Microeconomics 11th Canadian Edition By Christopher T.S. Ragan, Richard G. Lipsey SOLUTIONS MANUAL

SOLUTIONS MANUAL

_______________________________________ Chapter 1: Economic Issues and Concepts _______________________________________ Answers to Study Exercises Question 1 Microeconomics is the study of the allocation of resources within and across individual markets, and the determination of relative prices and quantities. Macroeconomics is the study of the determination of aggregates such as aggregate output, employment, the price level, the unemployment rates, and the exchange rate.

Question 2 Traditional systems: Behaviour is based primarily on tradition, custom, and habit.

Command systems: Decisions about production and consumption are determined by a central planning authority.

Free-market systems: Production and consumption decisions are made privately, by decentralized producers and consumers.

Mixed systems: Economic systems in which there are elements of tradition, command, and free markets.

Question 3 Scarcity: The production possibilities boundary (PPB) separates attainable combinations of goods from those that are unattainable. Thus scarcity is shown by the existence of some unattainable bundles of goods.

Choice: Because of scarcity, societies must somehow choose how resources are to be allocated; thus a particular point on the PPB must be chosen.

Opportunity Cost: The slope of the PPB is negative, revealing the opportunity cost that is unavoidable every time a choice is made. For the economy as a whole, the decision to produce more of one good must involve a decision to produce less of some other good.

Question 4 a) At point A, 2.5 tonnes of clothing and 3 tonnes of food are being produced per year. At point B, annual production is 2.5 tonnes of clothing and 7 tonnes of food. At point C, annual production is 6.5 tonnes of clothing and 3 tonnes of food.

b) At point A the economy is either using its resources inefficiently or it is not using all of its available resources. Point B and C represent full and efficient use of available resources because they are on the PPB. c) At point B, the opportunity cost of producing one more tonne of food (and increase from 7 to 8) is the 2.5 tonnes of clothing that must be given up. The opportunity cost of producing one more tonne of clothing (from 2.5 to 3.5) appears, from the graph, to be approximately 0.75 tonnes of food. d) Point D is unattainable given the economy’s current technology and resources. Point D can become attainable with a sufficient improvement in technology or increase in available resources.

Question 5 Since individual abilities differ, specializing allows each person to focus their energies on what they do best, leaving everything else to be done by others. As a result, total output will rise. In addition, as people specialize, they often “learn by doing” and become even better at their specific task. Thus specialization often leads to improvements in ability that would not otherwise occur.

Question 6 a) As the table shows, there are only 250 workers in Choiceland, and to construct the production possibilities boundary we must imagine all the combinations of workers in each sector. Using the two middle columns from the table, we can plot the output levels on a graph to get the following:

b) If the economy is already producing 60 units of X and 600 units of Y, then 10 extra units of X can only be produced by reducing the production of Y by 250 units. The opportunity cost of 10 units of X is therefore 250 units of Y (or 25 units of Y per unit of X). If the economy is already producing 70 units of X, the opportunity cost of producing an additional 5 units of X is the forgone 350 units of Y (or 70 units of Y per unit of X). Thus, we see that the opportunity cost of X rises when more of X is already being produced. c) If any given amount of labour can now produce 10 percent more of good Y, then the PPB shifts up in a particular way. Specifically, the Y values increase by 10 percent for any given X value, as shown below.

Question 7 The diagram in part (c) of Question 6 shows immediately why a technological improvement in one industry means that a country can now produce more of both goods. Since the PPB has shifted up (or out), there are many combinations of goods that are now available that were not before, and some of these involve producing more of

both goods. For example, if the economy was initially producing 45 units of X and 900 units of Y (see point A), it could now produce more than 45 units of X and more than 900 units of Y, such as at point B. This would require shifting some resources away from sector Y and toward sector X.

Question 8 In general, the opportunity cost for any activity includes three things: • the direct cost of the activity, plus • whatever you give up in order to do the activity, minus • whatever “savings” the activity generates In this case, the direct cost of transportation, lift tickets and accommodation of $300 is definitely included. The income of $120 that you give up also counts. Finally, we must deal with the restaurant meals of $75. Surely you would have eaten some food even if you hadn’t gone skiing, so the full $75 is not included. But given the relatively high price of restaurant meals compared to buying your own groceries, you will probably include most of the $75.

Thus the opportunity cost of the ski trip is $420 plus some (large) fraction of the $75.

Question 9 This question is good for forcing the student to think through the computation of opportunity cost and also in showing how the allocation of labour in particular ways can maximize total output. a) You can catch 3 rabbits or 6 fish in one day’s work. Thus, your opportunity cost for an additional rabbit is 2 fish.

