hydrogen is more expensive than gasoline.
Would an increase in the tax on gasoline encourage the development of hydrogen-based fuel cell technology
for automobiles? A tax which accounted for all external costs associated with gasoline emissions would
increase the price of gasoline and make operating a gasoline-powered car more expensive. Thus there would
be an incentive to for auto companies to develop and sell fuel cell powered cars because consumers would
find these cars to be relatively cheaper to operate. The demand for fuel cell powered cars would increase
and the demand for gasoline-powered cars would decrease.
Office of Homeland Security
After the events of September 11, 2001, an Office of Homeland Security was set up to try to coordinate the
antiterrorism efforts of various agencies of the federal government. In 2002 the Homeland Security Act was
passed creating the Department of Homeland Security. Two components of the mission of the Department
of Homeland Security set forth in the act is to “prevent terrorist attacks within the United States and to
reduce the vulnerability of the United States to terrorism.” The department evaluates intelligence concerning
potential terrorist threats and issues alerts when the danger of terrorist attacks appear to be imminent. In
addition it works with law enforcement and emergency services agencies in the states and cities to help
prepare for terrorist threats.
Does the part of the mission of the Department of Homeland Security identified above describe the provision
of a public good? The part of the mission identified appears to be a public good. First of all, it is a non-rival
good. The use of it by one person does not decrease the availability of it to another person. Also it is subject
to the exclusion principle, i.e., once it is produced, no one can be excluded from enjoying its benefits, even
if they do not pay for it. It is indivisible and would be difficult to price it based on how much a person uses it.
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Taxing Social Security Benefits
In 1993 Congress passed a bill that made part of Social Security benefits received by retirees subject to
income tax. A retiree who is single with an income from other sources than Social Security between
$25,000 and $34,000 or an income between $32,000 and $44,000 for couples will have to pay income tax
on up to one-half of their Social Security benefits. Thus in these income ranges, every time a retiree’s
income increases by $1.00 she must in effect report as taxable income $1.50. When income is greater than
$34,000 for a single retiree or $44,000 for a couple, they must report $1.85 in taxable income to each
additional dollar that they earn. A consequence for retirees is that additional income earned above the
minimums above is effectively taxed at higher marginal rates than would be the case for non-retirees.
Assume that a retired couple who were receiving Social Security benefits had other income that placed
them in the 15 percent marginal tax bracket and was equal to $40,000. Assume that they earned an
additional $1,000. What would the marginal tax rate on this additional $1,000 be? What effect on the
incentive to work or invest do marginal tax rates such as this have?
To calculate the tax owed by this couple you would first add $850 in Social Security benefits to the additional
$1,000 in income. Thus for tax purposes it would be the same as having earned $1,850 in additional income.
Now multiply $1,850 times 0.15 for tax paid of $277.50. The marginal tax rate is equal to (tax paid  change
in income)  100. In this case this will be ($277.50  $1,000)  100 or 27.75 percent. For 2004, this marginal
tax rate is nearly as high as the marginal tax rate (28.0%) on incomes up to $178,650. (See Table 5–1.)
A marginal tax rate of 27.75 percent would reduce the incentive of a retired person to invest or work.
Remember that Social Security and Medicare tax of 7.65 percent is levied on wage and salary income
so that the effective marginal tax rate on wage and salary income will be over 30 percent.
Microsoft Anti-Trust Suit
In 2002 a four-year-long lawsuit against Microsoft by the Justice department was settled. The Department
of Justice alleged that Microsoft had illegally maintained a monopoly in the operating systems market and
had used that monopoly to attempt to monopolize the Internet browser market by tying purchases of
Internet explorer to purchases of the Windows operating system. The company was found by the court to
have illegally maintained its virtual monopoly over computer operating systems and to have attempted to
monopolize the browser market. Microsoft agreed to no longer engage in its restrictive business practices.
Which economic function of government was being performed in this example? Are there any benefits to
the economy from the settlement of this case? The economic function of government being performed in
this case is promoting competition. By preventing Microsoft from continuing to maintain its monopoly of
PC operating systems and attempting to monopolize the browser market, the government hoped to increase
efficiency in the market for operating systems and to prevent the loss of efficiency in the browser market.
Chapter 6
Taxes, Transfers, and Public Spending
Health Care Insurance in Massachusetts
Massachusetts enacted a law in 2006 that mandates that everyone who lives in the state must have health
insurance. There is one exception. People who are rich do not have to buy health insurance because they
can afford any reasonably expected health care procedure. Individuals will be able to buy health insurance
out of pre-tax (state income tax) dollars. The state will have tax penalties and fines for those who do not
buy health insurance. For lower income citizens the state will subsidize their purchases of health insurance
policies. The lowest income residents will be enrolled in Medicaid when they seek health care in hospital
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emergency rooms. Governor Romney argues that because healthier persons will be included in the various
programs and because there are only 500,000 residents who do not have insurance, that the program will
cost no more than the state currently spends on health care—about $1 billion.
Is Governor Romney’s estimate of the cost likely to be met? Why or why not? No. Extending health
insurance to an additional 500,000 residents will be likely to increase the quantity of health care services
demanded by Massachusetts residents well above the amount they currently consume because the net price
they will pay out-of-pocket for these services will fall. The state will find that it will have to increase the
subsidy for lower income residents because the increased use of medical insurance will increase the cost of
health insurance policies and increased Medicaid enrollment will increase the use of medical services paid
for by the state.
Health Care—Should It Be a Right?
A major issue in the November 2006 congressional campaign was the problem of a large number of U.S.
residents being without health insurance. Given the high cost of health care, such a situation means that
many of these people must do without such care or seek care later even when they have conditions that are
quite serious than do people who have health insurance. For example a study by the American Cancer
Society, Cancer Facts and Figures for African Americans 2007–2008 reported that African-American
men have about a 20 percent higher incidence of cancers of all kinds as compared to white men. However
they have about a 40 percent higher death rate. For African-American women the incidence of cancer of
all types is about 7 percent lower than for white women. However they have about a 20 percent higher
death rate. The reason is explained in part because 20 percent of African-Americans do not have health
insurance as compared to only 11 percent of whites. The evidence is that persons who are uninsured seek
treatment later than do persons who are not poor and have health insurance. Thus African-Americans
have more advanced cancer that do whites when they seek diagnosis and treatment. The later cancer is
diagnosed and treated, the higher is the death rate.
This type of outcome for African-Americans and others who are uninsured has led some politicians to
argue that health care should be a right of every American. A right suggests that health care should be an
entitlement. Thus everyone should have free access to health care or at least have comprehensive health care
insurance that they can afford. If a person cannot afford health insurance then it should be subsidized or
completely paid for by the government.
What would happen to the cost of health care, medical services, if everyone were entitled to free health care?
The cost of health care would rise as the demand for health care would increase from the millions of persons
who became eligible for health insurance and began to seek medical services that they had postponed or
simply not purchased before.
No Child Left Behind Act
In January 2002, President Bush signed into law the “No Child Left Behind Act.” The act was in partial
response to the fact that even with increasing subsidies to public education that have increased by a more than
300 percent since 1960, measures of performance of U.S. students in all grades in such subjects as reading and
mathematics have remained static or fallen. In addition the performance gap between students from lower
income families and those from middle class families has not changed as a result of increased spending on
public education. The act increases federal spending (subsidies) to public education but targets much of
that extra funding for reading and supplemental instruction. The law requires schools that want federal
funding to demonstrate that they are actually teaching every child in an effective way. The centerpiece of this
legislation is having states test students in grades 3 through 8 to identify schools that do not meet standards in
reading and mathematics. Later science testing will be added. Schools which have students who are below
“proficiency” standards would get additional federal aid. If there were no progress of students taking the
proficiency tests after 2 years, parents would be able to transfer their children to other public schools or be
given money to pay for tutors or other additional instruction.
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Why didn’t the federal government simply increase funding for the public schools and not put so many
conditions on that spending? Simply providing more funding for public schools was not improving student
performance and not helping lower income students. Thus the act specifically requires schools to use
additional federal monies in ways that will improve student performance. It also requires schools to
demonstrate that they are teaching effectively and if they are not, to spend on underperforming students.
The government wants schools to spend money on high educational value programs.
Sweden’s Partially Privatized Social Security System
Starting in 1991, Sweden moved toward a partially privatized Social Security system. Currently in Sweden,
employers and employees contribute a combined 16 percent payroll tax similar to our Social Security
“contribution.” In addition, they pay 2.5 percent toward individual retirement accounts. In 2000, workers
were allowed to choose up to five funds in which to place their individual retirement accounts. A central
agency records all of the accounts and fund values. Those who do not choose a fund for their individual
retirement accounts have those accounts invested in a default fund that must invest 80 to 90 percent of its
assets in stocks. Those who have chosen their own mutual funds have on average shown a preference for
funds that invest heavily in Swedish companies.
Chapter 7
The Macroeconomy: Unemployment, Inflation,
and Deflation
The Nobel Prize for Economics and the Natural Unemployment Rate
The winner of the Nobel Prize for economics in 2006 was Edmund Phelps who developed the concept of
the natural rate of unemployment. His original argument was that the economy will not reach equilibrium
until the rate of unemployment reaches its “natural rate.” This natural rate means a rate of unemployment
in which all long-run forces work themselves out in the economy, and it is in long-run equilibrium.
Specifically Phelps was concerned with the role of inflationary expectations and that these will eventually
coincide with the actual rate of inflation. The idea is that there is a rate of unemployment that is in effect
an equilibrium rate toward which the economy tends to move. It is not, however a fixed rate that holds for
all time. Phelps argued that the natural rate of unemployment would depend on factors in each different
economy.
How is the natural rate of unemployment related to the concept of full employment? The natural rate of
unemployment is full employment which exists when there is no cyclical unemployment. It is the rate of
unemployment that is the sum of structural and frictional rates of unemployment.
Are a Self-Employed Dad and a Daughter Who Is Not Working
Part of the Labor Force?
Johnson is a self-employed painter. On most days he paints room interiors alone. From time-to-time,
however, he has taken on exterior house-painting jobs, which pay implicitly higher hourly rates. Whenever
he has tackled home exteriors, he has usually hired his daughter, who will be 18 years old next week, to
help after school. Johnson has not landed an exterior painting job in a couple of months, so he has not
required his daughter’s assistance during that time.
Johnson is hoping to expand his thriving painting business into a larger operation. To learn more about
how to function in the business world he is taking business courses at the local community college in the
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evenings. Currently, he is enrolled in a course in principles of macroeconomics, and his class has just
discussed how the labor force and the unemployment rate are measured. Now Johnson is wondering
whether his daughter is technically part of the labor force but unemployed. She just graduated from high
school and had been actively looking for a job until about a week ago, when she gave up looking any
further. In fact, Johnson is not even certain whether he, as an actively self-employed individual, is currently
included as an employed member of the labor force.
Is Johnson’s daughter currently part of the labor force but unemployed? No. While she does not have a
job, she stopped looking for a job last week. Thus she is not officially unemployed.
Is Johnson currently part of the labor force and employed? Yes. As an actively self-employed individual
he is part of the labor force. He has a “thriving painting business.” He must therefore be employed.
Structural Unemployment in Europe Never Seems to Go Away
In the 20-year period 1980–2000, virtually no private jobs were created in the countries of the European
Union (EU) as compared to 33 million new private sector jobs in the U.S. Unemployment in the EU reached
10 percent as compared to 4.1 percent in the U.S. As compared to U.S. firms, EU firms pay their governments
an amount equal to 50 to 200 percent of employees’ wages as “social charges.” In addition governmentmandated minimum wages often far exceed the value low-skilled workers might contribute to potential
employers. Consequently low-skilled unemployed cannot find jobs. Firing workers is costly because of
government required severance pay is high. Thus most new hires are temporary workers on short-term
contracts. Meanwhile the unemployment rate in the EU among persons under 25 averages around 20 percent.
If the reasons for the EU’s high structural unemployment are so obvious, why aren’t governments relaxing
strict labor laws and reducing social charges levied on employers? The reasons are political. The social
insurance taxes are used to fund popular social welfare programs. These programs would have to be
reduced if the tax rates were cut or would have to be funded out of income or VAT tax increases. Neither
of these types of policies would be politically popular. The labor market restrictions on plant closings and
high costs associated with plant closings are designed to protect workers’ jobs. Paradoxically, the existence
of such programs makes workers who have jobs fear unemployment because of the difficulty of getting a
new job and thus causes them to more strongly support the policies.
Deflation and Real Interest Rates in Japan
In the past few years the wholesale and consumer prices have been falling in Japan. In 2002 for example,
consumer prices fell by 0.4 percent in Japan. Short-term interest rates averaged around 0.1 percent.
Assuming that the 0.4 percent decrease in the price level was anticipated in Japan the real interest rate was
at 0.5 percent. This is computed by adding the expected rate of deflation to the nominal interest rate.
Why can’t nominal interest rates be negative? A negative nominal interest rate implies that a lender will
pay a borrower to borrow money. A lender could choose not to lend and have more wealth at the end of
any time period by not lending. His or her consumption and thus satisfaction would be higher.
How Reliable Is the CPI?
The CPI is a fixed-quantity price index, meaning that each month the Bureau of Labor Statistics samples
only prices rather than relative quantities purchased by consumers. The problem is that when relative
prices of particular goods go up, consumers substitute in favor of other, relatively less expensive items.
When relative prices go down, consumers do the opposite. An important way that consumers deal with
inflation is by buying less of products that become “too expensive.” The result is that the rate of inflation
is overstated.
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Would there be a similar problem during a period of deflation? During a period of deflation consumers
would substitute goods that experience a decrease in relative price for other relatively more expensive
ones. Because a fixed-weight price index such as the CPI ignores this effect, it will understate the rate of
deflation.
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Chapter 8 Measuring the Economy’s Performance
How the Internet Has Contributed to a Lower U.S. Inventory to Sales Ratio
In the 1990s there was widespread adoption of Just-in-time inventory techniques by U.S. businesses, which
are techniques that companies use to keep inventories from running out or building up beyond desired
levels. The Internet has facilitated the implementation of many just-in-time inventory techniques. When a
company that supplies basic components used in a variety of electronic products experiences an inventory
buildup, it has several options for reducing its inventory via the Internet. The company could offer some of
its inventory for sale on organized business-to-business exchanges that handle total transactions exceeding
$1 trillion per year. In addition it could use computer programs offered by Ariba and Commerce One to
operate its own Internet auctions to sell its inventory to the highest bidders. Alternately the company can
purchase the Web-auction services of eBay or other firms to assist in selling off some of its inventory.
There is considerable evidence that the use of the Internet-based just-in-time inventory techniques has
contributed to the noticeable decline in the ratio of inventories to sales in U.S. manufacturing. In 1990 the
inventory to sales ratio was about 1.75, which means that U.S. companies had about $175 in inventories
for every $100 in sales. Sixteen years later the ratio had fallen to 1.35.
What effect would this decline in the inventory to sales ratio have had on U.S. inventory investment? It
would have decreased the amount of inventory investment because the average firm would have decreased
its holdings of inventory by $40 for every $100 in sales in 2006 as compared to 1990.
GDP and Economic Welfare
Gross Domestic Product, or GDP, has become the most important measure of how well the economy
performs. It is used by policymakers, economists, international agencies and the media as the primary
measure of a nation's economic health and well–being, but it was not designed for this role. It is the sum
of the value final products and services produced in one year by domestic resources, with no distinctions
between transactions that add to well–being, and those that diminish it. In the computation of GDP it is
assumed that every monetary transaction involving the production and sale of final goods and service adds
to the nation’s well–being.
GDP ignores everything that happens outside the realm of the production and market exchange of final
goods and services, regardless of its importance to well–being.
Would GDP increase when the environment is damaged by toxic spills and then the damage caused by
these spills is cleaned up? Yes. The clean-up of toxic sites would increase GDP because resources would
be employed to clean it up. These resources would be providing final services to the economy. The
productive activity that led to the spills would also be counted in GDP.
Would the country actually have an increase in well–being as a result of the pollution and the clean-up
activities? No. The pollution initially reduced well–being. Cleaning it up simply restored the environment
to its original state and the earlier level of well–being.
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GDP and Costa Rica’s Forestry Production
Many developing countries depend on natural resources for much of their income and employment. When a
forest is cut down in Costa Rica, the output is sold, and if we look only at GDP figures, the economy appears to
be growing richer. But what if the trees are not replaced so that their removal results in flooding, soil erosion,
and loss of fuel and food by the indigenous population? Robert Repetoo of the World Resources Institute in
Washington, D.C., has recalculated GDP in Costa Rica to reflect the impact of resource depletion. His figures
show that within the forestry sector itself, net forestry product—after resource depletion is calculated—was
actually negative through most of the 1980s. Repetoo argues that such statistics are important because they
educate the developing countries and show them that their natural wealth is not limitless. He wants the United
Nations to take into account the depletion of natural resources when calculating each nation’s GDP. He points
out that currently a benefit from commercial forests is recorded only when trees are cut down.
In the United States there are actually more trees in our forests than there were 50 years ago. Does this
mean that we should be adding to our GDP figures for this increase in our forests? We should not be
counting these additional trees in current GDP. Using current definitions trees in a forest are intermediate
goods rather than final goods since the trees are not consumed as final goods until they are cut down and
processed into forestry products that are in some final product.
Can the Government Catch Up with the Real-Life Economy?
For years government statisticians have been classifying the industries in the U.S. according to the Standard
Industrial Classification (SIC). This system was developed in the 1930s. With so many complaints about
how outdated the SIC categories were, the government finally did start changing how it classifies industries.
It has developed the North American Industry Classification System (NAICS). Three hundred new industries
have been added including satellite communications. It has also regrouped new and existing industries
together. There is a group called “information,” which includes publishing, software, broadcasting,
telecommunications, and motion pictures.
We want to be sure that we can measure industrial boundaries for purposes of antitrust law enforcement.
Whether a firm is a monopolist or trying to be one depends on how industrial boundaries are defined.
What the GDP Figures in China Really Mean
For years the Western world has been regaled by impressive figures on the growth in the Chinese economy.
While the U.S. has been happy with growth rates of 3 and 4 percent per year, the Chinese economy has
been growing at 7, 8, even 9 percent per year. But what do such statistics really mean? One Chinese
economist in Beijing, Lu Feng, compared China’s official production rate of meat, eggs, and fish products
with what people actually consumed. He concluded that real output in these sectors had been exaggerated
by over 40 percent. The reason is that officials want to show good output performance, so they overstate
agricultural output. The same problem plagues the industrial sector. The reality is that so long as China
does not correct its reported output figures by doing many sampling surveys, it is bound to exaggerate its
real GDP and thus its economic growth.
Why do government statisticians in the U.S. not face a similar problem? In the United States good
performance by private producers is measured by profitability and not by total output. Thus U.S.
producers do not have any incentive to overstate output.
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Global Economic Growth and Development
Productivity Growth in the U.S. Since 2002
Productivity is the major driver of economic growth in the U.S. accounting for about half of the increase in
real GDP over time. Between 1996 and 2001 productivity showed no trend and averaged about 2.7 percent.
In 2002 productivity increased to 4.1 percent and then declined in every year to 2006 to 2.2 percent. This
development caused concern about such factors as higher inflation and slower economic growth. If
productivity continued to decrease, then the resulting slower rate of economic growth would mean smaller
increases in real wages and standards of living in the future.
By how much would output per labor hour and real GDP have increased in this 5-year period if
productivity growth had averaged 4.0 percent per year? (Hint: See Table 9–3.) Output per labor hour
would have increased by 22 percent. Real GDP would have increased by one-half of that amount or
11 percent other things constant.
By how much would output per labor hour have increased in this 5-year period if productivity growth had
averaged 3.0 percent per year instead? (Hint: See Table 9–3.) Output per labor hour would have increased
by 16 percent. Real GDP would have increased by one-half of that amount or 8 percent other things constant.
VOIP Finally Comes into Its Own
A concept known as Voice over Internet Protocol (VoIP) has been around since the 1990s. At that time the
inventors of VoIP realized that any signal, including phone signals, could be digitized and sent over the
Internet. The concept was straightforward, but implementing it in the market turned out to be a challenge.
When VoIP investors tried selling their own VoIP services to individual consumers, they ran into a
fundamental problem. To succeed, the investors had to convince many people to simultaneously switch
from regular telephone service to VoIP so that there could be enough people to talk to over the Internet.
These efforts had not been successful by the late 1990s.
By the early 2000s, however, two events had altered the prospects of VoIP. First, by that time many companies
were employing new technologies that permitted them to route incoming phone calls to computers. These
companies found that they could operate their internal telephone systems more cost effectively by using
VoIP to convert regular phone calls to digital information within their own phone networks. Second,
providers of telephone services, such as Verizon and SBC, implemented VoIP networks for routing
traditional phone calls. By the mid-2000s market forces created a situation in which VoIP was in wide
use everywhere except inside people’s homes. Thus the first place many inventors of VoIP attempted to
introduce the technology turned out to be the last place it had a chance of succeeding as an innovation.
How might the trend toward greater use of cell phones and increased integration of wireless computer
technology in cell phones improve the chances that VoIP may ultimately emerge as a true innovation in
consumer-to-consumer telecommunications? As telecommunication becomes increasingly digital and as
cell phones are increasingly able to access the Internet, it may become possible for consumers to simply
use VoIP as their primary telephone service.
The Productivity Paradox
In the course of a book review he wrote in 1987, Nobel economist Robert Solow made the offhand
comment, “you can see the computer age everywhere but in the productivity statistics. This comment
summed up what has become known as the “productivity paradox”: the seeming lack of productivity gains
from information technologies. For example, widespread adoption of information technologies in service
industries were supposed to allow these industries to reap big efficiency gains. Barcoding of merchandise
was supposed to allow sales clerks at retailers to do their work much more efficiently. Financial electronic
data interchange was supposed to provide big productivity enhancements in financial services. These
productivity gains were slow to emerge—either that or the data are wrong.
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Higher education is a good example of a service industry. College campuses are now full of computers.
How would you propose to measure the effect of computers on productivity in higher education?
There are two places where it might be possible to measure productivity in higher education. One area is in
administrative services, e.g., the registration process, student record keeping, payroll, etc., which are done
faster and with fewer person-hours than would be the case in the absence of computers. This is clearly the
case with the advent of computerized test banks. At one time, departmental secretaries and other clerical
personnel typed many, if not most tests. Today faculty members choose the questions as they always did
but have the computer generate the final copy of the test. Fewer clerical hours are used to support the
teaching function. In so far as the actual delivery of education by university faculty is concerned, the use
of semester credit hours produced or numbers of students enrolled to measure productivity (output per
faculty member per hour in the classroom) probably is not an appropriate measure of education. On that
basis, the only way for productivity to increase would be to increase class size. Another way would be to
measure how much additional learning occurs as a result of better teaching materials, student access to
vast libraries on the Internet, skills acquired in using computers that better prepares students for future
careers, and more efficient methods of presenting material (presentation software, for example).
Rates of Saving in Various Countries
Economists argue that any nation that devotes a relatively high proportion of its income to savings
ultimately will also have a relatively high level of income. This economic growth proposition is supported
by a consistent body of data of saving rates. There is a well-established positive correlation between higher
levels of per capita real GDP and higher rates of savings.
How can we expect relatively poor countries, such as Ethiopia, to save more? Saving depends on the level
of income. Domestic saving can increase if income levels increase. Of course domestic income will
increase if saving increases and is used to finance investment. The way out of such a dilemma is to attract
foreign investment which will increase GDP and income levels. Then saving can increase.
Japan and Germany Save and Invest More Than the United States,
but Does It Matter?
Japan and Germany have saving rates that are substantially higher than the U.S. rate. As a result they have
accumulated more capital. On a per capita basis Japan has about 22 percent more invested capital than the
U.S., and Germany has 13 percent more. Nevertheless, the U.S. creates more wealth per capita. In 2000
dollars the U.S. created $29,950 in new wealth per capita, compared to $23,600 for Japan and $23,600
for Germany.
At least part of the difference results from more efficient use of capital in the U.S. economists estimate
that a unit of capital in Germany or Japan generates output that is about a third lower than that in the U.S.
In other words if a $1,000,000 factory produces 1,000,000 units of output per year in the U.S., a comparable
factory would produce about 670,000 units of output per year in Germany or Japan.
Some claim that, “Americans over consume, under save, and under invest.” How do the figures here
counter this statement? Americans get a return on investment in output terms that has the effect of a onethird increase in saving and investment as compared to Germany and Japan. On that basis one cannot say
that Americans under invest (and thus under save) because the consequences of investment are greater
here than in Germany and Japan. On a comparative basis the effect of Japan’s greater capital investment
per capita are effectively 33 percent  22 percent  11 percent less than in the United States, while
Germany’s investment per capita are effectively 33 percent  13 percent  20 percent less than in the
United States.