For your friend, the opportunity cost of an additional rabbit is 4 fish. b) To allocate tasks in the output-maximizing way, each person should do the task for which they have the lower opportunity cost. You have the lower opportunity cost of catching rabbits. Your friend has the lower opportunity cost for catching fish (0.25 of a rabbit for your friend as compared to 0.5 of a rabbit for you). So to maximize output you should focus on catching rabbits and your friend should focus on catching fish. c) If instead you catch rabbits and your friend catches fish, there would be a total output (after two days’ work) of 6 rabbits and 16 fish. The reverse allocation would yield only 4 rabbits and 12 fish, which is clearly inferior.

Answers to Discussion Questions

Question 1 By scarcity we mean simply an excess of wants over the resources available to satisfy those wants. Poverty is concerned with a level of resources below some threshold of sufficiency. One can conceivably eliminate poverty, but that would not eliminate scarcity. Even if everyone had enough to eat, there would be demand for more food than the minimum required for survival if it were available at a price of zero. Therefore food would still be scarce. Even if goods became free, there would be a scarcity of time available to consume and enjoy them.

Question 2 This is a relatively straightforward exercise. The downward slope of the production possibility curve arises because of scarcity and implies the need to choose. The slope itself reflects the opportunity cost of having more of either of the variables. An improved fertilizer would shift the entire curve outward. A pollutionfree fertilizer, if developed, would mean that there are no longer any opportunity costs in terms of pollution, but of course there would be an opportunity cost of producing it with respect to the resources used.

Question 3 This quote will stimulate much interesting discussion, not only about views on how alternative economic systems work, but also about the words used to describe them. The term planned

economy, for example, describes the conscious use of centralized decision making for key economic decisions, but the results of that process often look anything but planned, with shortages in some sectors, surpluses in others, and often a rather dispirited and unmotivated private sector.

On the other hand, the unplanned decentralized market economy––though surely not perfect–– creates a much more orderly looking set of outcomes. A useful discussion would be to focus on the availability of some unusual item and then to discuss how each of the two systems would come to provide it.

Question 4 The market for physicians’ services depends heavily on the specialization of labour. A person with back pain will not know what is wrong. They go to a general practitioner (GP) who is somewhat familiar with a broad range of symptoms and illnesses. The GP may rule out the simplest possible causes for the pain, and in the process determine that the patient requires the services of a doctor who diagnoses and treats the back. The patient is referred to this specialist who may diagnose a ruptured disk and perform the delicate surgery necessary to effect a cure. Given this reliance on specialization, the market depends on having relatively more GPs who see a large number of patients and act as “gatekeepers” for patients to the more specific specialists. However, there is no reason to expect a unique “best” mix to exist, or at least to be easy to discern.

Question 5 This is one of the hardest lessons for many students to learn. The basic idea of the price system as a control mechanism is that when people pursue their selfinterests, they do provide many of the things that society requires, because they are motivated by profits, and profits usually depend on satisfying customers. Although unrestricted selfinterest may not always produce the best of all possible worlds, it is important for the student to realize that the operation of selfinterest can produce many results that are socially desirable.

Question 6 The central ideas illustrated by the two-good version of the production possibilities boundary (PPB) are scarcity, choice, and opportunity cost. Exactly the same ideas can be illustrated in a more realistic three-good version of the model, which is more complicated to draw, or by the much more realistic N-good version of the model (with N ≥ 4), which is impossible to draw. Thus the assumption of only two goods is merely a simplifying one  it allows us to easily grasp and illustrate some central points that would be more difficult to understand in the more general Ngood case. _________________________________ Chapter 2: How Economists Work _________________________________

Answers to Study Exercises Question 1 a) In the Canadian wheat sector, the amount of rainfall on the Canadian prairies is an exogenous variable; the amount of wheat produced is an endogenous variable. b) To the Canadian market for coffee, the world price of coffee is exogenous; the price of a cup at your local café is endogenous. c) To any individual student, the widespread unavailability of student loans is exogenous; their own attendance at university or college is endogenous. d) To any individual drivers, the tax on gasoline is exogenous; their own decisions regarding which vehicles to purchase are endogenous.

Question 2 a) These data are best illustrated with a time-series graph, with the month shown on the horizontal axis and the interest rate shown on the vertical axis.

b) These cross-sectional data are best illustrated with a bar chart.

c) These cross-sectional data are best illustrated in a scatter diagram; the “line of best fit” is clearly upward sloping, indicating a positive relationship between average investment rates and average growth rates.

Question 3 a) Along Line A, Y falls as X rises; thus the slope of Line A is negative. For Line B, the value of Y rises and X rises; thus the slope of Line B is positive. b) Along Line A, the change in Y is –4 when the change in X is 6. Thus the slope of Line A is ΔY/ΔX = -4/6 = -2/3.

The equation for Line A is: Y = 4 – (2/3)X

c) Along Line B, the change in Y is 7 when the change in X is 6. Thus the slope of Line B is ΔY/ΔX = 7/6. The equation for Line B is: Y = 0 + (7/6)X Question 4

Given the tax-revenue function T = 10 + .25Y, the plotted curve will have a vertical intercept of 10 and a slope of 0.25. The interpretation is that when Y is zero, tax revenues will be $10 billion.

And for every increase in Y of $100 billion, tax revenues will rise by $25 billion. The diagram is as shown below:

Question 5 a) Begin computing the values of Y for each value of X for each functional relation. Construct

the following table: Y = 50 + 2X + .05X2

(ii)

(iii) Y = 50 + 2X - .05X2

(i)

Y = 50 + 2X

X

Y

X

Y

X

Y

0 10 20 30 40 50

50 70 90 110 130 150

0 10 20 30 40 50

50 75 110 155 210 275

0 10 20 30 40 50

50 65 70 65 50 25

Now plot these values on scale diagrams. The diagrams are shown below. Notice the different vertical scale on the three different diagrams.

b) For part (i), the slope is positive and constant and equal to 2. For each 10-unit increase in X, there is an increase in Y of 20 units. For part (ii), the slope is always positive since an increase in X always leads to an increase in Y. But the slope is not constant. As the value of X increases, the slope of the line also increases. For part (iii), the slope is positive at low levels of X. But the function reaches a maximum at X=20, after which the slope becomes negative. Furthermore, when X is beyond 20, the slope of the line becomes more negative (steeper) as the value of X increases. c) For part (i), the marginal response of Y to a change in X is constant and equal to 2. This is the slope of the line. In part (ii), the marginal response of Y to a change in X is always positive, but the marginal response increases as the value of X increases. This is why the line gets steeper as X increases. For part (iii), the marginal response of Y to a change in X is positive at low levels of X. But after X=20, the marginal response becomes negative. Hence the slope of the line switches from positive to negative. Note that for values of X further away from X=20, the marginal response of Y to a change in X is larger in absolute value. That is, the curve flattens out as we approach X=20 and becomes steeper as we move away from X=20.

Question 6 a) Using Calgary as the “base university” means that we choose $6.25 as the base price. This means dividing all prices by $6.25 and then multiplying by 100. In this way, we will determine, in percentage terms, how prices at other universities differ from Calgary prices. The index values are as follows: University

Price per Index of pizza prices p i z z

a Dalhousie Laval McGill Queen’s Waterloo Manitoba Saskatchewan Calgary UBC Victoria

$6.50 5.95 6.00 8.00 7.50 5.50 5.75 6.25 7.25 7.00

(6.50/6.25)× 100 = 104 (5.95/6.25)× 100 = 95.2 (6.00/6.25)× 100 = 96 (8.00/6.25)× 100 = 128 (7.50/6.25)× 100 = 120 (5.50/6.25)× 100 = 88 (5.75/6.25)× 100 = 92 (6.25/6.25)× 100 = 100 (7.25/6.25)× 100 = 116 (7.00/6.25)× 100 = 112

b) The university with the most expensive pizza is Queen’s, at $8.00 per pizza. The index value for Queen’s is 128, indicating that pizza there is 28 percent more expensive than at Calgary. c) The university with the least expensive pizza is Manitoba, at $5.50 per pizza. The index value for Manitoba is 88, indicating that the price of pizza there is only 88 percent of the price at Calgary. It is therefore 12 percent cheaper than at Calgary. d) These are cross-sectional data. The variable is the price of pizza, collected at different places at a given point in time (March 1, 2004). If the data had been the prices of pizza at a single university at various points in time, they would be time-series data.

Question 7 The four scale diagrams are shown below. Note that the vertical scale on each diagram is different.