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Our High-Tech Economy
Four decades ago, one in six American businesses was automotive-related. In 2004, autos and light trucks
account for about 3.8 percent of GDP. So does spending on computers and related equipment. Yet despite
the fact that technology’s share has doubled in the last decade, government statisticians still refuse to use
chip inventories and personal computer sales as economic indicators. The reason is that the economic
welfare created by high-tech industries is much harder to measure than, say, tons of steel or bushels
of corn.
When software is distributed at no charge on the Internet, does that result in an increase in GDP? There
would be no effect on GDP because no market price is charged.
Chapter 10
Real GDP and the Price Level in the Long-Run
Productivity, Long-Run Aggregate Supply, and Inflation
After growing at an average rate of around 3 percent from 2002 to 2005, productivity of non-farm businesses
in the U.S. declined to less than 2 percent per year in 2006 according to the Bureau of Labor Statistics.
During 2006 labor compensation unit labor costs increased by over 5 percent which was the highest rate
since 1990. This combination led to increased unit labor costs since higher productivity, output per worker
hour, offsets increased compensation per hour. In this case, unit labor costs increased by about 3 percent—
percent increase in hourly compensation minus percent increase in productivity. There was concern that
this combination would lead to an increase in the rate of inflation.
If productivity stays at its current lower level, but the rate of growth of aggregate demand remains
unchanged in the long-run, what will happen to the rate of inflation in the long-run? The decrease in the
rate of growth of productivity will result in slower growth of long-run aggregate supply. Other things
constant aggregate demand will increase faster than aggregate supply and the price level will increase.
Regulation and Economic Growth
If the extent of federal regulation activities in U.S. product and labor markets can be measured by the
sheer volume of published regulations, then the scope of regulation has increased by more than 500
percent since 1950. To satisfy heath and safety, environmental, labor and various other regulations,
companies must shift resources away from producing goods and services. Consequently, the regulation of
economic activities entails an opportunity cost for society: forgone production of real GDP.
John Dawson of Appalachian State University and John Seater of North Carolina State University have
estimated the degree to which federal regulations have reduced real GDP growth. They have calculated
that the trend rate of annual growth of real GDP is almost one percentage point lower due to regulatory
growth. Thus if there had been no increase in federal regulations since the early 1950s, the economy’s
long-run aggregate supply curve would have shifted much farther to the right over the past five decades.
U.S. real GDP would be at least 40 percent higher today.
How do various activities involved in satisfying federal regulations get counted in real GDP?
(Hint: Income payments must be made to owners of resources directed toward meeting regulatory
requirements. The value of the activities involved in satisfying federal regulations would increase
GDP since they generate income to the resource owners who supply the information. These costs are
included in the prices of goods and services produced by the firms who are required to meet the
regulations.)
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Corporations Adjust to Potential and True Deflation
For decades the conventional wisdom among corporate financial officers was that they can lower their
companies’ costs by financing purchases of capital by borrowing—taking out loans from banks, selling
commercial paper, issuing new bonds, and the like. The reason is that debt has traditionally been less
expensive to a firm than issuing new shares. Corporate managers count on inflation to erode the value
of the firm’s debts even as the selling price of the company’s output increased.
In a deflationary environment, however, these dynamics are reversed. Deflation increases the real value of
outstanding debts. At the same time companies find that to repay their loans, they must dip into profits that
are declining because of falling profits. In 1997 and 1998 companies based in Southeast Asia faced lower
selling prices and mounting real values of their indebtedness. In addition the relative values of their
currencies fell and many of their debts were denominated in dollars. Thus in addition to a rising real value
of their debts in local currency, they had to also use more units of it to buy dollars to pay off their dollar
indebtedness. In the past few years U.S. manufacturing companies have been seeing their selling prices
declining. Corporate treasurers in these industries are now talking about a new balance sheet paradigm in
which companies will rely much more heavily on issuing stock instead of borrowing.
In what ways might deflation affect an individual’s well–being? For persons who are creditors, deflation
means an increase in the real value of the debts owed to them as well as increases in the purchasing power
of the interest payments. For example, a retired person with certificates of deposit and shares in a bond
mutual fund should experience a net increase in both wealth and his or her standard of living. Debtors
will find that they are worse off because they will have to pay off debts in dollars that are worth more in
purchasing power terms than the ones they borrowed. In a practical sense the debt repayments will be
made from a lower dollar income for the average debtor since a falling price level means lower dollar
incomes on the average. So someone paying off a car loan over a 5-year period would find him-or herself
giving up increasing amounts of purchasing power.
Chapter 11
Classical and Keynesian Macro Analyses
An Antiterrorism Regulation Creates an Aggregate Supply Shock
In August 2002, President George Bush signed the Trade Act, which among other things created a new set
of transportation-security rules aimed at reducing the likelihood that terrorists would smuggle weapons
into the U.S. The new rules apply to every mode of transportation—trucks, trains, ships, and planes—and
require these transportation companies to send e-mails or faxes notifying the Bureau of Customs and
Border Protection of the contents of all cargoes and the intended recipients. The purpose is to give officials
time to identify suspicious shipments so that they can intercept and inspect them for contraband. The
advance notice varies with the type of transportation, ranging from 30 minutes for trucks to 24 hours
for ships.
Large trucking companies had electronic systems to direct deliveries so they made costly modifications to
them to send automatic messages to government officials. Smaller companies incurred greater costs because
they had to make rapid transitions to electronic systems or buy fax machines and incur much higher long
distance phone charges. The two-hour notification requirement for international cargoes required FedEx
and similar companies to have to restructure aspects of their overnight delivery systems. Freight train
operators and owners of cargo ships also had to make expensive changes in their record-keeping procedures.
The effect was to increase shipping prices for U.S. companies using imported components for their
products. These companies also had to make adjustments in their inventory management systems to take
into account regulation induced shipping delays. Over time the effects on shipping costs and inventory
management costs diminished.
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What was the effect on the short-run aggregate supply curve of the Trade Act? Explain. The short-run
supply curve decreased. In addition to higher shipping costs, the delays caused by the Trade Act would
have meant that firms would have had their goods and/or resources tied up in the inspection process. As a
consequence the delays would have slowed deliveries. Thus the payments for these goods and services or
resources that could have been used to produce goods and services would have been idle during the delays.
In either case firms would have been able to produce less with the same resources as a result of the delays
associated with the inspection process.
How Sticky Are Prices in the United States Economy?.
Mark Mils and Peter Klenow in a 2004 paper, “Some Evidence on the Importance of Sticky Prices,” in the
Journal of Political Economy, made a study of how often prices change in the U.S. economy. What they
found is that in the U.S. economy, the median time between time between price changes (excluding
temporary price changes such as sales and specials) was 8 to 12 months. It is also the case that service
prices change less often than goods prices, and prices of goods that use a high proportion of raw materials
change more often as do prices of unprocessed food items.
Suppose that there is a supply shock such as the increase in oil and other energy prices that occurred after
Hurricane Katrina. In less than a year these prices fell from their high point in the fall of 2005 as Gulf
Coast refineries were brought back online and much of the damage to Gulf oil and gas production was
repaired. The price of oil did not fall all the way back to summer 2005 levels but this was due to other
factors such as cutbacks in production by OPEC and a continuation of rising demand for oil by China and
India in 2006. Also there was relatively little change in the U.S. rate of inflation in late 2005 and 2006.
If Mils and Klenow’s work is correct, why didn’t the inflation rate increase in 2006 as a result of the
Katrina supply shock? If prices do not change in the economy more often than every 8–12 months, then
the short-run aggregate supply curve will not shift upward immediately following a supply shock. In fact it
should take at least 8 to 12 months before it shifted upward. During the adjustment time the price of oil
and other energy declined. The price of oil and other energy products did not stay at their highest levels
long enough to permanently affect the price level.
Drilling for Oil in the Arctic National Wildlife Reserve (ANWR)
Starting in 2001 the Bush administration has strongly supported the idea of increasing U.S. energy supplies
by opening up the ANWR to oil exploration. Based on current assessments of the ANWR there are an
estimated 5.7–16 billion barrels of oil in the refuge. There has been a considerable controversy about
developing these oil resources with the Bush administration arguing that allowing exploration would
contribute to a reduction of U.S. dependence on foreign oil at a minimal effect on the environment of
the refuge. Environmentalists argue that the effect on a fragile arctic environment and species of animals
makes drilling and pumping oil from the ANWR is too costly. Thus they strongly oppose drilling there.
As of 2006 the environmentalists have been successful in blocking drilling in the refuge.
What would happen to the short-run aggregate supply curve (SRAS) if the Congress decided to permit
drilling and oil production in the ANWR?
Assuming that the estimates of oil reserves are correct, the effect would be to shift the SRAS curve to the
right. The reason is that the U.S. would have increased the world supply of oil and this would lower the
price of oil other things constant. The result would be lower production and transportation costs for U.S.
business.
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The Effects of a Stronger Dollar in 2002
In January of 1999 the euro was introduced as the currency for most of the countries of the European
Union (EU). The idea was to end the problems associated with each country having its own currency in
a free trade area that was attempting to coordinate monetary policy. At that time the dollar price of one
euro was $1.18. By January of 2002 the dollar price of a euro had fallen to $0.86 after which it began
to increase. During this period U.S. increased it exports of goods and services to the EU by less than
one percent, while U.S. imports from the EU increased by 14.4 percent.
Are these statistics consistent with what you would expect from a stronger dollar? What would have been
the effect on U.S. real GDP? Why?
In the period under consideration the dollar appreciated by about 27 percent. The effect was to increase
imports much more than exports since U.S. exports became about 27 percent more expensive for Europeans
to buy while European goods became about 27 percent cheaper for Americans. Thus net exports would
have decreased. The effect would have been to decrease aggregate demand in the U.S. and thus to have
reduced (the growth) of U.S. GDP.
Banning Women from the Labor Force: The Case of Afghanistan
In the mid-1990s the Taliban seized power in Afghanistan after 18 years of war and proclaimed a
fundamentalist Muslim state. This strict Muslim state existed until the Taliban government was
overthrown in 2002 by the U.S. military and the Northern Alliance. As part of the Muslim principles
as interpreted by the ruling clerics, women’s activities were severely restricted. Women and girls were
forbidden to go to offices and schools. The restriction on gainful employment was particularly painful
for women who were sole supporters of their families. After 18 years of war there were many fewer
men to support families.
It was estimated that women made up 10 percent of the labor force before the Taliban seized power so
that the prohibition on women working reduced the labor force by 10 percent.
What would have happened to real GDP and the price level after the Taliban took over Afghanistan?
Explain using aggregate demand-aggregate supply analysis. Real GDP would have decreased both longand short-run aggregate supply because the labor force would have decreased. Given the aggregate
demand curve, real GDP would have decreased. The aggregate supply curves would intersect the
aggregate demand curve at a higher price level.
Chapter 12 Consumption, Real GDP, and the Multiplier
Japanese Businesses Go on a Shopping Spree
Throughout most of the 1990s and early 2000s, even as market interest rates hovered near zero, Japanese
firms engaged in less investment spending than they had during the 1980s when the Japanese economy
was booming. Expectations of weak future sales in the stagnant economy that developed after the early
1990s discouraged firms from purchasing new equipment and factories.
Economic activity in Japan finally began to recover beginning in 2002 and so did firms’ anticipations of
future sales. Many companies began replacing facilities they had installed back in the 1980s. Others went
further and bought additional capital equipment that would permit them to expand their productive
facilities. In 2003 Japanese investment in new equipment increased by close to 25 percent.
What happened to the planned investment schedule in Japan in 2003? The planned investment schedule
shifted outward to the right.
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Changes in Wealth and Consumption
In a study done by Alan Greenspan and Federal Reserve economist James Kennedy in 2005 estimated the
increase in home prices between 2000 and 2004 and the amount of money that homeowners had taken out
of those increases in home values. They estimated that home values had increased by 53 percent and the
amount of cash that had been taken out by homeowners by selling or refinancing their home increased
from $204 billion in 2000 to $599 billion in 2004. Between 1985 and 1999 the value of household stocks
and mutual fund holdings increased from $1.4 trillion to $14 trillion, a tenfold increase. The estimated
minimum increase in consumer spending resulting from this increase in wealth was estimated to be from
$28 billion in 1985 to $280 billion in 1999. These increases represented funds that were in addition to
disposable income and much of it was spent on consumer goods.
From 1982 to 2004 consumption increased from approximately 63 percent of GDP to about 70 percent.
Does this represent a shift of the consumption function or a movement along a stable consumption
function? It is an upward shift of the consumption function. At every level of disposable income the
household sector spent more on consumer goods.
Is the U.S. Rate of Investment Understated?
Investment is measured in the national income accounts as the sum of spending on physical capital—
plants and equipment, infrastructure, and housing—and adjustments to inventories of produced goods.
Using this definition, the portion of U.S. real GDP allocated to investment lags behind much of the rest
of the developed world. Some economists worry that the result is that total planned expenditures are
depressed along with equilibrium income. In addition these economists are concerned that the lower rate
of investment reduces the rate of capital accumulation and reduces economic growth.
Other economists believe that the current definition of investment fails to capture the true meaning of the
term. Most of measured investment spending is on capital, i.e., resources used to produce output in the
future. There are at least three other types of expenditures that appear to fit this definition which are not
currently included in investment. The first is education, which yields returns over long periods of time.
Much of educational spending is for investment in human capital. Currently only spending on schools and
educational equipment are included in investment spending. The U.S allocates nearly 7 percent of real
GDP to education. In most other countries it is 5.5 percent or less. Second is spending on research and
development (R&D). R&D expenditures are counted as government consumption and private production
costs. It is clear that R&D expenditures aid economic growth. The U.S. allocates about 3 percent of real
GDP to R&D while most other countries allocate 2 percent or less. Finally, consumer durables yield a
stream of services over a number of years yet only housing is counted as investment in the national income
accounts. U.S. households spend about 6 percent of real GDP for other durables that yield service flows
for years.
Another factor in comparing the U.S. investment rate with that of other countries is that U.S. investment
goods are less expensive. That is, a given dollar of spending on factories or equipment provides more units
of these goods in the U.S. as compared to other countries.
When all of these factors are taken into account the adjusted measure of investment of the U.S. exceeds
35 percent per year, while the average rate adjusted the same way for other industrialized countries is
about 30 percent.
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The MPC and the Multiplier in the U.S.
An important issue from 2000 to 2002 was the problem of slow economic growth and a recession followed
by uneven growth of real GDP. An important problem was predicting what would “get the economy
growing” fast enough to get out of a “jobless recovery.” Part of the issue could be viewed as the amount of
new spending would be needed. The multiplier concept would be useful in determining the answer to this
problem. The multiplier concept appears to suggest that the MPC and thus the multiplier are constant over
time so that the size of a given change in autonomous spending will have a predictable effect on equilibrium
real GDP. According to the national income and product tables given by the Bureau of Economic Analysis
for real GDP and personal consumption expenditures in billions of 1996 dollars for the years 1999–2002 are:
Year
Real GDP
PCE
1999
2000
2001
2002
8,859
9,191
9,215
9,440
5,965
6,224
6,377
6,575
As an economic analyst, you could use these figures to determine the simple multiplier to predict given
changes in autonomous spending.
Instruct students to compute the MPC for the years 1999–2000 and for 2001–2002. What would be the
values of the simple multiplier shown in your text for these two time periods? MPC between 1999 and
2000 is the change in consumption (PCE) of $260 divided by the change in real GDP of $332 or 0.88.
Between 2001 and 2002 the change in consumption (PCE) of $198 divided by the change in real GDP of
$226 or 0.78. The resulting simple multipliers 1/(1  MPC) would be 1/(1  0.78)  4.5 for 1999–2000
and 1/(1  0.88)  8.3 for 2001–2002.
Why would a stable multiplier be necessary to come up with the appropriate change in autonomous
spending? Would these simple multipliers help if they were correct for the economy as a whole? If
the simple multipliers shown were the correct ones for the economy, they would not provide much
guidance for a person trying to determine how much of a change in autonomous spending would be
needed. A stable multiplier would be needed to be able to predict the effect of a given change in
autonomous on the equilibrium level of real GDP.
Chapter 13
Fiscal Policy
Direct Offset of Government Grants
Private companies fund a considerable amount of scientific and engineering research. So does the
government. Although some of this research is conducted by people directly employed by government
agencies, the government also helps fund research by providing grants to researchers. Many such grants
provide dollar payments directly to researchers to fund all or part of their salaries and those of their
assistants. In addition, the government often helps pay for special equipment for various research facilities.
Since 2000 the number of full-time researchers using funds provided by government grants has risen by
9 percent. Total federal outlays for research and development have increased by more than 45 percent. In
the absence of government grants, a portion of this growth in research funding would have been provided
by the private sector. This helps explain why the government’s share of total national spending on research
and development has risen from 25 percent to about 35 percent today.
How might increased government spending on research and development that simply replaces private
spending dollar for dollar affect aggregate demand? It would result in no change in aggregate demand
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because the increase in government spending would be exactly offset by an equal decrease in planned
private spending on research and development.
The Effects of the Bush Tax Cuts
In 2001 the Bush administration was faced with a recession and a budget surplus. Expansionary fiscal
policy suggested that an expansionary fiscal policy could be used to counter the recession. The Bush
administration chose to cut taxes because this was also a policy that it had campaigned on in 2000. The
tax cuts did, in fact, provide a stimulus to the economy in the short-run. The tax cuts also were designed
to shift the largest sums of tax savings to upper income groups because the Bush administration used the
supply side economics argument that these tax cuts would stimulate saving and thus investment. The result
would be economic growth and a long-run increase in income levels. Ultimately, the level of income in the
economy would rise so much that the resulting increase in tax revenues would eliminate any deficit that
might result.
The Congressional Research Service estimated that the economic stimulus that the Bush tax cuts had caused
had become virtually negligible by 2006. The deficits primarily caused by these cuts were very large and
had resulted in a significant growth in the deficit and resulting government borrowing. The interest payments
on this new debt offset about a quarter of the growth of revenue that occurred. It appears that in the longrun that tax cuts, especially large ones, ultimately add to the deficit.
Where on the Laffler curve did the Bush administration think the economy was located? It believed that
the economy was on the downward-sloping portion past the point at which tax revenues are maximized.
Thus cuts in tax rates would increase government tax receipts.
Where was the economy actually located on the Laffler curve? It was on the rising portion of the Laffler
curve before tax revenues were at a maximum. Revenues fell with decreases in tax rates and the deficit
increased.
Crowding Out Effects During World War II
Most American history books point to World War II as a clear-cut example of beneficial expansionary
fiscal policy in action. The U.S. economy was pulled out of the Great Depression by enormous governmental
outlays for the war effort—or so the story goes. The actual situation was that the U.S. economy’s growth
rate from 1933 to 1941 was already higher than any other recorded peacetime period of the same length.
Moreover the increase in military expenditures during World War II was not matched by a similar increase
in total output. In fact, it looks as if the crowding-out effect was relatively large, at least much larger than
the history books indicate. This can be readily observed in terms of what happened to personal consumption
expenditures. They dropped by 3.5 percent in real terms from 1941 and 1942 and did not rebound to 1941
levels until after 1944. In other words, the average American saw no real increase in living standards
during the war, in spite of massive military expenditures.
Given the information presented here, what could you say about the government’s spending multiplier
during World War II. It appears to have been less than one if total output did not increase as much as
military spending. There are two possible explanations. One is that to continue spending at the same pace
even after cutting taxes, the government had to borrow to finance the resulting deficit. Consequently,
market interest rates rose, thereby causing a crowding-out effect: an offsetting fall in private spending.
Another potential explanation is that people behaved in a way predicted by the Ricardian equivalence
theorem. That is, they realized that the tax reduction today would entail a future tax increase to repay debt
that the government incurred. Thus, people saved the amount of the tax reduction instead of spending it,
so that aggregate demand did not change.
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Islam and Supply-Side Economics
Supply-side economics has a long history, dating back to at least the 14th century. The greatest of medieval
historians, Abu Zayd Abd-ar-Rahman Ibn Khaldun (1332–1406), included in his book, The Muqaddimah
(1377) and Islamic view of supply-side economics. He pointed out that “when tax assessments . . . upon
the subjects are low, the latter have the energy and desire to do things. Cultural enterprises grow and
increase . . . (Therefore) the number of individual imposts (taxes) and assessments mounts.” If taxes are
increased in both size and rates, “the result is that the interests of subjects in cultural enterprises disappears,
because when they compare expenditures and taxes with their income and gain and see little profit they
make, they lose all hope.” Ibn Khaldun concluded that “at the beginning of a dynasty, taxation yields a
large revenue from small assessments. At the end of a dynasty, taxation yields a small revenue from large
assessments.”
How do this Islamic scholar’s theories apply to the modern world? If a tax hike pushes marginal tax rates
high enough, then tax revenues may actually fall if incentives to work, save, and invest are reduced. When
marginal tax rates are reduced, the incentives to work, save, and invest are increased, and tax revenues
may increase.
Keynesian Fiscal Policy Loses Its Luster
Some analysts argue that John Maynard Keynes was the most influential economist of the 20th century,
for he armed policymakers with fiscal weapons that allowed them to fight recession. Yet at the beginning
of the 21st century, influential policymakers throughout the world are ignoring the concept of government
spending as a way out of recessions. Even though European governments have long favored welfare spending,
the 11 that joined together to use the common currency called the euro also agreed to some specific antigovernment spending stipulations. These countries agreed to keep deficits at 3 percent or less of GDP.
When a country’s deficit exceeds 3 percent of GDP it can be fined up to 0.5 percent of its GDP.
The International Monetary fund did a study on fiscal policy a few years ago. It examined attempts by
governments to reduce public spending and public debt. It looked at 62 attempts over the two and a half
decades. Its conclusion was that in the 14 cases where the governments had aggressively reduced
government spending, as in Denmark and Ireland, those economies had the fastest growth rates. The
IMF contended that there may have been “a virtuous circle between economic growth rates and
debt-reduction.”
How might Keynes have responded to this increase in anti-Keynesianism? Keynes might have responded
by pointing out that his policies were for short-run adjustments of aggregate demand to get the economy
out of a recession or depression when one occurred. Keynes analysis does not in and of itself imply that
continuous large-scale government intervention via fiscal policy was necessary to keep the economy at
or near full employment only that deficit finance could be used to increase aggregate demand. Economic
growth is a long-run phenomenon. The policies that encourage growth are long-run policies. Thus, he
might argue that it is the same viewpoint difference that existed with the classical economists, a long-run
view versus a short-run view.
Chapter 14
Deficit Spending and the Public Debt
Republicans and Democrats and the Deficit
The Bush administration began with a $300 billion budget surplus in 2001. The deficit declined to
$318 billion in 2005. Then, fiscal year 2006 ended with a $260 billion deficit. The reason that the
budget surplus disappeared was because of tax cuts by the Bush administration and the Republican
Congress and war spending.
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Two different views of the effects of the tax cuts increased war spending and resulting deficits have
emerged from the Republicans and the Democrats. The Republicans argue that the economy was in
recession when the tax cuts were enacted and along with the war spending helped stimulate the economy.
The deficits are declining and will disappear in a few years as the economy continues to grow due to the
stimulus that is provided. The Democrats argue that the deficits have had no significant impact on economic
activity, because the government borrowing in financial markets has offset the increased deficit from
expansionary fiscal policy. As a result there is more public spending. The public’s buying of government
bonds has offset private spending. Basically what has happened is that government’s share of GDP has
increased.
Which party is using a long-run argument concerning the effects of expansionary fiscal policy and which
is using a short-run one? The Republicans are using a short-run argument. They argue that the war spending
and tax cuts increased aggregate demand during a recession. The Democrats are using a long-run argument
which argues that in the long-run increases in the deficit simply reallocates resources from producing
private goods to government goods though the crowding out effect.
The New Democratic Majority and Its Agenda
In 2006 the Democrats won back control of both houses of Congress. They campaigned for re-instituting a
law that would require any increase in spending that would result in an increase in the deficit to be offset
by either an equal reduction in spending in some other program(s) or an increase in taxes by enough to pay
for the increase in spending. In addition, President Bush has made it clear that he will veto any increase in
taxes so that the only option available to the Democrats is to cut spending elsewhere in the budget to fund
initiatives for more spending on such things as and health care and education.