Question 8 This is a good question to make sure the student understands the importance of using weighted averages rather than simple averages in some situations. a) The simple average of the three regional unemployment rate is equal to (5.5 + 7.2 + 12.5)/3 = 8.4. Is 8.4% the “right” unemployment rate for the country as a whole? The answer is no because this simple, unweighted (or, more correctly, equally weighted) average does not account for the fact that the Centre is much larger in terms of the labour force than either the West or East, and thus should be given more weight than the other two regions. b) To solve this problem, we construct a weighted average unemployment rate. We do so by constructing a weight for each region equal to that region’s share in the total labour force. These weights are: West: weight = 5.3/17.2 = 0.308 Centre: weight = 8.4/17.2 = 0.488 East:

weight = 3.5/17.2 = 0.203

These weights should sum exactly to 1.0, but due to rounding they do not quite do so. Using these weights, we now construct the average unemployment rate as the weighted sum of the three regional unemployment rates.

Canadian unemployment rate = (.308 × 5.5) + (.488 × 7.2) + (.203 × 12.5) = 7.75 This is a better measure of the Canadian unemployment rate because it correctly weights each region’s influence in the national total. Keep in mind, however, that for many situations the relevant unemployment rate for an individual or a firm may be the more local one rather than the national average.

Question 9 The six required diagrams are shown below. Note that we have not provided specific units on the axes.

For the first three figures, the tax system provides good examples. In each case, think of earned income as being shown along the horizontal axis and taxes paid shown along the vertical axis. The first diagram might show a progressive income-tax system where the marginal tax rate rises as income rises. The second diagram shows a proportional system with a constant marginal tax rate. The third diagram shows marginal tax rates falling as income rises, even though total tax paid still rises as income rises.

For the second set of three diagrams, imagine the relationship between the number of rounds of golf played (along the horizontal axis) and the golf score one achieves (along the vertical axis). In all three diagrams the golf score falls (improves) as one golfs more times. In the first diagram, the more one golfs the more one improves on each successive round played. In the second diagram, the rate of improvement is constant. In the third diagram, the rate of improvement diminishes as the number of rounds played increases. The actual relationship probably has bits of all three parts—presumably there is a lower limit to one’s score so eventually the curve must flatten out.

Answers to Discussion Questions Question 1 a) The issues concern the costs and benefits of applying fiscal or monetary stimulus to an economy (about which students cannot yet say a lot in detail). Some of the normative issues will relate to the reader's evaluation of the current government leaders, such as the Minister of Finance and the Governor of the Bank of Canada. This can be turned into an interesting illustration of how our value judgements can affect our assessment of positive but uncertain issues (in this case the costs and benefits of stimulation). b) North Americans are likely to emphasize the economic harm to the rest of the world done by these subsidies; the Europeans are likely to stress the social (and political) harm done by eliminating them. c) Positive questions relate to the effects of competition on the quality of education. Normative questions may relate to whether it is desirable to have the resulting changes in the quality of education or on the distribution of income. d) Positive issues relate to whether waiting times for medical treatment would fall, whether the quality of health care would rise, and whether incomes of those in the medical industry would be affected. Normative issues include whether it is desirable that some doctors make themselves available only to people that can afford to pay for the “extra billing”.

Question 2 Examples of some of the positive arguments are: (1) people who smoke cigarettes are less productive in their jobs; (2) smoking imposes costs on those around the smoker who breathe in the secondhand smoke; and (3) people who smoke have more serious illnesses at the end of their lives, the treatment of which uses resources that could be applied to others.

Examples of some of the normative arguments are: (1) smoking is addictive and we should not permit people to engage in addictive behaviour; (2) smoking kills people and we should not allow people to kill themselves; and (2) advertisements of tobacco companies are frequently aimed at children or adolescents, and we must protect this segment of society from risks they cannot properly evaluate.

Question 3 There are, of course, many possible answers to each part. Here we list only one possible answer. a) Surveying (over small areas) b) Framing an equalpayforequalwork statute c) The seventh (final) game of the World Series d) This assumption is useful, for example, for examining an individual's saving behaviour. In general, any issue in which time is important clearly cannot be examined with a oneperiod model.

Adding only a second period (and ignoring all others) often is all that is necessary to generate valuable insights about behaviour over time. e) In a world with only one good, it is not possible to discuss substitution between goods. But in a model with many goods, it may be difficult to mentally keep track of all the substitution that is going on. Thus, if one wanted to think about how a tariff on good X would affect the production of other goods, the central intuition would be well developed in a twogood model. f) This assumption is a convenient simplification for the standard economic theory of utility maximization. As long as selfinterest is the most important motive most of the time, then concentrating on it exclusively will be an acceptable simplification that will yield predictions that are accurate most of the time.

Question 4 a) We must first clarify what is meant by “best”. Three of many possible meanings are “the highest income per capita”, “the greatest equality of income”, or “the greatest growth rate”. Each of the resulting statements is testable, and at least one is wrong. b) Some students may have strong reactions. They will find it harder to specify their views in empirically testable terms. The statement could be phrased this way: “The higher and more easily obtained are unemployment benefits, the higher will be the rate of unemployment.” (Even if true, this is a long way from destroying the work effort.) Students who are inclined to believe the view given in the question should be probed about the duration of unemployment insurance benefits.

c) The following restatement is one: “Robotics––the substitution of automated processes for human labour––will not only eliminate specific jobs, it will permanently decrease employment opportunities of a large group in the population who lack, and cannot acquire, technological skills.” The same kind of assertion has been made about almost every form of technological advance from the time of the steam engine and the cotton gin. This may lead one to be sceptical of the assertion but does not prove it to be wrong since the future may be different from the past in this respect. d) Measurable effects might be on wages, unemployment, participation rates and the structure of jobs filled by women. Once again, the gap between the possibly significant quantitative effects in these dimensions (if they exist) and the vague “better off” needs to be stressed. e) One possible restatement is this: “Free trade will increase the income of some people and lower the income of others, but the income gains will outweigh the income losses.” Here, emphasis must be placed on the difference between improving everybody's income and improving average income.

Question 5 If there are “believers” and “sceptics” for any of these alleged phenomena, a class can learn from a discussion between the two sides. Emphasis is not on high school debating tactics but trying to get a meeting of minds on what is acceptable evidence that might help to reduce or remove the disagreement.

___________________________________ Chapter 3: Demand, Supply, and Price ___________________________________ Answers to Study Exercises Question 1 a) decrease; quantity demanded b) to the right; increase c) increased; decreased d) quantity demanded

e) The appropriate diagram is shown below.

Question 2 a) The reduction in the size of the peach harvest due to bad weather is a decrease in the supply of peaches  a leftward shift of the supply curve. For a given demand curve, this leads to an increase in equilibrium price. b) An increase in income leads to an increase in the demand for all normal goods. Assuming beef is a normal good, there will be a rightward shift in the demand curve for beef. For a given upwardsloping supply curve, this shock leads to an increase in the equilibrium price and quantity of beef.

This is an increase in the quantity supplied of beef (caused by the price increase). c) Technological improvements in microchips reduce the cost of producing computers and therefore cause an increase in supply  a rightward shift of the supply curve for computers. This causes a fall in the equilibrium price and an increase in equilibrium quantity. d) Greater awareness of the health risks leads to a reduction in demand for cigarettes and thus, for a given supply curve, to a reduction in the equilibrium price and quantity. As price falls, there is a reduction in the quantity of cigarettes supplied.

Question 3 a) At a price of $4.00 per can, quantity demanded is 2 million cans per year and quantity supplied is 8 million cans per year. There is a surplus of 6 millions cans per year. b) At a price of $1.50 per can, quantity demanded is 12 million cans per year and quantity supplied is 3 million cans per year. There is a shortage of 9 millions cans per year. c) Equilibrium, where quantity demanded equals quantity supplied, occurs at a price of $3.00 per can and at a quantity of 6 millions cans per year.

Question 4 Keep in mind for this question that we must distinguish between variables whose changes will cause a shift in the demand for chicken and a change in the price of chicken that will move us along the demand curve for chicken. a) The finding that eating chicken can improve your health should lead to an increase in the demand for chicken (and presumably a reduction in the demand for less healthy meats). This will be shown by a rightward shift in the demand curve for chicken. b) As the price of beef rises, consumers will substitute away from beef and toward other meats, including chicken. This will be shown by a rightward shift in the demand for chicken. c) If chicken is a normal good — meaning that consumers want more of it when their real income rises — then the rise in household income leads to an increase in the demand for chicken. This will be shown by a rightward shift in the demand curve for chicken.

Question 5 a) The demand and supply curves for coffee are shown below. Note that the horizontal axis has a break in the scale so that we can focus on the range of quantity beyond Q=10.

b) From the table in the question, or by reading off the diagram, we can see the following pattern of excess demands and supplies. Recall that excess demand at any given price is equal to quantity demanded minus quantity supplied.