There is another problem facing the Democratic majority. Entitlement spending grew from about $1.3 trillion
in 2005 to $1.5 trillion in 2006. It will continue to increase especially because the baby boomers will begin
retiring in large numbers in the next two years. The Democrats have also pledged to actually increase
entitlements—e.g., on the Medicare prescription drug plan.
Why does the automatic growth in entitlement spending complicate efforts to reduce federal government
deficits? Reducing deficits requires having revenue grow faster than spending. Growing entitlements mean
that decreases in overall federal spending must come at the expense of new programs or of existing
discretionary spending. This is a difficult problem for politicians.
Why might people disagree about whether growth of entitlement expenditures which increases the net
public debt is a burden on society? Entitlements are generally for persons who are viewed as deserving of
government assistance. Thus borrowing to finance these entitlements is seen by some as helping society
and not placing a burden on it. Others see the resulting deficits as resulting in a higher tax burden in the
future. Also the interest paid is mostly paid to U.S. bondholders so that there is no net burden to society.
There is a burden associated with paying interest to foreign bondholders.
Deficits and Political Parties
Historically, Republicans were considered fiscal conservatives and Democrats the opposite. Republicans
have historically been associated with balanced budgets or low deficits. In modern times, that is no longer
true. Democrats argue much more against deficits than do Republicans. Indeed, under Republican
administrations, deficits have been larger than under Democratic administrations.
Some Republicans have been using the argument that real economic growth was higher during years in
which the net public debt exceeded one-third of GDP than in years when it was less than for that. In other
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words, real economic growth was 1 percent higher (almost 3.5 percent) in high-deficit debt years than
it was in low-deficit years (almost 2.5 percent).
It’s often good to point out to your students that the real tax rate is the percentage of GDP controlled by
government. If GDP is $12 trillion and combined federal, state, and local total spending is $4 trillion,
then the real average tax rate is $4/$12 or 33 1/3 percent. Does how government finances its spending
affect this real tax rate? No, how government finances its spending does not take away from the fact
that its spending occurs today. Therefore, U.S. residents pay for government today in the form of reduced
consumption and investment as a result of paying taxes or lending money to finance a deficit. Irrespective
of how government spending is financed consumers and businesses have less of their incomes to spend
and therefore cannot buy as many private goods and services.
Chapter 15 Money, Banking, and Central Banking
Check Out Check 21 for Twenty-First-Century Check Clearing
During the 1990s the Federal Reserve decided to transfer most of its check-clearing operations to the
Federal Reserve Bank of Atlanta. Since then the Fed’s fleet of Lear jets has been flying boxes of checks
from cities of the various Fed district banks to one of the world’s busiest airports. There the boxes of
checks are loaded on trucks and driven to the Fed’s downtown check-sorting facility. After they were
sorted, the checks were re-boxed and driven back through traffic to the Atlanta airport where they were
flown to their final destinations for clearing.
Since 2004 the volume of checks being processed in Atlanta has declined as a result of the Check Clearing
for the Twenty-First Century (“Check 21”) Act of 2003. This act allows the Fed and private check-clearing
services to use the Internet to clear an increasing volume of checks. Employees of Fed district banks use
special machines that conduct high-speed scans to create digital images of checks. They then transmit
these images to other Federal Reserve district banks and depositary institutions via the Web. The physical
checks cleared in this manner require no further transportation beyond the warehouses where they are
stored before being destroyed.
How is this speedier check clearing made possible by the Check 21 Act likely to affect the willingness of
individuals and firms to continue writing checks, rather than switching to debit cards and other alternative
means of payment? It will decrease the willingness of people to write checks. An advantage of checks to
the writer is that it takes time for the check to clear. If this time lag is no longer significant, then the use of
debit cards is more likely to increase.
Changes M1 and M2 Reduce Their Usefulness
Banks and savings and loans were allowed to issue NOW accounts nationwide in 1981. An unexpected
result was that the relationship between the growth of M1 and GDP broke down. The reason was that
customers of depository institutions transferred funds from savings accounts, which are part of M2, into
interest bearing NOW accounts, which are part of M1. The Fed stopped using the growth of M1 as a major
policy variable for monetary policy in 1982. Shortly thereafter in 1987 the Fed no longer set growth
targets for M1.
In the early 1990s, the growth rate of M2 and a fairly strong relationship between it and GDP began to
break down. What happened is that some holders of savings and time deposits moved those funds into
mutual funds. M2 decreased but economic activity did not. The upshot was that the Fed could not rely
on past historical relationship between M2 and GDP.
In the early 1990s, the growth rate of M2 and a fairly strong relationship between it and GDP began to
breakdown. What happened is that some holders of savings and time deposits moved those funds into
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mutual funds for securities. M2 decreased but economic activity did not. The upshot was that the Fed
could not rely on past historical relationship between M2 and GDP.
Is the public more or less liquid as a result of the changes in M1 and M2? Yes. Savings accounts and small
CDs were always redeemable on demand in practice at the depository institutions that issued them. Generally
it was necessary to convert savings accounts into M1 assets to spend them. The major difference is that
NOW accounts can be transferred by check. Mutual funds for securities are less liquid in most cases than
are M2 or M1 assets.
Greenbacks Abroad
For years estimates of the M1 money supply have seemed at odds with the amount of dollars that are
printed each year. Of the currency and coins circulating outside the banking system, over 85 percent could
not be accounted for. University of Wisconsin economist Edgar L. Feige discovered that fully 45 percent
is held abroad. Indeed, the dollar is a de facto currency in many developing nations. Feige further discovered
that U.S. citizens admitted to hoarding another 12 percent of the missing currency and business another
10 percent. The underground economy accounts for between 4 and 6 percent.
Foreigners hold lots of our currency. Why don’t we generally hold any of theirs? In many foreign countries,
especially less developed ones, dollars can be used as money, i.e., they perform all of the functions of
money. There is therefore a demand for dollar denominated currency. In the U.S. foreign currency is
not acceptable as a medium of exchange and performs none of the other functions of money. Thus U.S.
residents demand foreign currency only when they plan to be in foreign countries.
Cashing Your Check at a Nonbank
One of the fastest growing banking industries in the U.S. is the check-cashing business. As America’s
large banks shy away from low-income areas, the number of private check-cashing outlets has skyrocketed.
In 1990 there were about 2,000 check-cashing outlets; today they number over 5,000. One reason that
check cashers have become popular is that the percentage of American families without a bank account
has increased from 9 percent in 1980 to about 15 percent today. Consider South Central Los Angeles with
a population close to that of Washington, D.C. At most times there are fewer than 20 banks in all of South
Central, yet there are more than 20 in a half-mile stretch of downtown D.C. Approximately 140 fee-charging,
check-cashing outlets compensate for the absence of banks in this Los Angeles neighborhood.
Forty-two states have no regulation on check cashing fees. These services generally charge anywhere from
2 to 10 percent of the amount of the check being cashed. Some check cashers have entered the lending
business by cashing a post-dated check for customers. The annualized interest rate on these short-term
loans often exceeds 1,000 percent. According to University of Illinois economist John Binder, checkcashers earn 10 to 20 times more on their initial investment than banks do. Check cashers argue that
Binder’s figures are inflated because they do not take into account the high security and insurance costs
that check-cashing outlets must pay.
How can check cashers get away with charging such high fees? There are few banks in South Central that
are available for residents to cash checks. Also banks typically cash checks not drawn on an account that
bank only for their own customers. That means that persons without bank accounts can only get most
checks they get cashed at such a service. Because there are a large number of companies competing for
check-cashing business, the high fees appear to be justified by high costs for insurance and security cited
by the check cashers. Presumably the risks of cashing bad checks are higher.
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How the U.S. Banking Structure Compares to the Rest of the World
Foreigners arriving in the U.S. are often overwhelmed by the number and kinds of financial institutions
that exist. The structure of the banking industry in the U.S. is quite different from that of other industrialized
countries. America is the only country that does not have a true national banking system in which a relatively
small number of banks have a large number of branches located throughout the country. The reason is that
the U.S. banking system is governed by both federal and state regulations. Until the Riegle-Neal Interstate
Banking and Branching Act was passed in 1994, interstate banking was prohibited. As a result the U.S. has
nearly 12 times the number of banks that other industrialized countries have. Japan has only about 1 percent
as many commercial banks as the U.S. (Note that means separate legal entities, not branches or offices.)
Because the U.S. has more banks, they are usually smaller than those in the rest of the world. And U.S.
banks may become even smaller in a relative sense as banks in the European Community (EU) increasingly
offer complete banking services throughout all of the EU countries. In addition, the EU has allowed
universal banking—the right of banks to offer a complete line of banking-related services and to own
shares of stock in other companies since 1988. In 1999 U.S. banks were allowed to engage in universal
banking.
Why do you think that U.S. banking laws were changed? Competitive forces are the explanation. Congress
came to realize that for U.S. banks to be competitive against these foreign banks both at home and
internationally, they had to be able to offer the same types of services that their foreign rivals offered.
Chapter 16 Money Creation and Deposit Insurance
In China Reserve Requirements Take Aim at High-Risk Banks
Since the early 2000s the Chinese central bank, the People’s Bank of China, has adjusted its reserve
requirements several times. In late 2003 it raised the reserve ratio for most deposits from 6.5 percent to
7.0 percent. The central bank intended for this change to reduce the money multiplier and slow the growth
of the money supply.
In the spring of 2004 the People’s Bank of China felt that it needed to do still more to rein in money supply
growth. It began by increasing the discount rate. In addition it decided to increase required reserve ratios
only for banks judged to be engaged in the riskiest lending activities. Thus the central bank used a change
in reserve requirements to try to achieve two goals simultaneously: (1) to cut back on the money supply
and (2) to induce the riskiest banks to allocate fewer funds to risky loans.
How does raising the required reserve ratio decrease the banking system’s overall loan expansion as well
as its total deposit expansion? Increasing the required reserve ratio increases the amount of legal reserves
that banks must hold. If initially the banks’ excess reserves are zero or if they fall below desired levels
then banks must cut back on lending and loans decrease as they are paid off and not reissued. The money
supply decreases as well because banks create money (deposits) by making loans. Also the potential
money multiplier, 1/reserve ratio, decreases as the reserve ratio increases.
Deposit Insurance and the Fed
In testimony before the Congress in 2003 the Federal Reserve Chairman Alan Greenspan said that deposit
insurance has prevented bank runs such as those in the 1930s that could have undermined the banking
system and the nation’s financial system. He noted, however, that the prevailing levels of deposit insurance
increased risk-taking at insured depository institutions to levels that could endanger the financial system.
The upshot is that deposit insurance increases financial stability in the short-run but increases risks taken
by depository institutions to a degree that could create problems for the financial system.
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Another issue associated with deposit insurance is that it makes it possible for depository institutions to
attract more funds, at lower interest rates, than would be the case without insurance. In effect it allows
them to make more risky loans without losing some or all of their deposits. The net effect is that resources
are misallocated because the link between risks and rewards is removed for depository institutions but not
for other financial services providers.
Chairman Greenspan argued that the risk-based premium system for deposit insurance be changed. Currently
the FDIC imposes higher deposit insurance premiums on depository institutions that engage in riskier loans
and investments. There is a loophole in the law. Well-capitalized, highly rated depository institutions do
not have to pay any premiums when the FDIC’s reserves are greater than 1.25 percent of insured deposits.
Chairman Greenspan also noted that 91 percent of depository institutions are not required to pay deposit
insurance premiums. Many of these institutions have never paid premiums.
Chairman Greenspan recommended that the risk-based pricing system be reformed to require every
insured depository institution to pay deposit insurance premiums. The exemptions for well capitalized
firms would be eliminated. Each depository institution would then pay deposit insurance premiums no
matter how well rated it may be, or how well capitalized it is.
How would Chairman Greenspan’s proposal reduce misallocation of resources mentioned in his testimony?
Under the current system 91 percent of the depository institutions did not pay anything for deposit
insurance since they were well capitalized and highly rated. In effect they had a subsidy equal to the
lowest insurance premium that they would have paid if the FDIC had not had 1.25 percent of insured
deposits. By imposing this premium the depository institutions would have been paying more for insured
depositors’ funds (the interest paid plus the insurance premium). Thus their cost of funds would be closer
to those of uninsured institutions.
The FDIC Quietly Prepares for a Megafailure
The 1990s and 2000s have witnessed many record-breaking bank mergers. The days of $100 billion-asset
banks seems here to stay. What would happen if one of these megabanks failed? The FDIC is quietly
preparing for just such a possibility. It has formed what has become known as the Mega-Merger
Committee, which is trying to answer the following questions:





When should the government pledge to refund uninsured deposits in order to avoid system-wide chaos?
Who would manage such a failed bank?
How new much staff would the downsized FDIC need to hire in case of a megafailure?
How could the FDIC hire such staff on short notice?
Would the FDIC have to send its employees to other countries to monitor the failed bank’s foreign
branches?
It would not be easy for the FDIC to sell a $100 billion-asset bank. Consequently, the Mega-Merger
Committee has determined that it would break a failed megabank into smaller pieces. The FDIC could,
for example, break the bank up along geographical lines.
Would U.S. banking authorities have the legal ability to shutdown a failed megabank’s foreign branches?
It would depend on the treaty arrangements with the governments of the countries in which the megabank’s
foreign branches are located. U.S. law cannot be enforced outside the United States any more than can a
foreign country’s laws be enforced by its government inside the United States without a treaty agreement.
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The Savings and Loan Crisis
In 1989 the Thrift Bailout Act, officially known as the Financial Institutional Reform, Recovery, and
Enforcement Act, was passed to salvage the savings and loan industry, which was swiftly spiraling into
disaster. By the end of 1985, some 130 thrifts were insolvent. In 1986 the number jumped to 255 and in
1987 it increased to 351. By the end of the crisis over 1,500 had failed The problem was related to banking
reform in the Depository Institutions Deregulation and Monetary Control Act of 1980 that allowed
Savings and Loans to begin offering transactions accounts. The problem that they began to face came in
the mid-1980s from rising market interest rates. The savings and loan industry had most of its interest
earning assets in long-term low-interest rate mortgages. NOW accounts and member share accounts were
interest-bearing accounts. Thus rising short-term market interest rates caused depositors to demand higher
interest rates on their NOW and share accounts and when these were not immediately forthcoming, moved
their funds to the financial markets or to commercial banks. When the savings and loan associations
increased the interest payments to their depositors, they began to incur losses.
The managers of saving and loan associations tried to increase their portfolio’s returns by making riskier,
and thus higher interest loans. After all, if the loans were actually paid off, they would be able to pay their
customers higher interest rates and return to profitability. If the loans failed and the savings and loan went
bankrupt, the depositors’ accounts were insured. Thus even honest managers had the perverse incentive to
attempt to undertake loans that were riskier than a prudent loan officer would approve in the absence of
deposit insurance.
Critics of the savings and loan disaster argue in favor of abolishing government-sponsored deposit insurance.
How could this change the incentive structure facing depository institutions?
If deposit insurance were to be abolished, then depository institutions would have a considerably different
incentive structure. The managers would be evaluated on the basis of the risk of their asset portfolios.
A manager of such an institution would have to engage in lending that was within the safety and liquidity
of the institution’s assets since depositors would have a strong incentive to evaluate the safety of their
deposits. Thus there would be an incentive to appear to be prudent in lending, avoiding very high risk
loans and investments.
Anatomy of a Roman Empire Bank Run
Bank runs were not confined to the U.S. during the Great Depression. In A.D. 33 there was a massive bank
panic in the Roman Empire. It started with the loss of 3 spice ships in a Red Sea hurricane. They were
owned by the firm of Seuthes and Son. The rumor spread in Rome that the firm was near bankruptcy.
Another important firm, Malcus and Company of Tyre, started to go under because of a strike by its
Phonecian workers and because of fraud by a trusted manager. Citizens of Rome learned meanwhile that
the Roman banking firm of Quintus Maximus and Lucius Vibo had loaned significant amounts of money
to both firms. Depositors started a run on this bank. This run spilled over to a larger banking firm owned
by the Pettius brothers because that bank had extensive dealings with the bank of Maximus and Vibo. But
the Pettius Brothers’ bank happened to be temporarily strapped for cash because it held many securities
issued by Belgium whose citizens had recently revolted.
Maximus and Vibo closed its doors: the Pettius Brothers suspended operations on exactly the same day.
To make matters worse, the Roman senate had passed a law requiring one-third of each senator’s capital to
be invested in Italian land. The wealthy senators needed to reduce their deposit balances at their banks in
Rome in order to buy land. Finally word arrived from Corinth and Carthage of bank failures in their towns.
A true bank panic hit the streets of Rome. Ultimately every bank in Rome closed its doors. The panic
ended when the emperor, Tiberius, ordered the distribution of a large sum of Roman currency from the
imperial treasury to reliable banks, which were to lend the funds to needy debtors with no interest for three years.
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Could a similar bank panic end up closing all of the banks in America today? Why or why not? It is
unlikely that a similar bank panic could occur in America today because of deposit insurance. Americans
no longer believe that the failure of one or even several banks means that all banks are likely to fail. Only
if people believed that the federal government would not or could not make good on deposit insurance
would a run on all banks be possible.
Chapter 17
Domestic and International Dimensions
of Monetary Policy
The Bank of Japan Forgets the Quantity Theory of Money
From 1999 through 2004 nominal interest rates in Japan were very close to zero. During the same period,
the nation’s price level fell. According to officials at the Bank of Japan, the Japanese central bank, the
inability to push interest rates any lower meant that monetary policy could do little to raise aggregate
demand. Thus, the officials argued, the Bank of Japan could not prevent Japan’s deflation.
Aside from a four month period in 2002, the M2 measure of the quantity of money deceased during the
1999–2004 period. The quantity theory predicts that a negative rate of growth of the money supply will
produce a negative rate of growth of the price level or deflation. Application of the quantity theory of
money indicates that the Bank of Japan actually had a lot to do with Japan’s deflationary situation. It also
implies that raising the rate of growth of the money supply to a positive level could have brought the
deflationary experience to an end.
How could an increase in the money supply have caused the Japanese price level to rise even though
nominal interest rates temporarily remained close to zero? An increase in the money supply would have
increased money balances in the hands of the public. Desired money balances would have been less than
actual ones and planned spending on goods and services would have increased. Thus aggregate demand
(or to have decreased at a slower rate) other things constant. In terms of the quantity theory of money, the
increase in the money supply would have increased actual spending thus increasing the price level other
things, V and Q, constant.
Iraq, Afghanistan, and the Fed
The Federal Reserve in its formulation of monetary policy seldom if ever publicly mentions the wars in
Iraq and Afghanistan as having an impact on the deliberations concerning the course of monetary policy.
Yet it is clear that the addition of spending on these wars will increase aggregate demand, other things
constant. This is especially the case because the Bush administration and the Congress have chosen to not
raise taxes to finance these war efforts. Instead they have chosen to pay for it by borrowing from
foreigners such as China and Japan. This was not an issue in when the wars started in 2001 and 2003
because the economy was in recession in 2001 and 2002 and was at less than full employment in 2003.
Thus in these years the stimulus of the war spending helped move the economy toward higher levels of
output without much danger of increasing the rate of inflation. By 2006 and early 2007 the economy was
near full employment.
If the U.S. economy had been experiencing the same economic conditions it is experiencing today, would
the effect of the wars on the U.S.’ real GDP and the price level have been the same as it was in the past
three years assuming that other things remained constant? Use the aggregate demand and aggregate supply
model to explain. Answer: No. The price level would have increased by more and real GDP would have
increased by less. According to the article the “labor and product markets were slack” in 2003. Thus the
increased aggregate demand mostly increased employment and real GDP. According to the article the
economy today is “running out of capacity.” This means that the aggregate supply curve is becoming
steeper. Increases in aggregate demand under these conditions leads to small increases in real GDP and
larger increases in the price level.
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The Choice Between Cash and Savings Accounts in Colombia
In countries with high inflation rates, nominal interest rates are also high. Recall that the nominal interest
rate equals the real interest rate plus the expected rate of inflation. Colombia is one country that has
consistently high rates of inflation. Consequently, its depository institutions usually offer high nominal
interest rates to attract people’s cash. In Cuidad Bolivar, about an hour from Bogota, the Caja Social de
Ahorros (Social Savings Bank) services a low-income area of about 1 million people. This depository
institution was started by a Jesuit priest and has a board of directors appointed by the Jesuits. In 1998 it
paid on 19 percent on passbook savings accounts. This sounds high but not compared to Colombia’s
22 percent rate of inflation that year. Thus its 10,000 depositors are willing to accept a 3 percent negative
real interest rate. Why? Because if they kept cash, they would suffer a 22 percent reduction in purchasing
power. Also, the bank keeps its low-income clients’ money safe in a high-crime area.
Why are nominal interest rates higher when a country experiences inflation? Nominal interest rates are
higher when a country experiences inflation because the demand for money will increase as people attempt
to buy more goods and services to “beat” inflation. Also more nominal amounts must be borrowed just to
buy the same quantity of goods. Borrowers become willing to pay higher nominal rates because their
incomes are, on average, rising. The burden of debt as a percent of their income would be declining.
Lenders wish to protect the purchasing power of their money and earn the real rate of interest. They will
demand higher interest rates from borrowers to cover the real interest rate plus the expected rate of
inflation.
Predict Monetary Policy Correctly and Win a $10,000 Scholarship
Every year since 1995 there has been a “Fed Challenge.” This is a contest sponsored by the Federal
Reserve Board and Citibank. More than 200 high school students throughout the country participate.
Each school has a five-member team. Each team recommends whether the Fed ought to raise interest
rates, lower them, or leave them unchanged.
The vice-chair of the Federal Reserve Board and two colleagues judge the national finalists at the beginning
of May of each year. The finalists give presentations of their models reflecting what they think should
happen at meetings of the Federal Reserve’s Open Market Committee. The winning team members each
get a $5,000 scholarship, their teacher gets a $5,000 achievement award and their school receives a
$10,000 grant to establish an “economics laboratory.”
What criteria do you think the judges should use to determine which team has presented the best monetary
policy recommendations? Presumably the criteria are centered on how closely the recommendations of the
model match the actual recommendations of the FOMC. The winning model ought to be able to predict.
Declaring Large Denomination Rubles Worthless
Just before the disintegration of the Soviet Union, it provided a type of experiment of the quantity theory
of money. In early 1991 the government declared all 50 and 100 ruble currency notes worthless. Citizens
had only three days to convert these large notes into smaller-denomination notes. Many citizens found that
deadline impossible to meet. The intended total reduction in large-denomination ruble notes was 26 billion
rubles, or a nearly 20 percent reduction in nominal money balances supplied by the government. In the
equation of exchange if velocity, V, is constant and if real GDP is relatively stable, a 20 percent reduction
in the money supply, M, has to lead to a 20 percent reduction in the price level, P. Did this happen? The
answer is no. the reason is that V increased. As a result aggregate demand did not fall significantly
following the reduction in the nominal money supply. In effect the only thing that really happened was
that large amounts of wealth held as money were expropriated by the elimination of the large-denomination
ruble notes that citizens had saved for years.
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Some policymakers in the U.S. have argued in favor of eliminating $100 bills in order to make large cash
transactions undertaken by drug dealers more difficult. Could the former Soviet Union’s experiment be
duplicated in the U.S.? The former Soviet Union’s experiment could not be duplicated in the U.S. because
it would deprive people of property without due process of law. Indeed the U.S. government stopped
issuing currency in denominations greater than $100 in 1969. However the existing $500, $1,000, $5,000
and $10,000 bills that are in circulation are, according to the Treasury Department, still legal tender.
Chapter 18
Stabilization Policies in the Global Economy
The Effect of Higher Inflation on Inflation Expectations
Three economists at the Federal Reserve Bank of St. Louis, Andrew Levin, Fabio Nattaluci, and Jeremy
Piger, have attempted to measure the effects of a short-lived increase in actual inflation on expectations of
future inflation. They considered what would happen to U.S., Japanese, and Euro-area inflation expectations
if the actual inflation rate rose by 1 percentage point for just three years.
Their estimates imply that, other things being equal, even five years after this short-lived inflation occurred,
the public would expect the future annual inflation to be about a third of a percentage point higher. As
much as ten years later, the expected annual inflation rate would still be one-fourth of a percentage higher.
Thus the authors conclude that higher actual inflation has a significant holdover effect on long-term
inflationary expectations.
These same authors also examined nations such as Canada and the United Kingdom in which central
banks announce inflation targets. They concluded that in these nations a 1 percentage point increase in
actual inflation for three years would raise expected future inflation by only 0.09 percentage points five
years later and 0.01 percentage points ten years later.