Price $2.00 2.40 3.10 3.50 3.90 4.30

Excess Demand (+) or Supply (-) +18.0 +14.0 + 8.5 0.0 - 5.0 - 9.0

c) The equilibrium price is the price at which quantiy demanded equals quantity supplied. In other words, it is the price at which excess demand is exactly zero. From the table or the diagram we can see that the equilibrium price of coffee is $3.50 per kilogram. d) If a minimum price for coffee were set equal to $3.90 per kg, there would be an excess supply of coffee equal to 5 million kg per year. The only way the government(s) could enforce this minimum price, and prevent the price from falling to the free-market equilibrium level, would be to purchase the excess supply of 5 million kg annually. (We will discuss such price-support schemes in detail in Chapter 5.)

Question 6 The apparent contradiction is solved when we recognize the difference between an increase in supply and an increase in quantity supplied. As the price of beef rises, say from p0 to p1, ranchers will sell more cattle to slaughterhouses. This is an increase iin the quantity of beef supplied, as indicated by a movement from A to B along the supply curve in the figure below. An increase in the supply of beef, caused perhaps by a reduction in the price of cattle feed, will shift the supply curve to the right (from S to S′) and reduce the equilibrium price from p1 to p3, a move from A to C along the stable demand curve in the figure.

Question 7 The figures below show the world market for wheat on the right and the Canadian market for wheat on the left. Since wheat is an internationally traded good, its (single) price is determined by the intersection of the world demand and world supply curves. With the world supply curve given

by S0, the equilibrium world price is p0. At this world price, Canada is a net exporter — shown in the left diagram by an excess supply in Canada at price p0.

Russia is a major producer of wheat and therefore contributes substantially to the world supply of wheat. A severe drought in Russia will reduce the Russian crop and have a significant effect on the world’s supply of wheat, shifting the supply curve to the left from S0 to S1. This will drive the world price up from p0 to p1. North American wheat farmers benefit because they experience a higher world price at which to sell their product, but suffer none of the quantity consequences of the drought. In fact, they increase their quantity supplied from point A to point B in the left-hand figure. Their income is unambiguously higher than it would be had the Russian drought not happened. The increase in Canadian farm income is shown by the shaded area.

Question 8 The quotation describes demand as becoming more “voracious” each year — this suggests that demand for cocoa is growing. The fungal and viral diseases suggest a reduction in supply as producers find it more expensive to grow cacao trees and thus deliver cocoa to market. Since demand is shifting to the right and supply is shifting to the left, it is clear that equilibrium price should be rising in the future. What happens to equilibrium quantity depends on the relative sizes of the shifts of demand and supply.

Question 9 a) The demand curve is: QD = 100 – 3p. This is a straight-line demand curve with a slope of –1/3.

The horizontal intercept (p=0) is QD=100. The vertical intercept (QD=0) is p=33.33. The supply curve is: QS = 10 + 2p. This is a straight-line supply curve with a slope of ½. When p=0, QS = 10.

Both curves are plotted below.

b) Equilibrium requires QD = QS. This equality defines the equilibrium price, p*. c) Imposing QD = QS, we have 100 - 3p = 10 + 2p. Solving for p we get 90 = 5p or p = 18. This is what we call p*, the market-clearing price. d) Substituting p* = 18 into the demand function we get Q* = 100 - 3(18) = 46. If we substitute p* instead into the supply function we get Q* = 10 + 2(18) = 46. (Of course, since the demand and supply curves intersect at p* = 18, it follows that Q* must be the same whether we use the demand curve or the supply curve.) e) Now there is an increase in demand. The new demand function is QD = 180 - 3p. Equilibrium requires QD = QS which means 180 – 3p = 10 + 2p. The solution for p* is therefore 5p* = 170 or p* = 34. Substituting p* back into the demand curve we get Q* = 180 - 3(34) or Q* = 78. The law of demand says that an increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity. Both predictions are correct. f) Now with the new demand curve in place there is an increase in supply. The new supply curve is QS = 90 + 2p. Equilibrium requires 180 – 3p = 90 + 2p. This gives p* = 18. Substituting p* back into the demand curve leads to Q* = 180 – 3(18) or Q* = 126. The law of supply says that an increase in supply leads to a fall in price and a rise in quantity. Both predictions are correct.

Answers to Discussion Questions Question 1 The economist’s statement assumes that the “classic pattern of supply and demand” involves responses only to a shift in supply, and therefore involves only movements along a stable demand curve. Plainly, increases in foreign demand shift the demand curve to the right, and this tends to increase price. Students should readily see that this shift could more than offset the downward effect on price of a rightward shift in the supply curve caused by the bumper crops.