Why does higher actual inflation have a smaller effect on inflation expectations when a central bank
announces inflation targets? The public will expect a central bank that announces an inflation target will
provide an expectation that the central bank will take actions that will reduce the inflation rate to the target
level and that the higher inflation rate will not be likely to continue.
Rational Expectations and the Bond Market
In Late November and early December 2006 there was speculation in the financial markets as to what the
Federal Reserve planned to do with interest rates. After raising the federal funds interest rate 17 consecutive
times and then keeping it constant for 3 months, the question was whether the Fed would begin raising this
interest rate again or perhaps even lower it. On Tuesday, December 12, the Federal Reserve Open Market
Committee met and announced that it was going to keep the federal funds interest rate at 5.25 percent. By
late Tuesday afternoon the prices of all maturities of Treasury securities had increased.
What happened to interest rates on Treasury bonds after the Federal Reserve’s interest rate announcement?
The interest rate fell because these bonds’ prices increased. Bond prices and interest rates move inversely.
What did investors in Treasury bonds expect the Federal Reserve to do with interest rates? Interest rates
actually fell after the Fed announced that it was not planning to increase or decrease interest rates.
Investors must have anticipated that the Fed was planning to raise the interest rate at this meeting.
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The New Policy Rulebook in a Globalized Economy
Economic events in other countries, such as the financial crises in Eastern Europe and Asia during the
1990s have apparently forced the Federal Reserve to take a more global view. This is particularly relevant
in how it sets interest rate policies for the U.S. When the economies of Asia suffered severe economic
crises, the value of their domestic currencies fell in international markets. This allowed U.S. companies to
buy commodities from these countries at much lower prices in terms of U.S. dollars. These falling
commodity prices apparently helped reduce any threat of inflation in the U.S. during this period. Some
observers argue that is why we saw robust economic growth without inflation as well as a surging stock
market. Policymakers at the Fed realized that they could continue to increase the money supply at a
historically fast pace without immediate fear of inflation.
At the start of the Asian financial crisis, the U.S. stock market began to falter. The Fed immediately
announced several interest rate cuts. Fed policymakers later stated that they wanted to cut rates to avert a
credit crunch that could have triggered a global recession. Clearly, the Fed is taking international
developments into account more than ever before when deciding what policy to make for the U.S.
In what ways can global events affect the U.S. economy? If several major trading partners of the United
States were to experience a major recession such as the one experienced during the Asian crisis, U.S.
exports would drop significantly adversely affecting the U.S. economy. If members of the EU decided that
higher interest rates were desirable there for domestic policy purposes, then foreign and U.S. investors
would sell securities in the United States and invest the funds in the EU securities’ markets. The effect
would be to raise U.S. interest rates and cause the dollar to appreciate. U.S. investment would decrease
and net exports would fall thus reducing aggregate demand in the United States.
Does the Political Business Cycle Cause a Fed Bias Toward Inflation?
The rate of economic growth and the unemployment rate are key variables in determining who will be
elected president. The presidential elections in 1956, 1964, 1972, 1984, and 1996 all had the pattern of low
unemployment and inflation predicted by the political business cycle that favors the incumbents and
Eisenhower, Johnson, Nixon, Reagan, and Clinton won these elections. The elections of 1960, 1968, 1976,
and 1980 did not have this political business cycle pattern that favors incumbents (or incumbent party) and
the White House changed hands. President Bush’s loss in 1992 came despite the fact that the economy had
been growing for several months and the unemployment rate had been falling for the four weeks prior to
the election. The falling unemployment and rising rate of growth of real GDP was not reported until after
the election.
If the theory that the actual stage of the business cycle is a key variable in determining who is elected
president, then the Fed could influence the outcome of an election by increasing the rate of growth of the
money supply about a year and a half before a presidential election. There is evidence that Arthur Burns,
Chairman of the Board of Governors during the Nixon Administration, actually pursued such politically
motivated tactics. To the extent that Fed policymaking is motivated by political considerations, there
is a built-in bias toward more inflation rather than less. The reason is that there is a political incentive to
increase the rate of growth of the money supply for short-run economic gains, but there is no political
payoff to reducing the rate of growth of the money supply after presidential elections. Presidents and heads
of the Fed simply permit the economy to revert to its natural level of employment and rate of economic
growth. Thus, we see changing rates of inflation but almost never deflation in the U.S. (or Europe).
What Happened to the Phillips Curve?
In the 1990s Dana Mead, the chief executive officer of Tenneco, Inc., quipped, “NAIRU is to economics
what a Nehru jacket is to fashion: outdated.” The relationship between the rate of inflation and the
unemployment rate between 1990 and 2002 appears to provide a rationale for this view. Through most of
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the 1990s reductions in the unemployment rate were accompanied by lower rather than higher rates of
inflation.
For the Federal Reserve the changing nature of the relationship poses a problem. In the early 1990s the
unemployment rate and inflation rate both declined at the same time. The Federal Reserve’s inflationforecasting models indicated that inflation was “too low” relative to the actual unemployment rates—or
alternatively that the unemployment rate was “too low” relative to observed rates of inflation.
Economists developed two possible explanations. The first focuses on the increase in competition
following widespread deregulation of many industries, reduced barriers to international trade, and the
growth of Internet commerce. This hypothesis proposes that most industries found that the demand for
their products was more price sensitive than it had been before. Increased competition tends to restrain
inflation at any given unemployment rate. In addition, increased competition will reduce the natural
unemployment rate. Both of these effects are consistent with the declines in both the inflation rates and
the unemployment rates in most of the 1990s.
The other theory focuses on the age distribution of the population. A large fraction of the current population
consists of the baby boom generation born in the 1940s and 1950s. These people were entering the labor
force in the 1960s and 1970s. Unemployment rates are always higher for teenagers than for any other age
group. Fewer people were born in the 1970s and early 1980s. These people reached working age in the late
1980s and early 1990s. In the 1960s and 1970s there were a large number of teenagers around and many of
them were unemployed. This factor pushed the unemployment rate in those years.
As the rate of population growth fell, fewer teens were in the labor force, and the unemployment rate fell.
Can the unemployment rate ever be “too low?” The unemployment rate can be “too low” in the sense that
the amount of unemployment in the economy can only be maintained by an accelerating rate of inflation.
Once the unemployment rate is below the natural rate, it can only be maintained in the long-run by increases
in aggregate demand by unexpected amounts that increase faster than long-run aggregate supply.
If the age-distribution hypothesis concerning the behavior of unemployment rates is correct, when might
we expect an upturn in the natural rate of unemployment as a result of the “baby boomlet” of the early and
mid 1990s? The natural unemployment rate should begin to rise around 2006–2015 when these “boomlet”
children reach 16 to 20.
Chapter 19
Policies and Prospects for Global Economic Growth
Africa’s Huge Dead Capital Problem
The average resident of Africa earns about 5 percent of the per capita real GDP of a U.S. resident.
Furthermore, his or her situation has not been improving. In 1970 10 percent of the world’s poorest
people lived in Africa. Today Africa is home to about 50 percent of the poorest people.
Given that Africa has vast human and physical resources, what is holding back the region’s economic
growth? A fundamental factor is dead capital. Less that 10 percent of the continent’s land is formally
owned. Only about 10 percent of the residents of the region have legal title to the houses in which they
reside. The total estimated value of informally occupied land and buildings in Africa exceeds $1 trillion.
This amount is almost 70 times the international aid that African nations receive each year.
African residents who do not own their land or their dwellings can neither borrow against the value of
those items, nor readily sell them to others interested in starting a productive business. Thus residents of
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almost an entire continent are residing on and within dead capital. Although dead capital is not the only
reason for slow growth in Africa, it is surely among the most important.
How might the assignment of property rights help to promote growth on the African continent? The
assignment of property rights would provide an incentive for owners of land and capital to improve it or
to sell it to those who would use it productively. The net effect would be that land and capital resources
would be used in their most productive employment.
Addressing the Problem of Dead Capital
An experiment in eliminating dead capital provides some insights into the issues usually overlooked by
economists in their discussions of giving title to the real property of persons, especially poor ones, in less
developed countries. In 1984 the government of the town of Quilmes near Buenos Aires in Argentina took
away land from some large landowners and gave title to it to squatters who had built shacks and other
types of housing and just plots of land that they used. The theory was that it would be possible for these
squatters to use the property as collateral for loans to improve them. At the same time some of the original
landowners took the municipal government to court and as of 2006 still had not gotten a final judgment.
The question then was what differences between squatters existed in terms of improvements to property
and access to loans for the new owners on the one hand and the squatters who have not gotten title to the
property they live on on the other?
As expected the new owners of their homes made more improvements than the persons who did not.
Interestingly the access to private credit for the new land and homeowners was virtually unchanged. These
new homeowners were poor, so the size loans that they could afford were very small.
Why might the size of the loan that poor borrowers in Argentina could afford to pay have an impact on the
reluctance of Argentine banks to lend them money even when the borrowers could offer their homes as
collateral? (Hint: Consider the effect of handling charges and the size of the loan.) The problem is that if
the interest rate is high enough to cover the cost of making and enforcing the loan, then the loan payment
might be too high for the poor to pay.
The World Bank and the Development of Poor Nations
The International Bank for Reconstruction and Development, known as the World Bank, was established
in 1944. To date it has lent nearly $390 billion, mostly to poor nations. However, its accomplishments
have been questioned. For example, since 1951, India has received over $58 billion—more foreign aid
than any other country on earth—yet over 40 percent of India’s population still lives in poverty. In
Sub-Saharan Africa, massive amounts of money have gone into development planning, yet that region
has a lower per capita income than it did before it received aid.
Another criticism of the World Bank is that its lending policies have encouraged large-scale, capital
intensive technology, which helped governments plunder their natural resources. There has been
significant environmental damage and dislocation of people caused by these large projects, such as dams.
A 2001 report indicated that nearly one half of the World Bank’s private sector divisions lending was in
environmentally harmful sectors.
The major problem with the World Bank’s lending activities is that they help government bureaucracies
flourish with funds that could be used to help individuals in host countries.
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How does lending to governments in less developed countries hinder market reforms? Lending to
governments in poor countries allows them to undertake economic projects that the market will not fund.
Thus resources are diverted into low return areas that do not have a significant economic return. The
governments in turn cannot allow these economic activities to bear the brunt of international or even
national competition because they would fail. The solution then is to limit the introduction and use of
the market mechanism to allocate resources.
International Capital Flows and Financial Crises
In 1997 and 1998 the Asian financial crisis occurred. The crisis stemmed partly from a situation in which
interest rates differ widely from country. Japanese, European, and American banks were able to borrow
dollars or yen at low interest rates and then lend these funds for short periods of time at higher rates to
banks in Thailand, Korea, Malaysia, and other Asian countries. These banks in turn loaned the money for
long periods of time at higher interest rates to domestic companies. As long as the local currency retains its
value, the foreign banks simply roll over the short-term loans. There was a crisis when the local currencies
began to lose value or were believed to be about to lose value because the foreign banks refused to roll
over the short-term loans. The borrowing banks are unable to pay these loans fast enough and in many
cases default on the loans. The essence of the problem was that domestic banks were borrowing short-term
funds but lending them for long-term projects.
By contrast Chile has avoided a debt crisis for more than 15 years because it has active policies in place to
discourage short-term capital inflows by requiring a borrower to deposit part of any foreign loan in a noninterest earning account for 6 months. This markedly reduces the profitability of short-term borrowing.
Some economists argue that such crises can be eliminated or at least reduced in severity if the International
Monetary Fund and World Bank let it be known that they would not bail out the foreign lenders (banks).
There would be a strong incentive for foreign banks to make more prudent loans and monitor them more
closely. The effect would be to reduce the problem of asymmetric information and moral hazard.
Chapter 20
Consumer Choice
Virtual Assets
Online games played by large numbers of players are called Massively Multiplayer Online Games
(MMOG) such as “World of Warcraft” and “Second Life” have become very popular. Like many games
these MMOG games involve winning assets such as weapons and other goods and virtual currency that
allow players to advance or move to higher game levels. Players have discovered that these assets can be
exchanged. Exchange is desirable for less talented players who want to advance in a game. Some games
allow players to win virtual currency that can be used to buy virtual assets. The obvious problem is that a
player must have either already acquired some virtual assets or currency to engage in exchange.
A market has therefore developed in which virtual assets can be bought and sold for real money. Players
can buy what they need to advance without first having to actually “own” virtual assets or virtual currency.
In addition it provides a market for those who are skilled in a game who have acquired virtual assets that
they no longer need to sell them.
Why would a player buy a virtual asset since it is not “real?” (Hint: Does something have to be “real” to
provide utility?) A virtual asset that allows a player to advance would provide utility to that player. He/she
would be willing to purchase such a virtual asset as long as the marginal utility per last dollar spent was
greater than the utility per last dollar spent on the next best alternative.
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Virtual 3D Pays Off at Land’s End
When shopping at a mall, an individual can try on an item of clothing before purchasing it so she can be
sure that it fits. When shopping online, however, the individual cannot try on the item. If it does not fit, she
will have to go to the trouble of returning it. This uncertainty about the fit lowers her anticipated marginal
utility from buying online.
To address this problem, clothing retailer Land’s End added a “virtual 3D model” tool to its Web site.
After clicking onto “My Model” in the left hand margin of the Land’s End home page, a shopper can enter
her height, weight, and various size measurements. The model on the screen automatically adjusts to a
shape matching the shopper’s body. Then the shopper can see how well a particular blouse or dress she is
considering buying is likely to fit.
Reducing uncertainty about how well clothing items will fit naturally increases an individual’s marginal
utility at any given quantity she might consider consuming—and at any price. Land’s End did not leave its
online prices unchanged, however. In the first year after incorporating the virtual 3D model into its site,
the retailer was able to raise the average price of an item of clothing sold at its site by 13 percent without a
net fall in the quantity of clothing it sold. There was an unambiguous increase in Land’s End’s revenues.
If marginal utility increases at each possible quantity consumed at a given price, then does this cause a
change in demand (shift of the demand curve) or a change in quantity demanded (movement along a
demand curve)? There is an increase in demand because an increase in marginal utility divided by given
prices will result in an increase in purchases of the good in question as he or she attempts to maximize
utility. Since the ratio of marginal utility of the good will increase at every price, the consumer will find
that this ratio will be greater than the ratio of marginal utility to the prices of other goods he or she purchases.
She will buy more of the first good and less of all of the others.
The “Freshman 15”: Gaining Weight While Living in the Dorm
University cafeterias serving students on a full meal plan allow students to go through the serving line as
many times as they wish. It is an all-you-can eat plan. Freshmen typically gain weight their first year under
such a plan because they eat until they are full.
What is the marginal utility of the last serving eaten by a student on a full meal plan? The marginal utility
of the last serving is zero. What would be the marginal utility of just one more serving? It would be
negative.
Should You Be Charged to Use the Internet?
Many Internet users continue to experience intermittent problems with delays in data transmission. This is
largely due to congestion on the Internet as too many people attempt to use the network at the same time.
Some economists believe that the Internet congestion problem is caused by setting the price of using the
Internet too low. A consumer makes choices such that the marginal utility for the last dollar spent on each
good is the same. For example suppose that for a typical individual, a consumer optimum is attained when
the ratio of marginal utility to price for each good and service consumed is a small positive number such as
1 unit of utility per dollar spent. Now suppose that the consumer decides to “consume” Internet access
time, which has an explicit price close to zero. At a consumer optimum the marginal utility per dollar
spent is small. This will require spending a sufficient amount of time spent surfing the web to push the
marginal utility of surfing the net pretty close to zero also. The law of diminishing marginal utility
suggests that marginal utility eventually declines with greater consumption of a good or service. Thus
pushing marginal utility near zero will likely require spending many hours surfing the web. Because
spending time on the Internet is such a low cost activity, the individual spends a large number of hours
on the Internet thereby contributing to the potential for Internet congestion.
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Ask students if the total cost of surfing the Internet to the consumer is just equal to the price paid to the
ISP? The total cost of surfing the Internet includes the opportunity cost of time. Most people value their
time at more than a little above $0 per hour.
Channel Switching: The National Pastime
According to the Cable Television and Marketing Society anywhere from 20 to 30 percent of TV viewers
consistently engage in channel switching. That is to say, they never watch one program for more than a
couple of minutes. Are these people different from those who watched TV in earlier years? The answer is
probably not.
As a result of the principle of diminishing marginal utility, the first few minutes of a TV show will yield
more utility per minute than the minutes viewed thereafter. The lower is the marginal utility of any particular
TV program, the more the viewer has an incentive to either turn the TV off or to switch channels. There
are two developments that have led to an increased desire to switch channels. The first is the widespread
adoption of the remote controls for TV by almost every TV user. The cost of changing channels has
dropped dramatically since a viewer does not have to get out of his chair and manually change channels.
The other development is the growth of the number of channels that are available through cable and
satellite dish TV. The channel switcher has an increased likelihood of finding a preferred program as
compared to pre-cable and satellite TV reception where there were few channels to watch.
How has the proliferation of remote controls and the number of cable channels affected the way
commercials are produced? Commercials have gotten shorter and more attention getting. In the 1950s
many commercials on live TV were in fact done by members of the cast of a show. The product was
displayed and the TV personality talked about it. The commercial would last up to one minute. Some
commercials had jingles and music. In recent years commercials have gotten shorter (10 to 15 seconds)
so that the audience will not switch and will be more likely to remember them. This often involves music.
Chapter 21
Demand and Supply Elasticity
Higher Gasoline Prices and Hybrid Car Demand
After Hurricane Katrina, the price of gasoline increased by about $1.00 per gallon to a little over $3.00 per
gallon. Americans didn’t drive appreciably less for the few months that this price increase held. They also
did not rush out and buy a large number of gasoline-electric hybrids such as the Honda Civic hybrid. This
hybrid is advertised as getting about 50 miles per gallon in city driving as compared to the standard Honda
Civic that gets an advertised 30 miles per gallon in city driving. The average family drives about 12,000
miles per year. The Honda Civic hybrid costs about $16,000 to $17,000 depending on accessories and the
Civic hybrid has a price of around $24,000.
Can you explain why the short-run increase in the price of gasoline had a very small effect on the demand
for Civic hybrids? If we assume that the Civic costs $17,000, that both are driven only in the city, and that
the price of gasoline increased to $3.00 per gallon, it would take over 14 years for the hybrid to pay for
itself. The hybrid would use 160 gallons per year less than the standard Civic for a saving of $480 per
year. Even if gasoline increased to $5.00 per gallon the consumer would only save $800 per year. It would
take 8.75 years to save the difference. Thus an increase in gasoline prices would not be likely to have
much effect on hybrid sales unless gasoline prices went up by a large amount and stayed there and were
expected to stay high for many years.
Who Pays Higher Gasoline Taxes?
Gasoline taxes are paid by sellers from the revenues they earn from their total sales. Thus to receive the
same effective price for selling a given quantity of gasoline, a gasoline producer must charge an actual
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price that is higher by exactly the amount of the tax. Sellers supply a given quantity of gasoline, but at a
price that is higher by the amount of the tax that they have to pay to the government.
Who truly pays the tax depends on the price elasticity of demand. The more inelastic is demand the greater
is the portion of the tax paid by consumers. Thus if the demand for gasoline was perfectly inelastic, the
entire burden of the tax would fall on buyers. If demand was perfectly elastic, the entire burden would fall
on sellers. Estimates of the price elasticity of demand for gasoline indicate values between 0.2 and 0.5.
Based on the information in this example, if excise taxes increased by 10 percent, by what percentages
may desired gasoline purchases decrease? For every 1 percent increase in the price of gasoline, the
quantity demanded falls by 0.2 to 0.5 percent. Thus a 10 percent increase in price would result in a
2 to 5 percent decrease in quantity demanded.
Fighting DVD Piracy by Lowering Prices
Almost 90 percent of all DVDs sold in Russia are illegal copies. To fight such piracy, a division of Sony
lowered its DVD prices to about $10, or 50 percent of the current price. Pirated DVDs sell for about $4 on
the streets of Moscow. Apparently, the quality of pirated DVDs is relatively high.
There are no numbers yet on increased sales of legitimate DVDs in Russia. Nonetheless, you could ask
your students what they think the cross price elasticity of demand might be for pirated versus legal DVDs
and have them work through a few hypothetical cases.
The Price Elasticity of Demand for Tourist Visas
Until November 2002, citizens of developing nations who wanted to visit the United States on a
nonimmigrant basis had to pay $65 to submit a visa application. Starting at the end of 2002, these
same visa application fees were raised to $100.
In a typical year prior to the increase in fees, 6.3 million residents from developing nations applied for
nonimmigrant visas. In 2003, that number dropped to 3.7 million.
Ask your students to calculate the price elasticity of demand.
To Cut Teen Drug Use, Make the Price of a “High” Higher
In 1998, John Tauras of the University of Illinois at Chicago and Michael Grossman of the City University
of New York conducted a study of teen use of cocaine. They found that as compared to adults, youthful
drug abusers are three times more sensitive to price changes. Whereas adult cocaine demand is inelastic,
teen cocaine is greater than one over the range of market prices tabulated by the Drug Enforcement
Administration. In other words a 33 percent increase in the price of cocaine likely would reduce teen
cocaine purchases and consumption by more than one-third. Undoubtedly some teens substitute other
drugs. Nonetheless, cocaine and crack cocaine, are considered addictive substances. Inducing teens to
reduce cocaine use might therefore take a significant bite out of the nation’s longer-term problems with
drug abuse. An implication of this study is that the legal crackdowns on cocaine dealers that restrict the
supply of the drug and push up its price might be an appropriate strategy in the war against drugs.
If teen price elasticity of demand for cocaine equals 1, what will happen to drug dealers’ revenues from
sales to teens if cocaine prices rise? If the price elasticity of demand for cocaine among teens is 1, then for
every 1 percent change in the price of cocaine, the quantity demanded would fall by one percent and drug
dealers’ revenues from sales to teens will not change
A Pricing Decision at Disneyland Paris
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Several years after it opened, the $4 billion investment in Disneyland Paris was in trouble. In an attempt to
reduce losses and hopefully to make a profit, Disney management decided to lower prices. Entrance fees
during peak periods (April 1 to October 31) dropped from $50 to $40. As it turned out park attendance
increased by 700,000 visitors and revenues increased by 22 percent.
Ask students to determine if demand was elastic, inelastic, or unit-elastic in the price range of $40 to $50.
Demand was price elastic in the price range of $40 to $50 because the decrease in price resulted in an
increase in total revenues.
What other factors may have affected attendance at Disneyland Paris? The weather may have been better.
Advertising may have improved. Tastes and preferences may have moved in favor of Disneyland Paris.
Chapter 22
Rent, Profits, and the Financial
Environment of Business
Do Entertainment Superstars Make Super Economic Rents?
Superstars do very well financially. For example actress Reese Witherspoon currently makes $15 million
per picture. How much of these earnings can be considered economic rent? Undoubtedly Ms. Witherspoon
would work for much less if less was all she was offered. How much less is hard to determine however
because she is very wealthy now and could afford to not work, or to work much less if she was not offered
these large sums of money.
Even if Ms. Witherspoon would work for less, what forces would cause her to make so much income
anyway? The forces that cause superstars to earn high incomes are all related to the demand for their
talent. By definition there is only one Reese Witherspoon. Because her talents earn large amounts of
money, producers seek her acting services. Her problem is that the number of various productions she is
offered is more than she could possibly do. She can thus limit the demand for her services (and hassles
by those who wish to employ her) by accepting only the highest offers and be known to only accept very
high offers.
Rents in Hong Kong
In the early 2000s the Hong Kong real estate market was suffering from overbuilding of office space about
the same time as the Asian financial crisis when there were huge outflows of funds from most Asian
countries that brought near depression conditions in the region. As a consequence many companies failed
and some foreign companies left the region. The upshot was that there was a large amount of empty office
space in Hong Kong.
In 2003 the market bottomed out and the economies of Hong Kong and other countries in the region began
to recover. The central business district in Hong Kong became a very desirable location for offices for global
financial services companies such as banks and hedge funds among others. In fact the central business
district became so desirable that the average rent on office space rose from a low of about HK$20 per square
foot in 2003 to over HK$60 in 2006. By 2006 there was very little office space available. Because of the
earlier financial crisis and large amounts of vacant office space, there was virtually no new office building
construction started in central Hong Kong during this period. The supply of office buildings is fixed for a
considerable time because of the time it takes to plan, finance, and build new large office buildings.
Is there any evidence to suggest that economic rent is being earned by owners of Central Hong Kong
commercial real estate? Yes. The short-run supply curve of real estate in this area of Hong Kong is
perfectly inelastic. The increase in demand for office space has led to a rising price of office space.
Economic rent arises when changes in demand and price have no effect on the quantity supplied.