Question 2 Students should be expected to discuss and distinguish between the effects on the demand curve and the supply curve. The demand curve for marijuana could shift in either direction. Legalization, for example, might increase demand as people previously deterred by respect for the law decided to smoke; alternatively, it might decrease demand by taking the excitement out of smoking. The supply curve of marijuana would presumably shift to the right because all of the costs of avoiding detection in bringing it to market would be eliminated. The overall effect on price and quantity would then depend largely on what happens to the demand curve.

Question 3 a) Decrease in quantity demanded b) Decrease in quantity demanded c) Demand increases d) Demand decreases e) Demand decreases f) Demand increases Question 4 This is a straightforward question with lots of acceptable answers, but students’ reasoning needs to be watched. In particular, be alert for confusing effects on demand versus supply and in movements along curves versus shifts of curves. a) An increase in the price of hotel rooms in the ski resorts of BC’s interior; a decrease in the price of hotel rooms in the ski resorts of Quebec. b) The price of things such as housing and restaurant meals will likely decline in Oshawa and nearby communities. c) The price of French wines will rise. d) The price of firewood in Ontario will rise.

Question 5 This is a straightforward repetition of the example given in the text, only now applied to housing. (a) An increase in population (or average household income) will shift the demand curve for housing to the right and raise housing prices. (b) As prices rise, individual households will reduce the quantities they demand (perhaps by buying smaller houses or by only buying later in life) thus moving along the demand curve.

The word “prohibitive” may lead some students to make the error in believing prices are so high that no one is buying housing. But, of course, prices stay high only if there are enough purchasers willing to take up all of the available supply at those high prices. The two observations are not inconsistent—they refer to two different phenomena.

____________________ Chapter 4: Elasticity ____________________ Answers to Study Exercises Question 1 a) 2; relatively elastic b) 0.4; relatively inelastic c) 1; unit elastic Question 2 a) The table should be completed as shown below. Note that elasticities are computed “between the rows”, reflecting the change in quantity and prices between points on the demand curve.

Price QD $11 1

Expenditure $11

9

3

27

7

5

35

5

7

35

3

9

27

1

11

11

%Δprice

%Δquantity

Elasticity

20

100

5

25

50

2

33.3

33.3

1

50

25

1/2

100

20

1/5

b) The diagram of the demand curve is shown below.

c) At points higher up the demand curve, price is relatively high and quantity demanded is relatively low. Thus a given Δp (such as the $2 increment shown in the table above) is a small percentage change, whereas a given ΔQ (such as the 2-unit increment shown in the table) is a large percentage change. These same absolute changes will be different in percentage terms as we move to the right along the demand curve (larger for Δp and smaller for ΔQ). Since elasticity is a ratio of the percentage change in quantity demanded to the percentage change in price, it follows that elasticity falls as we move to the right along a linear demand curve.

Question 3 a) The diagram below shows the relevant information and assumes that both demand and supply curves are linear. Point E is the initial equilibrium.

b) An increase in price from $1.00 to $1.50 per can leads to a reduction in quantity demanded from 4200 to 3000 cans per month. Thus the own-price elasticity of demand is:

η = (1200/3600)/(0.50/1.25) = (1/3)/(2/5) = 5/6 This is relatively inelastic demand. c) An increase in price from $1.00 per can to $1.50 per can leads to an increase in quantity supplied from 4200 to 4500 cans per month. Thus the own-price elasticity of supply is: ηS = (300/4350)/(0.50/1.25) = .0689/0.4 = 0.17 This is relatively inelastic supply. d) The availability of substitutes is the key factor affecting elasticity. How willing and able are consumers to substitute to competing products, such as frozen grape juice, apple juice, milk, or soft drinks? e) The ability of producers to substitute toward the production of other goods is the key factor affecting supply elasticity. Can their equipment be used for other purposes? Can their management skills be easily shifted?

Question 4 The key to this question is to recognize that own-price elasticity of demand is determined mostly by the availability of substitutes. Notice that the products are listed in order of decreasing generality. That is, item (e) is a subset of (d), which is a subset of (c), which is a subset of (b), which in turn is a subset of (a). This means there are fewer substitutes for food than for leafy vegetables sold at your local supermarket on Wednesdays. Thus we would expect demand for (a) to be the least elastic and demand for (e) to be the most elastic.

Question 5 The demand for the stamps is downward sloping, as shown in the diagram below. The supply is a vertical line at Q=2. If the stamp collector sold both stamps, the equilibrium price would be p2 and his total revenue would be the dark shaded area. If, instead, he chooses to burn one stamp, the supply (after the fire) will be a vertical line at Q=1. If he now sells the single stamp, the equilibrium price will be higher at p1 and his total revenue would be the light shaded area. It should be clear from the diagram that if the demand curve is sufficiently inelastic then p1 will be much higher than p2 and the total revenue from the single stamp when sold will exceed the total revenue of the two stamps when sold. In this case the decision to burn the stamp would be wealth maximizing and perfectly sensible.