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Funding a Start-Up Company on the Internet
Getting a business off the ground requires more than a lot of hard work. It requires raising hard cash.
Many small businesses have trouble raising seed money to get started, but those that succeed in raising
initial funds can seek out venture capital firms for additional financing. Eventually they can go public by
floating a stock issue. Today, a business can go public on the Net—it can sell shares to the public directly.
Spring Street brewing company made history back in 1995 when it became the first company to conduct
an initial public offering (IPO) over the Internet. It made history again in 1996, when the Securities and
Exchange Commission allowed Spring Street to trade its shares via its Web site without registering with a
broker-dealer. The SEC only required Spring Street to use an independent agent, such as a bank or an
escrow agent, to process the funds it raised on the Net. (Although the company broke ground with regard
to its financing, ultimately the market for micro-brewed beers declined, pushing Spring Street out of the
brewing business.)
The SEC estimates that going public via the traditional, non-Internet route takes about 900 hours of work.
Most of this time is devoted to preparing a prospectus prior to the sale of the stock. Companies also have
to hire specialized lawyers and use an underwriter, who normally charges a fee equal to about 10 percent
of the value of the IPO. The cyber-based alternative is to buy a program called CapScape. This program
automates the process of compiling the offer documents, permitting the company to sell shares directly to
investors over the Internet.
Who stands to lose if Internet IPOs become commonplace? The main losers are the traditional
underwriters that make IPOs and the specialized lawyers who prepare the prospectus.
Going Global Without Knowing It
Although it may seem much easier to buy and sell stocks of American companies than stocks of foreign
companies, it is in fact quite easy to invest globally even without realizing it. A few years ago, two
retirees, Mary Jo and George Paoni, residents of Illinois, had part of their savings in a money market fund
with ties to J.P. Morgan, the investment banker. Morgan in turn had invested $1 billion in high-risk trades
in the baht, the national currency of Thailand. The Paonis’ money market fund also had assets tied up with
Bangkok Land, a real estate company that owns a modern—largely worthless—ghost town near Bangkok
that was supposed to be a city of 700,000. Mrs. Paoni’s Illinois State Pension Fund owned a piece of
Aracruz Cellulose S.A., a Brazilian pulp and paper company that was hit by a sharp drop in pulp prices
from $850 a ton to $420 a ton in the late 1990s. The pension fund also had investments in Peregrine
Investments, a Hong Kong investment bank in 1998 when the firm collapsed leaving more than 2,000
creditors, including the pension fund, owed more than $4 billion.
Should pension funds be limited by law in the nature of the investments they are allowed to make? One
could make a strong case that the goal of a pension fund is a relatively steady stream of income to finance
the payment of pensions. Since the pension may be the only source or at least the major source of income
to retirees, allowing investment in high-risk securities jeopardizes pensioner’s living standards. On the
other hand, a less risky portfolio will yield lower returns over the long-run and thus a lower standard of
living for retirees than they could have had. Simply making the trustees of a pension legally liable to take
reasonable care in acting as a fiduciary agent could provide them with an incentive to act in a responsible
manner without legal limitations on what types of investments can be made.
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Should Pay Day Lenders Be Regulated?
Payday lenders are companies that typically offer an individual a small amount of cash, from $100 to
$300, in exchange for a personal check. The lender holds on to the check until the individual receives his
or her paycheck and then cashes the check. Payday lending is a booming business. Since 1995 the number
of payday lenders has grown rapidly. Payday lenders provide their services for a fee that typically ranges
from 15 to 25 percent of the face value of the check; that is they charge interest on loans that they
effectively make to individuals who use their services. When the interest rates on these loans are converted
to an annual percentage rate (APR), the numbers can be shocking. In 2003, the Federal Deposit Insurance
Corporation indicated the APR on such loans can range from 300 to 1,000 percent.
The Consumer Federation of America calls payday lending “legal loan-sharking” and argues that payday
lenders prey on the poor while making exorbitant profits. It calls for regulating interest rates charged by
payday lenders. But the key reason that payday lenders charge high rates is the risk of bad checks is very
high. There is also a big benefit to consumers: The ability to borrow up to $500 reduces the likelihood that
someone who is poor will not suffer a “spell of hardship” such as not having enough money for food. Thus
for someone who cannot obtain a speedy loan any other way, the only thing worse than borrowing $200 at
an annual percentage rate of 500 percent might be not being able to borrow $200 at all.
Payday lenders like to compare payday loans to taxicab transportation, which may be cost-effective for
short distances but not for long-distance travel. Does this analogy seem reasonable? The analogy is a
reasonable one. The idea is not to provide a large loan for a major purchase but to provide money for
someone in an emergency. Thus one could argue that the service is probably too expensive for borrowing
long-term, but is a reasonable price for someone with poor credit to pay when the alternative is to do
without emergency medical care or being unable to pay the rent or being unable to buy groceries.
Chapter 23
The Firm: Cost and Output Determination
Filling a Truck Is Less Productive Than Sending It Half-Full (pp. 544–545)
For years managers at Procter & Gamble, the consumer products family, told warehouse workers to pack
a truck full of detergent and send it out to make deliveries to retailers, then pack the next truck with
toothpaste, and so on. Then in the early 2000s, the company invested in inventory tracking software that
allowed managers to determine how many workers and how much time were required to get products to
their ultimate destinations. What they discovered at first seemed counterintuitive. Sending out trucks fully
loaded with a single product required the use of more inputs per unit of time than shipping a mix of
products on trucks that were less full.
Packing trucks as fully as possible, the data revealed, left warehouse workers idle for long stretches
between trucks. Also, filling individual trucks with boxes of a single product to be dropped off at many
locations ultimately required driving more miles and using more fuel than loading a variety of products
onto trucks driven to fewer final destinations. Based on this information, Procter & Gamble began sending
out rerouted and less full trucks carrying more than one product at a time. The company was able to ship
30 percent more output per unit of driving time using the same truck, labor, and fuel inputs as before.
If Procter & Gamble continued to manufacture and ship as much output each week after the change in its
distribution system, did it require the same amount of trucks, fuel, and workers to accomplish this task?
No. It would have been able to ship the same amount of product with fewer inputs. Because it could ship
30 percent more with the same inputs, it could now dispense with the inputs needed to ship 30 percent of
the same level of output.
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The World Market for Iron Ore
Between 2000 and 2006 the world market price of iron ore increased from around $30 per ton to a little
less than $80 per ton or about 266 percent according to the International Monetary Fund. The increase in
price was largely due to increased demand from China and India, two of the fastest growing economies in
the world during this period. This increased demand was added to slower increases in demand in other
countries. There are no signs as of 2007 that there will be any decrease in the demand for iron ore and thus
no likely decrease in the price.
What effect have these developments had on the average and marginal cost curves of the steel companies?
These curves have shifted upward. Since iron ore is a major resource used to produce steel, the total cost
of producing any given output of steel will increase so that the cost of an average ton of steel at each
output level will increase. The marginal cost of producing an additional ton of steel will increase by the
increase in the cost of the quantity of iron ore used to produce a ton of steel.
Europeans Use More Capital
Since 1970, the nations of the European Union (EU) have increased their total annual output of goods and
services relatively steadily. But over this same time period, the EU has dramatically increased the amount
of capital relative to the amount of labor it uses in its production processes. Business managers in the EU
have substituted capital for labor much more than in the U.S. because the cost of labor (wages corrected
for inflation) has increased by almost four times as fast in the EU as it has in the U.S.
How does a firm decide when to buy more machines? A firm decides to use more machines when it is
cheaper to use an additional machine to get a given increase in production than an additional amount of
labor that yields the same increase in output. Alternatively, more machines should be used when the
marginal product per last dollar spent on a machine is greater than the marginal product per last dollar
spent on labor.
Microsoft Confronts the Law of Diminishing Marginal Returns
One of the great success stories of the computer age has been Microsoft’s Windows, the dominant PC
operating system. Many businesses also rely on another Microsoft desktop software package called Office,
a “suite” of programs, including Word, Excel, and Access and starting with Office 2000, Internet friendly
features. Office promises speech-recognition software in the future that may make some keyboard and
mouse features redundant. In spite of these features, Microsoft has had to work harder at promoting each
new version of the software package. The reason is that many users of Office find that its programs are so
packed with features that they cannot exhaust all of the possibilities. According to some estimates, even
enterprising users with lots of time on their hands are unlikely to use more than a quarter of the features of
the Word 2000 program. Consequently a large number of users are concluding that upgrading to bigger,
more sophisticated versions of the Office suite do little to enhance their productivity. Evidently users of
Office are confronting diminishing returns from adding further to the extensive software code stored on
their hard drives.
Under what circumstances could adding computer software yield a negative marginal product, at least
within a period following the installation of the software? The period of learning how to use the software
is one in which productivity initially falls. In a word processing program extra time must initially be used
to learn how to find the features one wishes to use. Time spent using the “help” menu is time not spent
actually using the software productively. Thus, initially productivity can be expected to fall.
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Can “Three Strikes and You’re Out” Laws Reduce Crime?
Crime and violence have been at the top of Americans’ concerns for more than a decade. At both the state
and federal levels, politicians have responded with a variety of policies aimed at reducing crime. One
popular law is called “three strikes and you’re out.” A defendant with a prior conviction for two serious or
violent offenses faces a mandatory life sentence for conviction of a third offense. Such legislation has
dramatically affected the marginal cost of violence and murder to potential criminal defendants who
already have two prior felony convictions. Here’s what one career criminal, Frank Schweikert, said in a
New York Times interview: “Before if I was doing a robbery and getting chased by the cops, I’d lay my
gun down . . . but now you are talking about a life sentence. Why isn’t it worth doing whatever it takes to
get away? If that meant shooting a cop, if that meant shooting a store clerk, if that meant shooting someone
innocent in my way, well, they’d have gotten shot. Because what’s the worst thing that could have happened
to me: life imprisonment? If I’m getting a murder sentence anyway, I might as well do whatever it takes to
get away.” In other words, the “three strikes” legislation has reduced to zero the marginal cost of murder
(in non-capital punishment states) committed while engaging in a criminal activity after two prior felony
convictions.
Do criminals subject to the new legislation have to understand the concept of marginal cost in order for
our theory to predict well? A criminal does not have to understand the concept of marginal cost for the
theory to predict any more than a top-ranked pool player has to understand the laws of physics to make a
difficult bank shot. All that is necessary is for the criminal to act as if he/she understands the concept of
marginal cost. By increasing the level of violence while committing a crime after two prior felony
convictions in order to escape capture, the criminal acts as if he/she understands marginal cost.
Chapter 24
Perfect Competition
Why Exits Have Followed Entries at Online Auction Sites
Since the mid-1990s individuals have been using online auction sites such as those operated by eBay,
uBid, and Yahoo!, to sell off old clothes, collectibles, and other used items that they find when cleaning
out closets and attics. During the early 2000s, manufacturers and retailers discovered that online auction
sites were useful for selling unsold inventories of items such as digital cameras, lawnmowers, and laptop
computers. Sharper Image, Sears, and Hewlett-Packard are among the companies that regularly sell off
inventories of outdated products in online auctions.
In 2002 companies with names like “ReturnBuy” and “Connection to eBay” began buying large quantities
of outdated models of various items from manufacturers and selling them at higher prices in online auctions.
The high profits they earned signaled more firms to enter this market. With the increase in the supplies of
“like new,” yet outdated items for sale in online auctions, prices began to fall. Then the profits earned by
firms such as “ReturnBuy” and “Connection to eBay” declined. By 2004 these and a few other firms had
exited the market.
Why would you guess that it is not unusual for a big burst of entrants into a market to be followed by the
eventual exit from the market by several of those firms? The existence of economic profits would attract
new firms into a market. Since each new firm is likely to be small, its owners will not consider the firm’s
effects on market supply of the good or service. Because a large number of new firms enter the market, the
market supply curve shifts outward and the price of the good or service falls to the point that many of the
new firms which are unlikely to have achieved all economies of scale are making economic losses. They
then exit the industry.
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The Wind Power Industry
Some attractive features of producing electricity from wind power are that the wind is clean and free. It
does not have to first be produced as a fuel, then transported, and stored until it is needed. No wonder wind
power generation has become an attractive way to produce electricity, especially as oil and natural gas
prices have increased in the past few years. Wind power accounted for about 3 percent of Europe’s electricity
output in 2006 and is forecast to increase to about one-fifth by 2030 according to the European Wind Energy
Agency. Indeed Denmark has already reached that mark. The U.S. is also becoming a major producer of
wind power led by Texas and California. An important factor in the development of wind power is that the
price of wind power has fallen over the past 20 years even in the face of rapid industry expansion.
Is the electricity produced by wind power produced under increasing, decreasing, or constant cost
conditions? Because its price has been falling for 20 years as the industry has expanded, it must be a
decreasing cost industry facing a downward sloping long-run supply curve.
Web Shopping May Not Lead to Lower Prices
One of the major predictions that economists made about the increased use of e-commerce was lower
overall prices. Research has shown, though, that the main benefit of e-commerce is not necessarily low
explicit prices for standard items. Indeed, the most popular book sites such as Amazon.com do not offer
the lowest prices.
The major benefit of e-commerce is that, the Internet offers a selection of products that is impossible to
find in a “bricks and mortar” location. For example Wal-Mart.com has almost six times as many items as
the largest Wal-Mart store. Amazon.com does not advertise the cheapest prices, but rather the world’s
largest selection of books. Almost half of Amazon’s book titles sold are of the obscure variety.
What we are seeing is specialized stores available to every consumer with a credit card and Internet access.
The availability of ever-sophisticated search engines is making this process even more extensive.
A Common Pricing Denominator in Europe
Perfect competition is more likely to thrive in an environment in which buyers and sellers have more
nearly complete and equal access to information. Historically, a factor hindering the development of
European-wide competitive markets has been that a consumer in a country such as Portugal who was
contemplating whether to buy substitute goods produced by a German, Italian, or Belgian firm had to
compare prices in German marks, Italian lire, and Belgian francs. Making accurate comparisons of this
sort required that every consumer stay abreast of the latest currency conversion rates, making it harder for
consumers to shop around for the best buys. This contributed to great variability of goods from nation to
nation within Europe. For example the average price of a Big Mac varied by about 10 percent, Coca-Cola
by nearly 30 percent, and bank account charges by well over 50 percent from one country to the next.
In 2002 Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands,
Portugal, and Spain implemented a new monetary unit, the euro, replaced the national currencies of these
countries. Now that all prices in these countries are quoted in euros, the 300 million consumers residing in
these 11 countries have an easier time spotting the best buys. This change should go a long way toward
promoting more competitive markets in Europe.
Are regional price differences likely to have disappeared completely since the euro has been used since
2002 as the hand-to-hand currency in the euro zone countries? (As a hint, ask students if there are regional
price differences for the same goods in the U.S.) It is unlikely that regional price differences will go away.
There are, of course, transportation cost differences so that goods sold farther from the producer will be
higher priced. Also, knowledge of what each good sells for in each regional market will normally not be
widespread, just as it is not in the United States thus allowing for some price differences.
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Even Harvard Can’t Charge an Above-Market Price
In 1991 the U.S. Department of Justice filed suit against Ivy League universities. It claimed that they had
conspired in their financial decisions, thereby forestalling the competitive determination of tuition rates for
their students. Recently, however, Princeton University began to offer full scholarships to academically
qualified students with family incomes below $40,000, and it increased its aid offers for students from
middle income families. Not long afterward Yale also announced increased aid offers for middle-income
students, as did Brown and Cornell. Then Stanford and MIT (outside the Ivy League, but close competitors
nonetheless) established similar plans.
Finally the nation’s oldest and most distinguished university, Harvard, sent a letter to each newly admitted
student. In part it said “We expect that some of our students will have particularly attractive offers from
the institutions with new aid programs, and those students should not assume that we will not respond.”
Translation: We’ll meet the market price. Even Harvard is a perfect competitor in the market for top-notch
higher education.
According to the model of perfect competition, all sellers charge the market price. But if sellers conspire to
fix prices, they also charge the same price. How might one discern if sellers are charging competitive or
noncompetitive prices for their products?
One method would be to see if profits earned by the firms were above normal profit levels and remained
so for long periods of time. With non-profit institutions such as private universities one could look at
similar private universities in other parts of the United States (on the assumption that nationwide collusion
would be unlikely) to see what they charge and compare it to what the suspected colluders charge.
Can the Government Cure Market Failure Due to Asymmetric Information,
or Are Lemons Here to Stay?
If information is not the same for buyers and seller, markets may be dominated by low quality product.
This type of market failure is due to the situation of asymmetric information. It is called the lemons
problem because cars, particularly used cars, that turn out to be bad deals are called lemons. The potential
buyer of a used car has relatively little information about the true quality of a car. The only way the buyer
can find out is to purchase the car and use it for a time. In contrast the seller knows a lot about the true
quality of the car since the seller has been using the car for some time. The owner of the used car knows
whether or not it is a lemon. In situations like this, with asymmetric information between the buyer and
seller, buyers want to pay a only a price that reflects the lower quality of the typical used car in the market,
not a price that reflects the higher value of a truly good used car.
From the car seller’s point of view, given that the price of used cars will tend to reflect average qualities,
all of the owners of the lemons will want to put their cars up for sale. The owners of high-quality used cars
will be reluctant to do so. The logical result of this adverse selection is a disproportionate number of
lemons on the used car market and consequently relatively fewer sales than would exist if information
were symmetric. The result is that lemons will be overpriced and high-quality used cars will be underpriced.
Can government policy improve this market? Because government has no better information than used-car
buyers, it cannot provide improved information. What the government has done is to require mileage
certificates and disclosure of major defects and work that has been done on the car. Some used car dealers
also offer extended warranties.
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If used-car dealers depend on repeat customers, is the lemons problem reduced or eliminated? The lemons
problem is reduced but not necessarily eliminated. A car dealership that sells used cars which decides to
cheat its customers can only do it for one period. Repeat customers and referrals only continue to occur as
long as the dealership sells high-quality cars and continues to provide high-quality service. If buyers were
provided with a guarantee of quality (say a warranty), they would come back and be willing to pay more.
Without such a warranty they would not pay as much. The problem is that dealers are also faced with the
problem of asymmetric information. They do not always know whether or not a car is a lemon, but the
issue of adverse selection says that many of the used cars they acquire will be lemons.
Chapter 25 Monopoly
Monopoly in Mexico
Telmex is Mexico’s largest monopoly. The telcom controls 94 percent of Mexico’s phone lines. The largest
stockholder of Telmex also control a company called Telcel, a cell phone carrier, that has 76 percent of
the cellular market. These companies dominate the telecommunications business in Mexico. Recently the
Mexican government decided to let cable companies and the telcom operators to provide Internet and video
in addition to traditional phone service over the same wires or wireless systems. In addition Telmex must
allow cable companies and the other small telcoms access to its wires.
Why do you suppose that Mexico has decided to encourage competition in the telecommunications industry?
The government must expect that competition will decrease the price of telecommunications if there is an
increase in competition.
Online Journal Subscriptions and Demand Elasticity
JSTOR (Journal Storage) is a non-profit organization that sells subscriptions for Internet access to back
issues of scholarly journals in fields such as chemistry, literature, and business and economics. To determine
the fees it charges institutions for online subscriptions, JSTOR analyzes the electronic data it accumulates
on how often faculty and students access articles in different journals. Intensive downloading of large numbers
of articles in physics journals at any price, for instance, indicates that the price elasticity of demand for
JSTOR subscriptions to physics journals is likely to be relatively low. JSTOR takes such data into account
when it sets the price it charges a college library for its physics journal subscriptions. In this way it can
charge a higher price to colleges where faculty and students have more inelastic demand.
Why might data show a large proportionate rise in downloads of sociology articles in response to a relatively
small price reduction indicate about the price elasticity of demand for subscriptions to sociology journals
other things being equal? It would suggest the demand for sociology journals is very price elastic. The
percent increase in quantity of articles demanded is very large compared to the percent decrease change
in price.
Technology: No Longer a Barrier to Entry
It used to be said that technology could cause a barrier to entry. Relatively major investments had to be
made in sophisticated, but relatively expensive computer systems. Only the largest corporations could
justify such expenses. They could therefore gain a competitive advantage over smaller rivals who could
not justify the technology investment.
Consider that when Henry Ford invested in a large-scale assembly plant, he created a competitive advantage
that lasted at least for a decade, if not more. When competitors started imitating him, he lost his competitive
advantage. Today, using information technology is not much different than knowing how to run an assembly
line—which certainly does not give any automobile manufacturer a competitive advantage.
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No one who buys off-the-shelf computer technology that is relatively easy to use today has any competitive
advantage over his or her rivals. What happens, though, is that those who learn to innovate in the use of
existing—and relatively cheap—information technology can obtain higher than normal rates of return for
some time.
Taxicabs and Medallions
Not too long ago, the city of New York allowed cab drivers to raise their fares by 27 percent. This should
have proven a boom to taxi drivers, but that has not happened. The majority of drivers have to pay lease
fees to the owners of the rights to use a legal cab in New York City. Beneficiaries of the increase in cab
fares have been medallion holders. Medallion holders are those who own the aluminum badges that give
a taxi the right to pick up passengers for a fare. Currently, medallions go for about $300,000. That means
that drivers rarely own them. Rather, investors, partnerships, and sometimes investment companies own
medallions.
In 1937, New York City issued a fixed number of medallions for a $10 fee. In spite of a rather large increase
in the population of New York City since then, no new medallions were created until 1996 when 400 more
were sold. Three hundred were auctioned off in 2004 and 600 in 2005 and 2006.
The largest owner of medallions is an investment company called Medallion Financial. Its stock market
share price doubled in 2004.
The Case of the Instant Camera
Edwin H. Land invented instant photography in 1947. He founded Polaroid and held a monopoly in the
instant photography market until 1976, the year that Kodak entered the market. Polaroid believed that
Kodak was infringing on many of its instant photograph patents. It went to court and sought $12 billion
in damages. When the case was settled, Polaroid won, but not $12 billion. Kodak was forced to leave the
business and pay Polaroid $925 million. The monopoly value of patents can be great indeed.
What has happened since in the photography market to reduce the value of Polaroid’s instant photography
patents? Key factors include the development of the camcorder, which permits the taking of motion
pictures on videotape, and the digital camera, which allows the taking of instant pictures and reproduction
of them by use of a printer and PC.
Intel Inside
Many observers of today’s high-stakes, high technology world argue that the world’s largest manufacturer
of microprocessors, Intel, is a monopoly. They point out that to compete effectively with Intel, a potential
adversary would have to invest billions of dollars. Intel provides the critical microprocessor chip that goes
into a majority of the world’s personal computers. Each new generation of microprocessor quickly becomes
the industry standard for IBM-compatible personal computers. Apple computers for years used a Motorola
made chip. In an attempt to fight back against Intel, Apple, Motorola, and IBM formed an alliance that did
develop the Power PC microprocessor. So far, though, it has not made serious inroads into Intel’s market.
In 2003 IBM and Advanced Micro Devices, Inc. (AMD) teamed up to develop the next generation
microprocessor in another attempt to try to compete against Intel. A few companies have tried to clone
Intel’s chips, but they have not been successful for both technical and legal reasons.
Intel spends billions of dollars developing each new generation of a new microprocessor. Would it spend
more or less if it had a smaller share of the microprocessor market? It is likely that Intel would spend less.
The reason is that the very large investment in R&D forms barriers to entry in two ways. First, the amount
of money that a potential competitor must spend to compete with Intel would be great enough that few
could afford it, and initially the payback period could be very long. Second, the high rate of spending on
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R&D results in new patents, which form a legal barrier. The resulting high rate of development of new
chips makes the use of Intel’s expired patents worthless for potential competitors.
The International Coffee Association and the Price of Coffee
A cartel in coffee, the International Coffee Organization lasted 30 years until the U.S. pulled out. It was
succeeded by the Association of Coffee Producing Countries. In May of 2001 the organization agreed to
cut production by 20 percent to increase the world price of coffee, which had been falling for over 2 years.
At first prices of coffee went up but by October of 2001 the price of coffee collapsed and the Association
decided to shut down. The problem was that production was rising due to some countries, which were new
to coffee production not joining the cartel. Also, of the cartel members, only Brazil, Colombia, and Costa
Rica actually reduced exports. The other 12 countries in the association increased production. These
12 countries argued that they were too poor to be able to afford to cut exports. When the three countries
that had cut exports found out about this, they stopped withholding coffee for export, too.
Assuming that actual cutbacks in exports would have raised coffee prices, why do you think that 12 countries
said that they could not afford to reduce the physical volume of exports? (Hint: What incentive did they
have to cheat on the cartel agreement?)
Even though the profits of the cartel would have increased as a result of higher coffee prices, a single country
could increase profits by more than its share of cartel profits if it cheated and no one else did. Thus it was
not a matter of being unable to “afford” a reduction in physical exports that did the cartel in, but the incentive
to earn higher profits by cheating by each of the 12 countries.
Chapter 26 Monopolistic Competition
What Besides Healthier Teeth Do Toothpastes Have to Offer?
Recently television commercials promoting toothpaste featured a well-known chef expressing satisfaction
with the latest in toothpaste flavors, including citrus, herbal, mint, and cinnamon. U.S. consumers fully
understand the health benefits of brushing their teeth, so makers of the various brands sold in the toothpaste
market seek to emphasize how good their toothpastes taste.
Manufacturers have also differentiated their toothpastes by promoting them as beauty products. Using such
names as “Whitening Expressions” and “Rejuvenating Effects,” toothpaste companies battle in media
ads to convince toothpaste consumers that their great tasting brands of toothpaste will also produce the
brightest smiles.
If a number of consumers become convinced that a particular brand of toothpaste really will “rejuvenate”
their teeth, what will happen to the price elasticity of demand for that particular toothpaste? The price
elasticity of demand for that toothpaste will fall—it will become less price elastic because the other brands
of toothpaste will not be viewed by consumers as being as good substitutes as before.
Should Hair Braiders Be Licensed?
Many service industries have raised entry costs by getting legislation passed that requires extensive
training and licensing before someone can enter the industry. Physicians and lawyers are good examples.
Less well-known are the high entry costs imposed on individuals who wish to give massages or trim and
style hair. For example, in California, a license to style hair requires the expenditure of over $6,000 for
1,600 hours of cosmetology classes. Hairstylists in California spend about $600 million on classes and test
administration fees.
Enter hair braiders, who are hairstylists for the African-American community. Individuals entering this
business long assumed that because they didn’t use chemicals, they would not be required to take extensive
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classes in the use of chemicals. But the California Barbering and Cosmetology Board recently ruled
otherwise. Given that there are 10,000 hair braiders in America, this issue affects more than California.
Currently there are several lawsuits challenging the licensing requirements for hair braiders. The regular
beauty solons are fighting the hair braiders to prevent this new competition.
Suppose that the hair braiders win their case and do not need to meet cosmetology licensing requirements.
What will the long-run effect on the economic profits from braiding hair of licensed cosmetologists in
California? (Hint: What type of long-run adjustment process will occur?)
The regular beauty salons must be fighting the competition from hair braiders because they expect that
if the hair braiders win, their profits will be lowered. Because entry barriers would be very low for hair
braiders compared to licensed cosmetologists, they would enter the market as long as there were economic
profits to be earned. The market share for the regular beauty salons would decrease. Price would fall until
it was equal to average total cost.
Advertising on the Internet Pays
The Internet is a place where firms advertise their products. Sales of advertising of all kinds dropped in
2001 but online advertising dropped dramatically. This was because there was no good evidence that
Internet advertising generated sales. In 2003 the European Interactive Advertising Association (EIAA)
examined 15 major Internet advertising campaigns in the UK, France, and Germany recently to find out if
Internet advertising had any major impact on consumers. A panel of consumers was used some of whom
saw the ad campaigns only on the Internet, some on the Internet and television and other media, and some
who saw the ad campaigns only on television and other media. The study found that brand awareness was
increased by online advertising alone. The aggregate reach of the ad campaigns from television alone was
41 percent. When people exposed only to Internet advertising was included, the ads reached 63 percent.
Ad recall from exposure to television increased by 27 percent. But, when both TV and the Internet
campaigns were seen by consumers, the ad recall almost doubled to 45 percent. Of even more interest to
advertisers was the result that persons exposed to TV campaigns only had an increased intent to buy of
2 percent but this rose to 12 percent when consumers were exposed to both the television and Internet ad
campaigns. (See http://www.eiaa.net/press-information/shwPress-information-releases.asp?id=6 )
Why do you suppose Internet advertising has such dramatic effects on intent to buy? (Hint: Who is likely
to go to an Internet site and what kinds of products are they likely to be interested in?) Persons going to an
Internet site are likely to be interested in particular information, products, or perhaps games. If the
advertising is targeted to people who have self-selected themselves for ads directed specifically at them,
then they would be more likely to be interested in buying the advertiser’s product especially and would be
more likely to recall the brand if ads for it are seen in both media.
Prescription Drugs: “Information Products?”
According to a study by Tufts University the cost of developing a new prescription drug rose from about
$231 million in 1987 to $802 million by 2001. That cost includes $403 million that a pharmaceutical
company might have earned if it had invested the funds used in an alternative line of business. According
to the study for every 5,000 chemical compounds that are tested on animals as medications, only 5 are
tested on humans and of these only one is approved for sale. Also it typically takes 12 years on average
for a new drug to reach the market. The explanation for much of the rapidly rising cost of developing new
drugs is increases in the costs of human clinical trials, which have been increasing at 12 percent per year.
Does the study appear to use the accountant’s or the economist’s use of the term cost? The economist’s
concept of cost appears to be used because in addition to the explicit costs of developing a new drug,
the study includes the opportunity cost of capital as a cost.
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What is the average cost of the first dose of a new drug? What about the marginal cost of subsequent
doses? Is this consistent with the behavior of costs for an information product? The first dose costs
$802 million because it costs this much to bring the first dose to market. The marginal cost of the second
and subsequent doses would be much lower because the very high fixed development costs would not be
included and equal to the average variable costs associated with producing them. This is consistent with
the behavior of costs of an information good.
Chapter 27 Oligopoly and Strategic Behavior
The Merger Movement in the U.S. Airline Industry
Since the terrorist attacks on September 11, 2001, the airline industry has suffered a number of setbacks.
Initially the new security regulations and resulting long waits in airports along with a reluctance to fly on
many members of the public resulted in a large drop in passengers. The result was excess capacity in the
industry. Airlines began to engage in vigorous price competition. A consequence was that for many airlines
there was a decrease in profits as ticket prices dropped below average costs. By 2005 the industry had gotten
smaller and was beginning to recover when Hurricane Katrina struck. The price of oil and jet fuel which
had begun to increase in price because of increased world demand for oil skyrocketed with the damage to
U.S. crude oil production and refining capacity in the Gulf of Mexico and the Gulf states. A consequence
was the development of merger talks between airlines. An example was United Airlines and Continental,
the number 2 and number 5 biggest airlines, began talks exploring the possibility of merging in late 2006.
What kind of merger is the one being proposed between United and Continental Airlines? It is a horizontal
merger because the firms produce the same product.
What would be likely to happen to the four firm concentration ratio in the airline industry if United and
Continental merge? It would increase because United is already the second largest airline in the country
while Continental is the 5th largest. Thus a new airline would be brought into the calculation of the four
firm concentration ratio.
The Cooperative Game of Sports Licensing
It is a Sunday in late November, which means that college football teams will be pitted against their most
hated rivals. Auburn fans will attend tailgate parties wearing t-shirts depicting the Auburn tiger mascot
strangling the Alabama elephant. Ohio State fans will have spent the preceding week working at desktops
adorned with paperweights depicting their buckeye mascot smashing Michigan wolverines.
Why do you suppose that the University of Alabama, the University of Auburn, and the University of
Michigan give permission for these items to be produced and sold, when the items do not flatter their
trademarked mascots? Is this a cooperative or non-cooperative game? The universities share in the
revenues from the sale of items upon which they have a trademark. Since each university benefits from
allowing the others to use its mascot and benefits from using theirs, it is a cooperative game
Strategically Relating Loan Subsidies to Nuclear Weapons
Companies are not the only entities that can engage in opportunistic behavior. Nations can, too, particularly
in their interactions with international agencies such as the International Monetary Fund (IMF). The IMF
routinely offers loans to developing countries and to nations that suffer foreign exchange crises. Typically,
the IMF grants loans only after receiving promises of “economic self-discipline.” The IMF might require,
for instance, that a nation reduce its inflation rate, cut its fiscal deficit, improve its legal system, and so on.
That is the tack the IMF took when it loaned Pakistan $1.6 billion in the latter part of the 1990s. In 1999
the IMF discovered that in 1998 and 1999 the Pakistani government fudged its budget deficit figures to
hide $2 billion in government spending. Much of this spending was directed toward Pakistan’s military
budget, including development of nuclear weapons.
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From July 1999 to the spring of 2000, the IMF withheld loan installments from the Pakistani government.
Soon the Pakistani government found itself facing default on its debt. The country’s military government
was already struggling to deal with declines in national saving, investment, exports, and output, and the
nation only had sufficient foreign exchange reserves to cover 6 weeks of imports. Faced with a weakening
economy, Pakistan’s military leaders began to hint that they might forgo more nuclear tests if Western
governments, which fund the IMF, encouraged the international agency to back a debt-rescheduling plan
for Pakistan. The IMF gave Pakistan a reprieve until 2001, which gave its leaders some breathing room to
get the government’s budget in order. Pakistani government officials acted opportunistically toward the
IMF. They did so because they knew they could get away with it, at least for a while.
Why might a foreign government engage in more opportunistic behavior with the IMF than it would with a
private lending institution? The IMF has a political agenda as well as an economic one. Thus it will not act
strictly in accordance with its economic interest. A private lender, by contrast, is simply interested in
expected profits. If the borrowing country engages in opportunistic behavior that the private lender does
not believe is in the lender’s interests, it will refuse to supply more funds in the future.
Giving Away Services on the Web: Thwarting an Emerging Rival,
Limit Pricing, or Both?
eBay, the Internet auctioneer, earns revenues by assessing commissions based on sales prices. It is a popular
site for selling anything from concert tickets to antiques. It is so popular, in fact, that some businesses
began to run ads on eBay’s Web site because they knew so many people were visiting it. That is how eBay
got into the Web advertisement business. This development alarmed Yahoo! and other Internet search
engines because it constituted a threat to a core part of its business. People who use Yahoo!, for example,
are exposed to ads on its site, ads that generate significant revenues. Yahoo!’s strategic response was to
offer free online auction services. It established a limit price of zero for other firms that might consider
becoming auctioneers as a means of horning in on its bread-and-butter online advertising business.
In spite of Yahoo!’s action and competition from other Internet sellers such as Onsale.com and
Amazon.com, eBay remains the most popular auction site on the Internet. Most observers agree that its
popularity is the key to its success, because when sellers list items for auction, they want to be certain that
there will be lots of potential buyers. In addition eBay continues to provide a wider range of auctioneering
services.
How can eBay continue to charge auction commissions while Yahoo! offers its auction services at no
charge? eBay offers more auctioneering services so Yahoo’s service is not strictly speaking identical. The
other reason is that eBay attracts the largest number of buyers. This means that the price that a seller can
expect to receive by selling through eBay is likely to be higher than at competing sites. Thus, a seller might
come out worse off on the Yahoo! site because the selling price is lower than it would have been on eBay
even accounting for commissions.
Switching Costs in the University World
Colleges and universities are in competition with one another. One way to deter entry into this industry is
to make switching across colleges more costly. This is what many colleges and universities have done.
Students who attempt to transfer from one school to another often find that many of the credits they earned
are non-transferable. This means that the course must be repeated. If the cost of repeating courses is high
enough, students will be deterred from switching universities. Typically, students who attempt to switch
are not aware of this problem prior to the attempt. Those who are aware of the problem can make sure that
they only take courses that transfer. Most switching in higher education occurs between community
colleges and four-year colleges and universities.
The Texas legislature required the community (two-year) colleges that receive state funding to adopt a
common numbering system for their courses starting with the 1999–2000 school year. In addition state-
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funded four-year colleges and universities are now required to accept these courses for transfer credit
for freshman and sophomore equivalents required by the four-year schools. The four-year colleges and
universities also use the same course numbers for common freshman and sophomore courses as the
community colleges.
What effect does the Texas common course numbering requirements have on switching costs for a
community college student who wishes to transfer courses to a four-year Texas public institution? The
switching costs for a student are decreased because four-year colleges and universities cannot arbitrarily
refuse to accept community college credits for the same course offered at the four-year school.
Chapter 28
Regulation and Antitrust in a Globalized Economy
Why This Cigarette Manufacturer Wants to Be Regulated
During the 1990s the Food and Drug Administration (FDA) launched preliminary efforts to convince
Congress to grant the FDA the authority to regulate the manufacture and sale of cigarettes. FDA officials
argued that it should have this power because nicotine, a key ingredient in cigarettes, is an addictive drug.
Initially, tobacco companies unanimously responded by denying that nicotine is addictive.
In 2003 Phillip Morris, the manufacturer of the top selling brand, Marlboro, began lobbying to be regulated
by the FDA. Regulation, the company decided, would improve the public image of cigarettes. After all, if
the company could market cigarettes with “FDA Approved” printed on the package, more people might be
willing to consume cigarettes. In addition, the company reasoned, a pro-regulation position would help it
gain favorable treatment from regulators if cigarette manufacturing does eventually become a regulated
industry. Favorable treatment from regulators might, in turn cement Marlboro’s position as the number
one brand.
Why might a firm that is particularly cooperative with its regulators have a good chance of “capturing” its
regulators? It would be viewed as supportive of regulation and as a result have a better chance of getting
some of its top managers on the regulatory board. Even without that result, the firm would have a better
chance of having its views taken seriously if the eventual regulators believed that the company favored
rather than opposed the purposes of regulation. The firm would be in a position to help draft the regulations.
Salmon, Farmers, Fishermen and Ranchers, and Electric Power in California
There has been conflict in California over competing uses of river water for agriculture and for the fishing
industry. Chinook salmon are relatively abundant in the ocean so they are not an endangered species. The
trouble is that the fish originate in two California rivers, the Sacramento River and the Klamath River.
There is no problem associated with the Sacramento River. Salmon are able to return to the river and
spawn thus renewing the stocks of fish caught by fishermen. The real issue is on the Klamath River where
a large percentage of its water is removed for agricultural purposes and the water flow is so low that it
endangers salmon’s ability to go up the river to spawn. In addition the Klamath’s water is impounded in
dams used for hydroelectric power causing its temperature to increase to levels that salmon cannot
tolerate. The resulting decrease in the number of salmon has required the federal government to step in to
protect the salmon in the Klamath River.
Several issues have come to the fore. To protect the salmon as is required by law, the federal government
must take action to improve the quality of the river so that the salmon population will recover. The options
include reducing the water diverted for agriculture and/or eliminating some of the dams. Reducing the
number of dams, and thus reservoirs, has its own problems. The dams produce electric power for the region.
It is clear that no solution using only one of these options is going to be acceptable to everyone. Nevertheless
the problem is that the river cannot suport all of these demands so something must be done. Also a oncein-50-year event is occurring—namely the dams that produce hydroelectric power were to be reauthorized
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by the Federal Energy Administration. If they were not reauthorized, they would have to be removed.
If reauthorized, they would probably have to be modified to allow fish to get around them.
It seems that everyone was willing to compromise. The residents along the river said they would be
willing to have some of the dams removed providing power could be gotten to replace the hydropower
lost. The federal government will require fish bypasses around the remaining dams to be built, and the
agricultural interests are receptive to some restrictions on when they can get larger amounts of water.
The regulators appear to be receptive to these views.
What theory of regulation seems to be operating in this case? It is the share-the-gains, share-the-pains view
since the solution appears to be one in which each group is willing to give up some of what it wants to
protect the river water upon which all depend.
Power Surges at Electric Utilities: Shocking?
The concept of a natural monopoly has applied to electric utilities until recently. Technology has changed
that situation. Efficient high-voltage transmission lines now exist. This means that the market for electricity
generation can transcend local and even national boundaries. This has led governments to remove most
restrictions on the sale of electric power, thereby permitting competition in the electric utility market.
The Department of Energy forecast that by 2010, greater competition in electricity generation could cause
the retail price of electricity to fall to three-fourths of its 1997 level.
Shortly after deregulation began, however, a Midwest heat wave induced two energy trading companies to
default on contracts to deliver power to the Chicago-based Commonwealth Edison Company. It had to pay
up to $5,000 per megawatt-hour to buy electricity on the spot market—more than 100 times the price that
had prevailed during the preceding weeks. Commonwealth Edison cut power to manufacturers and sent
out emergency notices to households to conserve electricity. A number of congressional representatives
immediately called for rolling back the legislation authorizing the new competition in electricity generation.
An interesting thing happened, however. The incident helped convince an independent power producer to
invest in a $100 million gas turbine power-generating plant near Chicago. The higher electricity prices had
induced market entry. This reduced the likelihood of a similar problem arising in Chicago in the future. Just
as the competition model predicts, price increases induce new firms to enter the market, which ultimately
pushes market prices down toward competitive levels.
Is there any true natural monopoly left in the world? It is likely that only a few local natural monopolies
still exist. It would be difficult to imagine competition for the delivery of piped water in a small-to
medium-sized town.
Is the Postal Service a Natural Monopoly?
For almost 200 years the U.S. Postal Service (USPS) has had a legal monopoly, particularly in the delivery
of first-class mail. When the President’s Commission on Postal Organization looked at the U.S. Post Office
in the 1970s, it accepted as “apparent” the existence of large economies of scale and the waste that would
result from competition in postal services. The commission was saying, in effect, that the post office was a
natural monopoly. When you think of a natural monopoly, you think of large fixed costs such as those
involved in laying a power lines in a city grid. But labor costs account for 83 percent of the USPS budget;
capital costs are low. It is hard to imagine such a labor-intensive industry exhibiting large economies
of scale.
In any event, a natural monopolist does not have to worry about competition because, presumably, no one
can produce at comparable average unit costs. There would be no need, for example for postal laws that
make it illegal for any competing service to charge less than three times the USPS’s rate for first class
mail for any type of delivery service. In reality it is its status as a legal monopoly, rather than as a natural
monopoly, that has kept the USPS in business. Wherever competition has been allowed, the USPS has
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fared badly. In fact in 2001 the USPS signed a seven-year deal with Federal Express for air express delivery
services. In addition United Parcel Service (UPS) announced in 2001 that it had found ways to significantly
reduce the cost to companies of sending mail through the USPS. UPS will electronically deliver timesensitive mailings to its regional centers, print them, presort them by zip code and deliver them to the USPS
closest to their final destination. In addition UPS will pick up mail, sort it by zip code and put this mail
into the USPS system. Generally this service is of most benefit to companies that do smaller mailings that
do not qualify for presorting discounts. In fact USPS is working with the UPS and other private companies
to reduce costs. None of this would be necessary if the USPS were a natural monopoly.
What technological innovations have occurred that have greatly reduced the demand for the USPS’
first-class mail delivery services and thereby reduced the value of the government’s mail monopoly?
Two innovations are the fax machine and the computer modem that allows direct computer-to-computer
communication.
Conflicting Social Regulations in a World of Multinational Firms
The Data Protection Directive took effect in October of 1998 in all nations of the European Union. This
law governs how firms collect and export personal data about European citizens. Under the directive, any
company doing business within the European Union must obtain consumers’ permission to collect
information about them, disclose how they will use the information, and reveal why it is being collected.
European backers of the law argue that it protects consumers against Big Brother-style corporate intrusion.
For U.S. multinational firms, however, the law is a headache. The European requirements run counter to
standard U.S. business practice in the U.S., where it is relatively common to gather information about
customers and corporate rivals without their knowledge. Some American business leaders have argued that
because information on U.S. firms and consumers is so readily available, the directive gives European
firms an unfair advantage in compiling information about competitors and potential partners in the U.S.
Indeed it will severely limit the ability of U.S. firms to do the same in Europe. In this regard, the directive
effectively acts as a protectionist mechanism that hinders U.S. and other foreign companies from
competing in Europe.
The law is particularly burdensome for multinational financial firms. Major U.S. banks have had to set up
separate systems for American and European customers. In addition, U.S. bankers and government officials
worry that criminals will use the directive to learn about investigations of their activities. The directive
requires all firms to give customers unlimited access to the information held on them, including files
opened as part of money laundering operations. Such files are closed in the U.S. Some law enforcement
officials are already forecasting that money laundering will soon become big business in Europe.
Why are companies willing to buy this information from other firms? Companies are willing to buy
information about consumers from other companies because they expect to make profits from the information
and thus it is profitable for other companies to collect this type of information. By gathering information
on the types of goods purchased by consumers, those who are likely to be interested in a company’s
products can be targeted for advertising or other selling efforts. Buying the information is less expensive
than developing the information.
Regulation in the Milk Market
An industry that has been heavily regulated for many years is the dairy industry. The 1937 Agricultural
Adjustment Act (AAA) provided for federal control over the marketing of fluid milk (as opposed to milk
used in the manufacture of cheese). Today the AAA still allows the producers of fluid milk to the public
to force marketing controls on dairies and bottlers. The federal government controls over 60 percent of
today’s milk markets, and states control the majority of the rest. The regulation of milk prices was justified
by the 1962 Federal Milk Order Study Committee as “promoting orderly marketing conditions for farmers
in the production of fluid milk” by “equalizing the market power of buyers and sellers to obtain reasonable
competition but not local monopoly resulting in undue price enhancement.” The regulation of milk prices
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today has one continuing effect: the market price of milk currently exceeds what it would have been in the
absence of regulation.
Which theory of regulatory behavior do you think describes what has happened in the regulated dairy
industry? The “capture theory” of regulatory behavior applies to the dairy industry since regulation keeps
price above market clearing levels. The dairy industry benefits from this regulation rather than the dairy
industry.
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Chapter 29
The Labor Market: Demand, Supply, and Outsourcing
Manufacturing Jobs Disappear Worldwide
Political leaders and media commentators often express concern that since 1995, U.S. manufacturing
employment has fallen by nearly 12 percent. Their comments commonly imply that other countries must
be capturing those lost manufacturing jobs. In fact, many other countries have also experienced declines in
manufacturing employment. Since 1995, the number of people making goods in factories has also decreased
by 12 percent in Russia and South Korea. The United Kingdom has lost about 13 percent of its manufacturing
jobs, and manufacturing employment has declined by 16 percent in both Japan and China. In Brazil the
number of manufacturing jobs has fallen by 20 percent.
Technological improvements experienced worldwide have enabled manufacturing industries to substitute
capital for labor as wages have increased. Many of the approximately 22 million people who used to be
employed in the world’s factories have obtained jobs in such industries as telecommunications networking
and software design and support.
If global prices of capital goods used in manufacturing increase substantially during the next decade,
would you expect employment in factories to continue to decline? No. If capital goods prices increased
dramatically, then labor would be substituted for capital as explained in the substitution effect.
The Immigration Debate in the U.S.
In 2006 and 2007 illegal immigration became a major political issue between the Republicans and
Democrats. There are an estimated 12 million illegal aliens working in the U.S. A large percentage
of these workers are in unskilled or semi-skilled occupations such as landscaping, custodial services,
construction, and agriculture. On one side there are Republicans who want the federal government to
send these workers back to their countries of origin. They argue that these people have broken the law
and do not deserve to stay in the U.S. The Democrats and some Republicans want to find a way to let
these immigrants stay in the U.S. legally but only on a temporary basis. An important fact is that the
number of unemployed in the U.S. is typically between about 6 and 7 million in any given month.
No one has addressed the issue of what sending these workers home would do to the economy.
Using the supply and demand model for labor, explain the implications of immigration on wages.
Immigration increases the supply of labor and decreases wages other things constant.
Suppose the government passes an immigration reform law that is successful in preventing most illegal
immigrants from getting employment in the U.S. Which American groups would benefit and which would
be harmed? Explain. Since a large percentage of illegal aliens are unskilled or only semi-skilled. The
supply of unskilled and semi-skilled labor would decrease and wages for Americans in this category of
labor would benefit by having higher wages and more job opportunities. Wealthier Americans would be
financially harmed because house construction costs would increase along with landscaping services
because the wages of labor used in these activities would increase thus increasing the prices of housing
and landscaping.
Does Attractiveness Lead to Higher Marginal Revenue Product?
Economist David Hamermesh of the University of Texas, Austin, and Jeff Biddle of Michigan State
University discovered that “plain-looking” people earn 5 to 10 percent less than people of “average” looks,
who in turn earn 5 percent less than those who are considered “good-looking.” Surprisingly, their research
showed that the “looks effect” on wages was greater for men than for women. This wage differential
related to appearance is not, contrary to popular belief, evident only in modeling, acting, or working
directly with the public. Looks seem to account for higher earnings in jobs such as bricklaying, factory
work, and telemarketing.
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According to Hamermesh and Biddle, part of the wage differential may be created by the fact that
attractiveness leads to higher marginal revenue product. More attractive persons may have higher
self-esteem, which in turn causes them to be more productive.
What are some other possible reasons that more attractive people tend to earn more? More attractive
people may make a better overall impression on employers and thus find it easier to get better paying jobs,
and once on the job, be better at getting raises because of a more favorable overall impression. In addition
a favorable impression may also lead to more opportunities for on-the-job training, which would increase
marginal revenue product. There may also be outright discrimination against average or plain looking
persons in the labor market.
Labor Demand Curve Slopes Downward—Except in France
In France the unemployment rate has exceeded 10 percent for several years now. In an effort to do
something about the problem, the French government has cut the legal workweek from 39 to 35 hours for
both salaried and hourly workers. Only senior executives are exempted from this restriction. To enforce
the law, the government has issued thousands of citations charging companies with working their employees
too many hours. Legal penalties, levied on chief executive officers of offending companies, include fines
up to $1 million and jail terms up to 2 years. This has induced some French firms to install electronic time
clocks in hallways. Workers swipe ID cards to record arrival and departure times and coffee and lunch
breaks. To allow some flexibility, the government allows workers to build up hourly “work credits” in
the weeks when they exceed the 35 hour week. The maximum allowable credit is 15 hours. Managers are
required to contact workers who overstep that limit and assist them in drawing up a plan to reduce the
backlog.
This policy has an interesting implication. Lower-paid workers at companies are often blue-collar workers
and salaried white-collar workers. The law restricts the hours that these people can work for their relatively
low wages. But the highest paid senior managers can work as many hours as they wish every week. Thus
in France there is now a positive relationship between the wage rate and the quantity of hours that a firm
employs workers. In this sense, the law has produced an upward-sloping labor demand curve.
What effect is the French workweek regulation likely to have on the ability of French companies to
compete in the face of ever-tougher global competition? It should reduce the ability of French firms to
compete globally because an increase in the demand for their products, which requires more labor input,
will actually cost more as higher wage workers must be hired to perform the work.
Superathletes’ Marginal Revenue Product
At least once a year some superathlete lands a multimillion dollar contract, and the press is all agog over
the seemingly astronomical salary. You will hear sports writers and other persons commenting that no one
is “worth” that kind of salary just for playing a sport. Before we can determine whether an athlete is
overpaid, we must first establish an athlete’s marginal revenue product. Economists have come up with
several estimates of the MRP of athletic superstars. One of these was Wayne Gretzky, thought to be the
best professional hockey player ever, who was traded from the Edmonton Oilers to the Los Angeles Kings
in 1988. The Oilers received $15 million and some draft picks for Gretzky. When we add in his salary, we
find that the Kings paid about $6.5 million a year to have Gretzky play for them. After his contract was
announced, Los Angeles TV decided to expand its coverage from 37 to 60 games. Season ticket sales and
attendance at home games experienced significant increases. It has been estimated that the Great Gretzky’s
first year MRP was about $8 million.
How might you calculate the MRP of today’s cinematic superstars? The MRP of a movie superstar would
be the additional revenue that could be expected from employing that star as opposed to another actor. For
example, one could look at the revenue projections from employing say, Julia Roberts, in a film versus a
relatively unknown actor. The positive difference would be the MRP of Ms. Roberts.
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Why Are European Businesses Using More Robots and Fewer Workers
Than U.S. Businesses?
Some European countries are experiencing the highest levels of unemployment since the Great Depression.
Since 2000, unemployment rates have been between 8 to12 percent in many of the European Union (EU)
countries. For example the unemployment rate in Spain has been around 11–12 percent, 8–9 percent in
France and Germany, and 9–10 percent in Italy. Compare this with the rate 4–6 percent unemployment
rates in the U.S. during the same period. One would expect, therefore, that European firms could easily
replace capital with labor and that there would be general pressure to lower wages. The opposite has
occurred. For example, in Germany, department stores use robots in shoe storerooms to seek out shoes that
a salesperson wants. In Denmark Dairy warehouses have gone robotic. In fact, the market for automated
systems in Europe has grown by more than 10 percent per year, a much greater rate than in the U.S. The
reason is that European businesses have concluded that it is cheaper to use robots than to employ people.
In Germany an industrial robot costs about $10 an hour to operate. An industrial worker may cost as much
as $37 an hour. And while compensation to workers has continued to rise in Germany and elsewhere since
the early 1990s, the operating costs of robots has fallen.
There are many reasons why wages have remained so high in spite of high rates of unemployment in Europe.
First of all, minimum wages there can be as much as 50 percent higher there than in the U.S. Also, Social
Security contributions that employers have to pay for each worker often equal or exceed the wages that the
worker takes home. In addition a firm must pay significant severance penalties if it fires a worker. Finally
many workers will not take low-paying jobs in some European countries because they are actually better
off receiving unemployment and welfare benefits.
Why have robots not taken over as many jobs in the U.S.? Unemployment benefits are relatively low in
the United States and have a 6-month limit, and thus it is economically attractive for most people to find
employment. In most cases it costs little or nothing for an employer to lay off or fire a worker, and thus
employers are not reluctant to hire workers since they know that the worker can be laid off if demand falls
or if the worker could be replaced by capital. Finally the minimum wage is lower in the United States,
which would cause fewer workers to be priced out of the labor market.
Explaining the Large Pay Differences in Corporations: A Quest
for the Boss’ Job
Although efficiency wage theory and the insider-outsider theory may explain wages that are above the
competitive level, they have a harder time explaining the really big differences within a firm’s management
structure. CEOs tend to make many times more than vice-presidents do. Senior vice-presidents in turn,
earn double what a regular vice-president is paid.
According to a theory called “tournament theory” by its developers, Edward Lazear of Stanford University
and Sherwin Rosen of the University of Chicago, corporations create big salary differentials not in an
attempt to reward recipients but rather to create a structure of powerful incentives to get people in the
organization to work harder. Pay is based on relative performance, relative to one’s peers within the
management organization. The pay of the vice-president is not what motivates the vice-president: it is
the pay of the CEO to whose job the vice-president aspires. Thus vice-presidents and those under them
are involved in a series of tournaments. At each level the winner moves up to the next highest level. All
aspire to the highest level, the CEO’s job.
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If luck plays an unusually large role in a manager’s rise to the top of a corporation, will the pay differential
between CEOs and the next highest group have to be relatively larger or smaller compared to a situation in
which luck is not very important? If luck is important in a vice-president’s rise to the top, then the reward
differentials would not have to be greater than when luck is not important. If luck is important, then one
person could work as hard as others and do everything right and still not get the top job. Likewise, a person
who did not work as hard as others could get the job. Large relative pay differentials would not be very
important in inducing work effort. By contrast in an organization in which merit rather than luck is an
important element for promotion, persons in the organization will compete by working very hard. Relative
pay in this type of organization will be much more important to induce effort in the rise to the top job.
Chapter 30
Unions and Labor Market Monopoly Power
In Europe Jobs Can Now Move Farther East
Germany has an extensive system of centralized wage bargaining that involves nearly 60,000 different
labor agreements. Furthermore, any German company with more than 2,000 employees must give half the
seats on its management board to employee representatives. The result has been steady wage increases.
Wages are higher in Germany than in most other European nations. German wages are certainly much
higher than the wages in all ten of the EU’s new members from Eastern Europe, whose borders are now
open to factors of production from elsewhere in the EU.
When union workers at German companies recently began pushing for higher wages, managers at several
firms pointed out that German wages were already twice as high as the average wage in Slovakia. This big
wage differential, the managers noted, could help cover the costs of moving plants and equipment out of
Germany and into Slovakia, where willing workers could easily replace German workers. Discussions
about big wage increases for German workers died out rapidly thereafter.
The UAW versus Delphi
Once upon-a-time the U.S. automobile industry was an oligopoly with significant market power. The
UAW was a powerful union. The auto industry and its suppliers were able to bargain with the UAW and
grant increased wages which were then passed on to consumers in the form of higher prices for cars and
trucks. The firms had very high costs but no real competition. Then foreign firms found that they had a
significant cost and thus price advantage and began to enter the U.S. market. They have subsequently
taken over about 40 percent of the U.S. car market. The U.S. automobile firms no longer have any significant
market power and have found that they remain uncompetitive. They are unable to compete and thus there
suppliers who also have high union wage costs are also uncompetitive.
Back in the fall of 2005 a new CEO, Steve Miller, was hired by the Delphi corporation to try to avoid
bankruptcy. A critical issue for Delphi was its collective bargaining contract with the United Auto Workers
(UAW). Union workers earned between $25 and $65 per hour in wages and benefits. Effectively the wage
was $25 to $65 per hour. The bargaining issues between the UAW and Delphi were highlighted at Delphi’s
Lockport, New York, plant where union workers wages ranged upward from $25 per hour. Mr Miller
sought to cut the lowest paid workers wage to $9.50 per hour. The union naturally resisted such a drastic
cut in wages saying that it wanted to keep both the current wage structure and the jobs of its members.
Are the union wages above or below the equilibrium market wage? Union wages are above the equilibrium
market wage because without the union contract they would fall. Thus the quantity of labor supplied is
greater than the quantity of labor demanded at the union wage. If union wages were equal to or below the
market wage, there would be no reason for management to find it necessary to reduce them to avoid
bankruptcy.
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Made in America, but Not Really
Boeing, Inc. is a U.S. company. Its Boeing passenger planes are made in American factories. Nonetheless,
Boeing buys more the 50 percent of its airplane structure parts from abroad.
Consider the new 7-E7 airframe structure. Boeing itself will only build 35 percent of that structure. Three
Japanese companies, Fuji Heavy Industries, Kawasaki, and Mitsubishi, will build another 35 percent. Italy
and other countries will build about 20 percent and Vaught Aircraft Industries in the U.S. will build the rest.
Government’s Helping Hand to Construction Unions
The Davis-Bacon Act was passed in 1932. It specifies that the Secretary of Labor can establish minimum
“prevailing wages” that contractors must pay workers when engaging in any construction that is paid for
or subsidized with federal funds. The Department of Labor Wage Determination Division has typically
determined “prevailing wages” to mean union wages. In their bargaining sessions with employers, negotiators
for construction unions become more and more set on increasing negotiated rates. In a normal situation, an
increase in wage rates (when there is no inflation) will lead to a decrease in employment, but this is not the
case for federally assisted construction projects. The government requires that the contractors hire workers
at the prevailing minimum. Therefore government will foot whatever increase in the bill is due to
increased union wages.
Federal projects account for almost 30 percent of all construction work in the U.S. That means that almost
30 percent of all construction projects have the Davis-Bacon minimum applied to them. Obviously
construction union negotiators realize that there are many federal construction projects for which they can
get the high wage rates that they establish in negotiation. As can be expected, with union wage rates rising
rapidly, the number of jobs available in private construction at the union rate has declined.
How might the Davis-Bacon Act actually end up reducing union employment in the long-run? If union
wages are kept too high, relative to non-union wages, then contractors in non-federal projects will
increasingly turn to non-union labor in the 70 percent of construction not subject to the provisions of
the act. Thus union employment will decrease.
Taking on the Teamsters: The “Big” UPS Strike
As unionization rates have fallen so have the number of strikes by unions. The number of strikes has fallen
from between 400 to 450 per year in the 1950s to under 100 a year since the early 1980s. Major strikes
used to have significant disruptive effects on the economy, but that is rarely the case today. One of the last
strikes to bring at least a part of the economy to a halt was the 1997 Teamsters’ strike against UPS. For
several weeks mail-order companies, college book publishers, and hundreds of other firms scrambled to
replace UPS shipments with alternatives. Federal Express and Airborne Express in particular gained
handsomely from the Teamsters’ strike.
Many media pundits concluded that the strike yielded a big victory for the Teamsters and organized labor
as a whole since the Teamsters got most of what they asked for. However, the Economic Policy Foundation,
a conservative organization, calculated that the typical UPS worker lost about $1,850 in income as a result
of the strike. It calculated that relative to the final prestrike offer by UPS, a typical worker would require
5 years to come out ahead on net after the strike. Furthermore, after the strike the average part-time worker
actually earned slightly less relative to what he or she would have earned under the company’s pre-strike
offer. Finally, the higher costs that the new contract imposed on UPS pushed up shipping costs for
manufacturing industries that are more heavily unionized, thereby raising prices of manufactured goods
and reducing the quantity demanded by consumers. This tends to push down wages. So in a sense the
Teamsters’ gain at UPS translated into a loss for union members in other unions.
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In what way may the Teamsters’ victory have helped organized labor? It may have sent a message to
workers that unions can be effective in acting for the interests of unionized workers since the union got
much of what it wanted. It may also have convinced management that unions that are willing to strike can
be very effective and thus be more willing agree to union demands.
Monopsony in College Sports
About 600 colleges and universities belong to the NCAA, which controls more than 20 sports. The NCAA
operates as an intercollegiate cartel that is dominated by universities that operate big-time athletic
programs. It operates as a cartel with monopsony and monopoly power in four ways:
1.
2.
3.
4.
It regulates the number of student athletes that universities can recruit.
It often fixes the prices that universities can charge for tickets to important intercollegiate events.
It sets the prices (wages) and the conditions under which the universities can recruit these student
athletes.
It enforces its regulations and rules with sanctions and penalties.
The NCAA rules expressly prohibit bidding for college athletes in an overt manner. Rather the NCAA
requires that all athletes be paid only for tuition, fees, room, board, and books. Moreover, the NCAA limits
the number of scholarships that can be given by a particular university. These rules are ostensibly to
prevent the richest universities from “hiring” the best athletes. Not surprisingly from the very beginning,
individual universities and colleges have attempted to cheat on the rules in order to get the best athletes.
The original agreement was to pay athletes no wages. Almost immediately schools began offering athletic
scholarships, free room and board, and other enticements. Eventually the NCAA allowed student athletes
to be paid wages for other jobs in the university.
If all universities had to offer exactly the same money wages and fringe benefits, the academically less
distinguished universities in metropolitan areas (with a large number of potential ticket-buying fans)
would have the most inducement to violate NCAA agreements to compensate for the lower market value
of their degrees. They would figure out all sorts of techniques to get the best athletes. Indeed such schools
have, in fact, cheated more than other universities and colleges, and their violations have been detected and
punished with a greater relative frequency than those of other colleges and universities.
College and university administrators argue that the NCAA rules are necessary to “keep business out of
higher education.” How can one argue that college athletics is related to academics? The major argument
that college athletics is academically related is that the players are also students. For many players, the
athletic scholarship is what allows them to enroll in college. In many sports there are no large revenues to
be earned for the average school (e.g., track, soccer, golf, tennis) and at some smaller colleges the athletic
programs do not even pay for themselves through ticket sales, let alone contracts with the media. The
athletes are essentially supported by scholarships that allow them to attend college.
Will Internet Job-Hunting Services Finally Make Monopsony
an Irrelevant Economic Concept?
The classic example of monopsony is the “company town”—a small community in which a single firm is
the dominant employer. In extreme examples, companies have owned and managed all housing, stores,
and health care facilities in such towns. Of course, the coming of the automobile put an end to most of
these towns. It did not necessarily bring a complete end to monopsony power for some businesses. For
example, imagine being a licensed practical nurse in a remote area with relatively few doctors and a single
hospital largely managed by those same doctors. Avoiding some monopsonistic exploitation might be
difficult because it might be difficult to obtain information about alternative job openings for nurses in
home health care or nursing care facilities within commuting distance of your home.
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Today, however, the opportunities for a nurse in this situation are likely to improve if she logs on to web
sites such as Monster.com, ihirenursing.com, or Careerbuilder.com. These and other Web sites post job
listings sent by company recruiters and help wanted ads from all over. Some of these sites allow job
seekers to post their résumés, and others even collect data from job seekers and then e-mail them potential
matches. Increasingly the Internet is blurring the distinction between “local,” regional, and national labor
markets, making it harder for any firm to exercise much monopsony power.
If a local hospital faces little or no competition from other hospitals, is it possible for it to exploit its
nursing employees even if it has no monopsony power? Such exploitation would be possible in the shortrun until nurses located other jobs that paid higher wages. Over the long-run lower wages could be paid
only to nurses who were not mobile for some reason.
Chapter 31 Income, Poverty, and Health Care
The U.S. Poverty Level versus Average Incomes Abroad
Each year the World Bank issues a report that provides the per capita incomes of about 150 nations.
Out of all these countries, only 26 percent have per capita incomes higher than the poverty income
threshold income level defined by the U.S. government. This official poverty threshold income level
for the U.S. is twice as high as the world’s average per capita income level. It is approximately equal
to the average income of a resident in Slovenia or Portugal.
Does the fact that the U.S. government raises its official poverty threshold income each year imply that
it defines poverty in a relative or an absolute sense? No. The increase in the poverty threshold income is
based on increases in the price level. Thus the real threshold poverty level is constant.
Mandatory Health Insurance Law Enacted in Massachusetts
In 2006 Massachusetts enacted a law requiring all Massachusetts residents to have health insurance. At
the time the law was passed there were about 500,000 uninsured residents who would be required to buy
health insurance. Low-income residents’ insurance would be paid for or subsidized by the state. The law
requires all residents to obtain health insurance by July 1, 2007. Those who do not comply with the law
will face financial penalties. The Massachusetts Commonwealth Health Insurance Connector Board has
proposed basic coverage that must provide benefits for hospitalization, primary care, emergency services,
and mental health services, and which has no limit on coverage per sickness, number of years or lifetime
benefits. Deductibles are capped at $2,000 for in-network care for an individual. At least three preventivecare doctor office visits are required before the deductible takes effect. Plans currently include prescription
drug coverage and have a separate maximum deductible of $250 per individual.
Insurance companies developed plans that include all of the minimum requirements that cost about
$380 per month per person. Currently the Board is waiting on insurance companies to submit bids for
plans for one plan that includes drug coverage and for another plan that does not. The new bids must
provide coverage. The estimated cost of the plans to the state is about what it is now, $1 billion to $1.5
billion.
Is it likely that the health care costs incurred by the state of Massachusetts will be about the same? No. The
addition of 500,000 newly insured persons who will find that their out-of-pocket cost of medical services
has drastically declined will use more medical services. In addition the demand for medical services will
increase with a resulting increase in the price of these services. Thus the state will be spending much more
on medical services for those it pays for and will be paying for more of them.
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Should the Government Encourage Marriage?
Since the end of the 1970s, the average income of the top fifth of male income earners has risen by about
4 percent. During the same period, the average earnings of men in the bottom fifth fell by 44 percent. A
key reason for this disparity is that poor men today are less likely to be married. In 1979, almost 3 out of
every 5 men among the poorest 20 percent of income earners were married. Today, however, only about
2 out of 5 are married.
The reason this drop in the marriage rates among lowest-income men makes such a big difference is that
the incomes of women has risen. Today, about 65 percent of women with poor husbands work, up only
slightly from 61 percent in 1961. The wages of these women have increased by about two-thirds, however.
If the poorest males were marrying at the same rate as before, fewer lower-income households would have
suffered big drops in their average earnings. Marriage has only added to the income gap of the highestincome men. In 1979 just over half of the women married to high-income men worked. Today three-fourths
of these women work, and their wages have risen by more than 70 percent. This has further enriched the
households of the highest-income males.
Based on this data, some economists recommend that the government should develop policies that
encourage higher marriage rates among poorest individuals. At a minimum they recommend eliminating
policies that discourage marriage, such as taxing married couples at higher rates than single individuals at
the same income levels.
Some poor men are probably less likely to be married because their income drop has hurt their marriage
prospects. What, if anything, should the government do about this? Eliminating the marriage tax as
mentioned in the example would be a start. Allow higher social security earnings without loss of benefits
(already enacted). Whether or not the government should do anything about such a problem is a value
judgment and cannot be addressed scientifically. If reduction in poverty is considered a desirable social
policy, then the government should “do something” to alleviate it.
Economists, Aging, and Productivity
Do the actions of professional economists fit the model that predicts a decrease in productivity after some
peak at around age 50? Yes, according to University of Texas economist David Hamermesh. One measure
of productivity of economics professors is the number of articles they publish in professional journals.
Whereas the over-50 economists contribute 30 percent of the profession, they contribute a mere 6 percent
of the articles published in leading economic journals. Whereas 56 percent of economists between ages
36 and 50 submit articles on a regular basis, only 14 percent of economists over 50 do.
Why should we predict that an economist closer to retirement will submit fewer professional journal
articles for publication than a younger economist? One of the major determinants of promotion, tenure,
and raises in salary at most universities is an economics professor’s publication record. A younger
economist will need to publish at the beginning of his or her career to gain tenure. Then promotion will
depend in large part on the number of professional publications. There is a powerful incentive to publish
for younger economists. An older economist will most likely have become a full professor. He or she
cannot be promoted any higher and remain in teaching. He or she will have tenure in most cases. Thus
there is considerably less incentive for such a professor to publish. Some publication would still be
predicted for older economists, however, since annual raises are based in part on publication records at
many universities.
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Removing Racial Barriers: The Colorful but Color-Blind Internet
When a white customer asks an African-American salesman if a different salesperson can assist her, the
salesman may assume that his race may have cost him a sale. Likewise, when a white banker turns down
an African-American loan applicant, there is always the chance that race made a difference. To explain
why race or other factors might affect peoples’ economic choices, economists have developed the cultural
affinity hypothesis. It indicates that lenders find it less costly to evaluate applicants who share their own
backgrounds. This hypothesis could also help explain why applicants for loans might prefer to apply at
banks that are owned by people who share their characteristics or why customers might prefer to do
business with certain salespersons rather than others.
Documenting or explaining differential interactions on the basis of different characteristics does nothing
for people who feel that their, racial, ethnic, or gender status causes them to lose out on earnings. For
many African-American entrepreneurs, the Internet is increasingly providing a means to avoid such lost
opportunities. For instance, Autonetwork.com is a booming Web site that offers auto broker services and
leasing information, but there is no need for anyone looking for a good deal on an auto lease to know—or
care—that the site is owned by an African-American man who earns more than $200,000 in advertising
revenue alone from operating the site. Likewise, all a college student who wants to do better in biology
class cares about is whether Cyberstudy101.com can help him, without regard to the fact that this
successful online business was the brainchild of an African-American woman.
Some online businesses advertise that they are owned by people of a particular race, ethnicity, or gender
and offer products aimed at people who share that characteristic. Could the cultural affinity hypothesis
help explain this phenomenon? It could because it is possible that many potential buyers would be more
likely to believe that an entrepreneur of the same race, gender, or ethnicity would be more likely to
understand the type of products and services that the buyers of the same race, gender, or ethnicity want.
While Americans Complain About Health-Care Expenses,
Canadians Wait in Line
In the U.S., government programs and some private programs engage in nonprice rationing. Nonetheless,
the primary rationing device for health care services continues to be the market mechanism. A disadvantage
of this approach is that some people may not wish (or be able to) pay for best-quality care. A large number
of U.S. residents do not have health insurance at some time of year.
In Canada the government provides a “single payer” national health system under which all citizens are
promised “free care.’ In recent years proponents of a national U.S. health care system have held up the
Canadian system as a model. In recent years dramatic events highlighted the pitfalls of the Canadian
system. A pregnant woman died of a brain hemorrhage when her doctors could not locate a neurosurgical
facility that had room for her. After months of postponed appointments, a woman suffering from stomach
pains died of cancer that might have been treatable if detected earlier. Other patients with suspected
cancers had to sign lists to get on to waiting lists for magnetic resonance imaging (MRI) devices.
Offering free health care encourages patients to seek as much care as they can get. A government that
promises care must incur costs to provide it. To cope with rising costs, Canadian officials have closed
hospitals and limited the hours that physicians can treat patients. They have depended on rationing by
queues. For people who can get treatment in Canada, the quality of care is very good. The problem is that
people typically have to wait in line to get it—and some die waiting.
What identifiable group stands to gain from allowing market prices to ration health care? Do any specific
groups gain from health care rationing by queues? Clearly, physicians, hospitals, and medical testing
service providers stand to gain from allowing market prices to ration health care. Their incomes will rise.
Persons who can afford health insurance or are covered by employer plans benefit because they would
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have access to treatment when they need it. Low-income persons gain from rationing by queues because
they would often be unable to get any medical services if they had to pay for them.
Chapter 32
Environmental Economics
No Manure, Sherlock
There has been a controversy in Michigan concerning the manure generated by the state’s dairy farms. The
milk cattle produce large amounts of manure, which is liquified and spread on farmland as fertilizer. A
problem arises when it is spread too thickly and there is rain or storm melt. Then polluted water runs into
streams and rivers polluting the water for those downstream who must pay to treat the water to make it
drinkable. There is a bill in the legislature to require dairies to prevent or pay to clean up runoff.
What would happen to the price and quantity of milk being produced in Michigan if dairy farmers were
required to prevent the pollution from runoff? Because the cost of producing milk would increase, the
supply of milk would decrease. The price of milk would increase and the quantity of milk produced would
decrease other things constant.
How Chinese Fish Farming Helps Wild Fish Populations
Fish farming or the growing of edible fish in small freshwater ponds and sea inlets blocked with earthen
dams began in China thousands of years ago. Twenty years ago Chinese fish farmers were producing
about a million tons of fish each year. Since then production of farmed fish has increased dramatically.
Chinese fish farmers currently produce almost 35 million tons of fish per year, or more than 70 percent of
the world’s total production of farmed fish. Much of this yield goes for human consumption in China and
other Asian nations where Chinese fish farmers now sell a considerable amount of their fish production.
The rest of China’s farmed fish is used to produce fish meal and fish oil. These fish by-products are fed to
poultry and pigs and to carnivorous fish such as salmon, eel, and cod grown in fish farms.
Back in the 1980s environmentalists worried that wild fish populations in the world’s oceans, lakes, and
rivers would eventually be extinguished as the global human population increased. In fact annual catches
of wild fish have been declining since the 1990s. The reason is that consumers in Asia and eslewhere have
gradually been substituting farmed fish for wild fish. Current estimates indicate that by 2030 more than
half of the fish consumed globally will be grown on farms.
What do you suppose has happened to the market price of wild fish such as salmon and shrimp since the
1980s as the farmed fish share of U.S. fish consumption has risen from less than 10 percent to more than
50 percent. The prices of these wild species of fish have fallen. The demand for wild fish has decreased as
consumers have substituted farmed fish for wild fish. Other things constant a decrease in demand results in
a decrease in price.
The Underpricing of Water
We’re running out of water, say many observers of the environmental scene. Of course, these people can’t
be talking about total water in the earth; because—unless Martians are siphoning it off—the amount of
water is fixed. What they are referring to is the lack of clean drinking and cooking water in developing
countries. Two issues come to mind when examining these serious problems. The first has to do with
subsidized irrigation (sound familiar?). Developing nations’ farmers use 75 percent of all water in those
countries.
The second problem has to do with underpricing. The main beneficiaries of the underpriced water are
large-scale farmers and relatively richer households in the cities that have access to piped water from
municipal facilities. Unbelievably, the poorest people in developing countries have to pay for water from
door-to-door water vendors.
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An increase in water prices, at a minimum, would force farmers to shy away from water-intensive crops
when faced with the full opportunity cost of this important input. In some countries where water rights are
now trading, farmers find that it is more profitable to sell water rights than to grow water-intensive crops.
These countries include Australia, Chile, and Spain. (Note that California has established a market in
water, too.)
There are ways to protect the poor from suffering too much from correctly priced water. In Chili, the
government gives out “water stamps” to the most deprived members of society. In South Africa, most
people do not have to pay for the first 25 liters of water each day.
Will Anyone Be Able to Tell If Abiding by the Kyoto Protocol
Affects Global Temperatures?
In December 1997, the U.S. government tentatively agreed at a United Nations meeting in Kyoto, Japan,
to reduce nationwide emissions of greenhouse gases by 7 percent below 1990 levels. This goal would be
achieved by reducing the combustion of fossil fuels sufficiently to diminish emission levels in 2010 to
41 percent below where they would end up at current rates of emission growth. Although any estimates of
the overall economic effects of the agreement are fraught with uncertainties, economists estimated that
abiding by the agreement could reduce U.S. GDP growth by as much as 2.5 percent per year. As a result,
President Bush announced in March of 2001 that the U.S. would not sign and ratify the treaty and his
administration continues to oppose this initiative in 2005.
Scientists using a climate model developed at the National Center for Atmospheric Research also had
trouble coming up with precise estimates of the likely effect of the proposed emission reduction in global
temperatures. Their best estimate was that such a reduction in emissions might reduce planetary warming
by 0.19 degree Celsius (0.32 degrees Fahrenheit) over a 50 year period—a barely discernable reduction in
the earth’s potential warming trend. Another problem is that the networks of surface thermometers that
scientists use to monitor the earth’s overall average temperature are unable to differentiate such a small
temperature change from normal year-to-year variations. Even accounting for improved temperaturemeasuring capabilities 50 years from now, measuring the ultimate impact of the Kyoto Protocol on
Greenhouse Emissions might prove impossible. Consequently, determining the marginal social benefit
of emissions reductions, at least from a global warming standpoint, may be impractical.
If the effects of greenhouse gas emission abatement on global temperatures are too hard to measure, how
else might the marginal social benefit of emission abatement be determined? One possible benefit of
reduced emissions might be a measured reduction in respiratory disease in urban areas. Another benefit
might be the reduction in the amount of acid rain and its adverse effects on water quality, forests, and
agriculture that resulted from burning less fossil fuel.
Can Citizens Recycle Too Much? The Case of Germany
Recycling is popular throughout the European Union, but the Germans have raised it to an art form—a
very expensive art form. Germany has a law requiring that manufacturers or retailers take back their
packaging or ensure that 80 percent of it is collected rather than thrown away. What is collected must be
recycled or reused. The law covers about 40 percent of the country’s garbage. The problem is that German
consumers responded more enthusiastically.
How is it possible that German citizens might have recycled “too much” of their trash? “Too much”
recycling occurs when the marginal cost of the last unit of garbage recycled is greater than the price that
can be gotten for it in the market. Resources could be moved out of recycling and into other economic
activities and the total value produced in the economy would increase.
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Preventing Over Fishing by Trading Quotas
Under the European Union’s Common Fisheries Policy, countries are allocated quotas for the amounts
of fish that their fishermen can catch in various areas of the sea. In most European nations, governments
control the allocation of fishing rights under these quotas. When a fisherman dies or retires, his quota goes
into a pool to be reallocated. In the United Kingdom, however, fishermen can buy, sell, or lease their
quotas. It turns out that this has had beneficial side effects for fish conservation.
The reason is that because many fishermen would like to catch more fish than their quotas permit them to
catch, there is always a temptation to exceed quota limits. If a British fisherman thinks that he is more
efficient than another fisherman, he can buy or lease the other fisherman’s quota. If he is right, he earns
higher profits than he would by over fishing and trying to sell his excess catch, which fishermen call
“black fish,” illegally in the black market.
Indeed, many British fishermen might be pleased if the European Union were to cut quotas in a further
effort to repopulate stocks of fish. Their current incomes might fall, but the market value of their quota
would rise. The values of the quotas are already relatively high. When a tragic accident led to the sinking
of a fishing boat off the coast of Scotland, the deceased owner’s quotas sold for about $10 million.
How does the existence of a market for quotas help keep the stocks of fish off the shores of Europe from
dwindling? Fishermen have a property right in the fish. They have an incentive to conserve fish because
they know that they have a valuable asset, the quota, which depends on there being fish to catch.
Earning Profits from Conserving Natural Wonders
In Virginia’s Shenandoah Valley, 230 miles south of Washington, D.C., stands a 215-foot tall rock arch
called Natural Bridge. A tributary of the James River flows beneath. A 347-foot cavern lies inside the park
surrounding Natural Bridge. The 1,600-acre park receives about 300,000 visitors a year. This park has been
in private hands since 1774 when Thomas Jefferson paid King George III 20 shillings for it. Today the
park belongs to Natural Bridge of Virginia, a private company controlled by a Washington, D.C., real estate
developer who purchased it in 1988 for $6.6 million. The reason he paid so much is that the park earns a tidy
profit, estimated at $5 million per year. A park visitor pays $22.50 to see the bridge, take a tour of the cave,
and see a wax museum and a toy museum. A visitor can also buy souvenirs at park shops, purchase food
at one of its three on-site restaurants, and pay to stay in one of the park’s 180 guest rooms. To attract these
profit-generating visitors, the company pays close attention to details. It pays botanists to plant and care
for native plants, and it stocks the river with rainbow trout. The park is kept free of graffiti: the last known
person to carve his initials into Natural Bridge was a young surveyor by the name of George Washington.
Some economists have argued that lands currently owned by the government and administered by national
and state park services might receive better long-term care if they were privately owned and administered.
Natural Bridge is one example of a part of the environment that the profit motive is helping preserve.
Why does the profit motive encourage environmental conservation efforts at a private park? The future
income of the owners depends on the preservation at a private park.
Chapter 33
Comparative Advantage and the Open Economy
The Internet Boosts International Trade
Caroline Freund of the World Bank and Diana Weinhold of the London School of Economics have
examined how increased use of the Internet has affected international trade in the U.S. and 55 other
nations. They found that greater Internet use by a nation’s residences reduces their costs of engaging in
international trade. As a consequence, the immediate effect of the take-off in commercial sales on the
Internet between 1997 and 1999 was a 1 percentage point increase in the average country’s international
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trade. Since then each 10 percentage point increase in Internet use by a nation’s residents has resulted in
a further 0.2 percentage point increase in trade with other nations.
How might the ability to buy and sell items using the Internet reduce the costs of trading with other
countries? It reduces transactions costs by reducing the cost of information concerning the types of goods
and their costs. Simply by going to company Web sites in foreign countries, information concerning price
and availability of products can be obtained in a very short time at a much lower cost.
Democrats, Republicans, and Free Trade Policy
Democrats and Republicans have been divided in recent years on the issue of free trade. Republicans
generally view free trade as promoting economic growth. Republicans largely hold the economic
profession’s view that free trade results in an increase in the efficiency of both the U.S. and global
economies and results in more output being produced at a lower cost. The result is increased standards of
living in both the U.S.’ and global economies. The bottom line from the Republican point of view is that
consumers as
a group are better off.
Democrats by contrast have adopted the view that free trade increases economic inequality. They note that
since the 1980s, a period of declining barriers to international trade barriers, a majority of Americans’ real
incomes have not increased by much. Also they note that the share of wage and salary income has declined
from 56 percent of national income in 1980 to about 53 percent in 2006. This group is largely made up of
workers in the middle class. Between 1975 and 2007 the share of money income before taxes for the top
20 percent of households increased from 43.2 percent to 50.4 percent. Finally, Democrats note that free
trade is not truly fair because such nations as China, India, and Mexico do not have the same labor standards
and environmental protection laws that exist in the U.S. These standards and protections raise the cost U.S.
businesses must pay as compared to these countries.
Sebastian Malloby writing in the Washington Post notes that countries such as Mexico could adopt all of
the labor and environmental protections and still have lower wages than are paid in the U.S. The results of
free trade for labor intensive industries and their workers would not change. The real reason Democrats
oppose free trade according to Mr. Malloby is that some workers are harmed by globalization, i.e., the
operation of specialization and trade along lines of comparative advantage.
What is the name of the argument made by Democrats against free trade or attempts to increase free trade?
It is protecting domestic jobs. Democrats oppose attempts to decrease protection of U.S. markets because
trade harms some American workers.
Imports Are Consumers Best Friends
All of the debates about improving our export sector to increase jobs and U.S. competitiveness ignore the
benefits of imports. David Wessel of the Wall Street Journal came up with the following example of baby
clothes:
Currently, a typical family spends about $500 a year on baby clothes. The total expenditures are over
$2 billion a year. For years, there was a quota on imports of baby clothes. In 1998, the quota was lifted for
all countries except China, and that was lifted in 2003. Since 1997, imports of baby clothes have doubled.
The wholesale price of baby clothes has dropped by almost 30 percent. During the same period, the CPI
rose by 15 percent. In contrast, the net price of baby clothes to U.S. families dropped by over 5 percent.
Had the price of baby clothes gone up as much as everything else during that period, American parents
would have spent about $400 million more than they did in 2003 alone.
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Consider another example that goes in the opposite direction. When we restricted Canadian lumber imports,
that added about $65 per thousand board feet of lumber. That lumber quota raised the price of the average
new American house by over $1,000.
Protecting the Steel Industry
In 2001 the U.S. steel industry successfully petitioned the U.S. government agency called the International
Trade Commission (ITC) to provide tariff protection from low prices of imported steel that the industry
said posed a significant threat of serious injury to the U.S. steel industry. This is one of the reasons that
tariff protection can be temporarily provided to a domestic industry under both U.S. law and WTO rules.
The problem was that steel imports into the U.S. had actually declined since 1998. Nevertheless the ITC
recommended that the industry be given temporary protection for 3 years, to have a chance to respond to
lower world prices by introducing efficiencies that would cut costs. In March of 2002 President Bush
implemented the recommendations of the ITC. Tariffs ranged from 30 percent to 8 percent on different
types of steel in the first year, falling to a range of 24 percent to 7 percent in the second year, and 18 to
6 percent in the third year. Under the executive order, the tariff increases do not apply to Canada or
Mexico which are members of NAFTA and which are exempt from U.S. tariffs on steel and most other
products. By August of 2002, the prices of steel had risen by over 30 percent in the U.S.
Canadian steel makers announced support for the U.S. steel tariffs. Why do you suppose that they would
be in favor of this U.S. tariff policy on steel? Canadian steel is a substitute for steel imported into the U.S.
from other countries. The increase in the price of steel imported from other countries as a result of the tariff
would increase the demand for Canadian steel. The Canadians would be able to raise the price of the steel
they sell in the U.S. and sell more of it.
An Infant Industry Blossoms due to Protection from Foreign Imports:
The Case of Marijuana
Marijuana was made illegal in the U.S. in the 1930s, but just as for many other outlawed drugs, a market
for it remained. Until about 25 years ago, virtually all marijuana consumed in the U.S. was imported.
Today, earnings from burgeoning and increasingly high tech “pot” industry are estimated at $35 billion a
year, making it the nation’s biggest cash crop (compared to corn at $15 billion). Starting with President
Richard Nixon in the 1970s, the federal government has ended up protecting the domestic marijuana industry
from imports by declaring a “war” on drugs. Given virtually no foreign competition, the American marijuana
industry expanded and invested millions in developing more productive and more potent seeds as well as
more efficient growing technologies. Domestic marijuana growers now dominate the high end of a market
in which consumers pay $300 to $500 an ounce for a reengineered homegrown product. New growing
technologies allow domestic producers using high-intensity sodium lights, carbon dioxide, and advances in
genetics to produce a kilogram of the potent sinsemilla variety every 2 months in a space no bigger than a
phone booth.
What has spurred domestic producers to develop highly productive indoor growing methods. Rising
government efforts at finding and destroying outdoor marijuana fields with an attendant risk of a producer
being arrested and the rising price of marijuana as a result of protection of the domestic industry has
stimulated indoor production. Indoor production is harder to find than outdoor fields. The higher revenues
allow for higher cost production methods. In addition, higher potency marijuana can be sold for a higher
price so less has to be grown to yield high profits. This also makes indoor production more desirable.
Who’s Dumping on Whom?
Claims of dumping are handled on a case-by-case basis under international rules. Only a few firms in an
industry have to lodge a claim to justify a dumping investigation. Under international law anti-dumping
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rules permit governments to impose duties—special taxes on imported goods—on the products sold by
firms of offending nations. In the early 1990s developed countries filed an increasing number of claims
seeking anti-dumping relief. The biggest filer during this period was the U.S., which launched cases
mainly against companies based in South America and Asia. The U.S. began cutting back on dumping
claims in the mid-1990s. Never-the-less dumping claims by emerging economies—notably Argentina,
Mexico, Brazil and South Africa—rose precipitously. Most of these cases accused the U.S. of dumping.
Starting in the late 1990s the number of dumping claims by emerging economies began to decrease.
Why did dumping claims by emerging nations fall as their economies expanded after the early 1990s?
The likely explanation is that as their economies expanded, the emerging economies had fewer adverse
employment effects from international competition and thus did not need the excuse of foreign dumping
to protect their industries.
Did the Smoot-Hawley Tariff Worsen the Great Depression?
By 1930 the unemployment rate had almost doubled in a year as the economy entered the Great Depression.
Congress and President Hoover wanted to do something that would help stimulate U.S. production and
reduce unemployment. The result was the Smoot-Hawley Tariff, which set tariff schedules for over 20,000
products, raising duties on imports by an average of 52 percent. This attempt to improve the domestic
economy at the expense of foreign economies backfired. Each trading partner of the U.S. in turn imposed
its own high tariffs, including the United Kingdom, the Netherlands, France, and Switzerland. The result
was a massive reduction in international trade by an incredible 64 percent in three years. Some believe that
the Great Depression was partially caused by such tariffs.
The Smoot-Hawley Tariff has been called a “beggar-thy-neighbor” policy. Each country tried to improve
its own economy by reducing imports. Imports to one country are the exports of other countries, and their
exports are part of their GDP. If their exports fall, their GDP and employment fall. Thus a “beggar thy
neighbor” policymakes the other countries worse off by reducing their exports and replacing their goods in
the domestic economy with domestic production.
Chapter 34 Exchange Rates and the Balance of Payments
The Euro’s Value Is Up, So French Wine Exports Are Down
Between 2002 and 2005 French wine exports to the U.S. dropped by nearly 18 percent. Some wine experts
blamed part of the decline on what they perceived to be a drop in the quality of French wine. Others blamed
a shift in U.S. tastes in favor of domestic wines and others suggested U.S. residents unhappiness with the
French government’s foreign policies.
Economists offered a different explanation. During 2003 the dollar depreciated by almost 20 percent relative
to the euro. Even if the euro price of a bottle of French wine remained the same, U.S. residents would have
seen its dollar price rise by nearly 20 percent. The effective increase in the U.S. price of French wines
resulted in a decrease in the quantity of French wine demanded by U.S. residents. Thus French wine exports
to the U.S. decreased.
What do you predict will happen to French wine exports to the U.S, other things being equal, if the dollar
appreciates considerably in relation to the euro? French wine exports to the U.S. would increase as the
dollar price of French wine decreased.
The Dollar Takes a Roller Coaster Ride
Between 1995 and 2001 the dollar appreciated by 28 percent in inflation adjusted terms and the trade
deficit increased from 1.3 percent of GDP ($96) in 1995 to 3.6 percent of GDP ($363 billion) in 2001.
In 2002 the dollar began to depreciate and fell by 16 percent by 2004. It appreciated again for the first
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10 months of 2005 and then depreciated by nearly 7 percent again through the end of the year. In the
meantime the trade deficit increased to about 5.9 percent of GDP.
The U.S. economy began to slow down in the second half of 2006. As a result the Federal Reserve which
had been increasing interest rates for 17 months prior to the summer of 2006 stopped doing so for the rest
of the year. In the euro area interest rates are predicted to increase.
Given the information above, what do you predict will happen to the value of the dollar in 2007? A large
trade deficit means that the quantity of dollars supplied to the foreign exchange market will be greater than
the quantity demanded to finance imports and exports. A decline in U.S. interest rates relative to those in
Europe should lead to outflows of capital from the U.S. increasing the supply of dollars in the foreign
exchange market. Other things constant the increased supply of dollars relative to demand should cause
the dollar to continue to depreciate.
Does Competitiveness Apply to Countries as Well as Corporations?
Although a nation’s balance of payments bears similarities to the accounting system of a company, deficit
or surplus measures in the balance of payments are much different from a corporation’s bottom line—that
is, its net expenditures relative to receipts. Economist Paul Krugman of the Massachusetts Institute of
Technology argues that a nation’s balance of payments differs from a corporate income statement in four
important ways.
1.
2.
3.
4.
The bottom line for a corporation is truly its bottom line. If a corporation persistently fails to meet
commitments to pay its employees, suppliers, and bondholders, it will go out of business. Countries,
in contrast, do not go out of business.
Bottom lines for a country, such as the merchandise trade balance do not necessarily indicate
“weakness” or “strength.” A deficit is not necessarily good or bad.
U.S. residents typically consume about 90 percent of the goods and services produced within U.S.
borders. Even the largest corporations rarely sell any of its output to its own workers. By way of
contrast, the “exports” of Microsoft—its sales to people who do not work for the company—account
for nearly all of its sales.
Countries do not compete the same way that companies do. A negligible fraction of Netscape’s sales
go to Microsoft Corporation, for instance. Countries may export and import large portions of their
goods and services, however.
Thus we must be very cautious about drawing conclusions about the meaning of a deficit or surplus in a
nation’s balance of payments accounts. Using balance of payments statistics to support an argument that
one nation is more viable or “more competitive” than another may be completely misguided.
Under what circumstances might a nation find a trade deficit to be beneficial? A trade deficit implies a
capital account surplus. If foreigners are supplying their savings to the United States, then investment will
be higher that it would have been, and the rate of economic growth will be higher.
Can Exchange Rates Be Fixed Forever?
Trying to keep the exchange rate fixed in the face of foreign exchange market volatility can be a difficult
policy to pursue. Consider Thailand’s experience. At the beginning of 1997, the Bank of Thailand was
holding $40 billion in foreign exchange reserves. Within 10 months those reserves had fallen to $3 billion.
Whatever the Bank of Thailand promised about not devaluing its currency, it no longer had credibility.
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Not surprisingly, Thailand was forced to move to a floating exchange rate system and the baht’s value
relative to the dollar fell by more than 25 percent in July 1997 alone.
The Thai experience was repeated on a larger scale throughout Southeast Asia in 1997 and 1998 as efforts
by the central banks of Indonesia, Malaysia, South Korea, and Vietnam to fix exchange rates ultimately
collapsed, leading to sizable devaluations. Even the previously stalwart exchange rate arrangements of
Singapore, Taiwan, and Hong Kong became increasingly less credible. These nations learned an old lesson:
Trying to protect residents from foreign exchange risks work only as long as foreign exchange market
traders believe that central banks have the financial wherewithal to keep exchange rates unchanged.
Otherwise, a fixed exchange rate policy can ultimately prove unsustainable.
Why do you think that governments attempt to maintain the foreign exchange value of their domestic
currencies? From an economic standpoint governments seem to be interested in limiting foreign exchange
risk. Politically it is likely that there is some degree of prestige (from the politicians’ viewpoint) in having
a fixed exchange rate.
Does America’s Continuing Trade Account Deficit Mean
It Has a Weak Economy?
The U.S. current account balance has been in deficit continuously since the early 1980s. This is not
something new. During the 1880s the U.S. had many years of current account deficits. They were matched
by capital account surpluses as the rest of the world sent capital to the U.S. to finance the building of
railroads and the development of the trans-Mississippi West. By the early 1900s, the U.S. accumulated a
long string of current account surpluses. By World War I Americans had repaid all of their external debt
and had become a net creditor. Whenever America is in deficit on its current account, it is in surplus in its
capital account and vice versa.
Contrary to popular belief, the U.S. does not have a trade deficit because it is a weak economy and cannot
compete in world markets. Rather, the U.S. appears to be a good place to invest capital because there are
strong prospects for growth and investment opportunities. So long as there are more foreigners who wish
to invest in the U.S. than there are Americans who wish to invest abroad, there will be a deficit in our
current account balance. Americans are beneficiaries of international capital flows.
Why are politicians, nonetheless, so worried about the international trade deficit? A major concern is that
foreigners have increasing claims on the U.S. that they could cash in. In the short-run the outflow of funds
would have the same effect as a reduction in domestic saving and thus would reduce the U.S.’s ability to
finance investment.
Politicians probably also worry about the job implications for import competing industries and the fact that
capital inflows imply that financial and real claims by foreigners against the U.S. economy are increasing.
Also, there may be some confusion between money and wealth. If we have a balance of trade deficit, then
“money” i.e., wealth, is leaving the U.S. Also a balance of trade deficit is viewed as a bad thing simply
from a semantic viewpoint—after all a balance of payments deficit “worsens” if it gets bigger and
“improves” as it gets smaller. A trade deficit may imply to politicians that foreigners are taking advantage
of the U.S. with low wages or unfair trade barriers.
Should We Go Back to the Gold Standard?
In the past several decades, the U.S. has consistently run a current account deficit. The dollar has become
weaker. We have had recessions, and we have had inflation. Some economists and politicians argue that
we should return to the gold standard. The U.S. actually operated under two gold standards. From 1879 to
1933 the dollar was defined as 32.22 grains of gold, yielding a price of $20.671835 an ounce. During that
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time period, general prices more than doubled during World War I, there was a major depression in
1920–1921, and the Great Depression occurred. The second gold standard prevailed from 1933 to 1971,
when the price of gold was pegged at $35 an ounce. A dollar was defined as 13.714286 grains of gold.
During that time period prices tripled. Clearly, a gold standard guarantees neither stable prices nor
economic stability.
Why does no country today operate on a gold standard? To be on a gold standard is to allow a country’s
money supply, price level, and level of economic activity in the short-run to depend in part on international
gold movements. The governments and citizens of modern countries are unwilling to let these important
macroeconomic variables depend on the international sector.