Question 6 a) The concept is that of the own-price elasticity of demand, since we are considering changes in the price and quantity of ticket sales. The measure of elasticity in this case is the percentage change in quantity demanded divided by the percentage change in price. The average quantity is 1275 and the average price is $12.50. Thus, we have: η = (150/1275)/(3/12.50) = 0.49 b) The concept is that of the income elasticity of demand because we are relating changes in income to changes in quantity demanded. The measure of income elasticity is the percentage change in quantity demanded divided by the percentage change in income. The average quantity is 61,500. Note that we are given the percentage change in income equal to 10 percent or 0.10.

Thus we have: ηY = (11,000/61,500)/(0.10) = 1.79 The positive sign reveals that Toyota Camrys are a normal good since a rise in income leads to an increase in quantity demanded. c) The concept is that of the cross-price elasticity of demand because we are relating changes in the price of coffee to changes in the quantity demanded of tea. The measure of cross-price elasticity is the percentage change in the quantity demanded of tea divided by the percentage change in the price of coffee. The average coffee price is $3.90 and the average quantity of tea is 7 750 kg. Thus we have: ηXY = (500/7,750)/(1.80/3.90) = 0.14 The positive sign reveals that coffee and tea are substitute goods since a rise in the price of coffee (which presumably reduces the quantity demanded of coffee) leads people to demand more tea. d) The concept is the Canadian own-price elasticity of supply because we are relating changes in the world price of pulp to changes in the quantity of pulp supplied by Canadian firms. The

measure of supply elasticity is the percentage change in (Canadian) quantity supplied divided by the percentage change in the world price. The average quantity is 9.5 million tons. Note that we are given the percentage increase in the price equal to 14 percent, or 0.14. Thus we have: ηS = (3/9.5)/(0.14) = 2.26

Question 7 a) Total expenditure along the demand curve is equal to price times quantity demanded. Thus, the values for total expenditure are: Total Expenditure A $12 million B $13.3 million C $14 million D $14.4 million E $15 million F $14.3 million G $13.8 million H $12.35 million

b) As shown in Figure 4-5 in the chapter, we make two diagrams, one for the demand curve and one showing total expenditure. Note in both cases that the scale on the vertical axis does not start at zero. The diagrams are as follows:

c) Own-price elasticity of demand (from one point on the demand curve to another) is the percentage change in quantity demanded divided by the percentage change in price, where we use the average price and quantity over the arc of the demand curve. The calculations are shown in the table below. (Prices are in $ and quantities are in hundreds of thousands.)

Points A to B B to C C to D D to E E to F F to G G to H

Average p and Q p = $32.50, Q = 390 p = $37.50, Q = 365 p = $42.50, Q = 335 p = $47.50, Q = 310 p = $52.50, Q = 280 p = $57.50, Q = 245 p = $62.50, Q = 210

Computation of Elasticity η = (20/390)/(5/32.50) = 0.33 η = (30/365)/(5/37.50) = 0.62 η = (30/335)/(5/42.50) = 0.76 η = (20/310)/(5/47.50) = 0.61 η = (40/280)/(5/52.50) = 1.5 η = (30/245)/(5/57.50) = 1.41 η = (40/210)/(5/62.50) = 2.38

d) “Elastic” demand refers to the range of the demand curve over which the measured elasticity (in absolute value) is greater than one. From the table above we see that the demand for denim jeans is elastic between points E and H — that is, for prices above $50. e) “Inelastic” demand refers to the range of the demand curve over which the measured elasticity (in absolute value) is less than one. From the table above we see that the demand for denim jeans is inelastic between points A and E — that is, for prices less than $50.

Question 8 a) The four scale diagrams are shown below. Note that all four diagrams have the same scale on the vertical axes but different scales on the horizontal axes.

b) The own-price elasticity of supply is equal to the percentage change in quantity supplied divided by the percentage change in the price. The calculations for cases (i) through (iv) are : i) average p = $30, average Q = 15. ηS = (10/15)/(20/30) = 1 ii) average p = $30, average Q = 7.5. ηS = (5/7.5)/(20/30) = 1 iii) average p = $30, average Q = 6. ηS = (4/6)/(20/30) = 1 iv) average p = $30, average Q = 3. ηS = (2/3)/(20/30) = 1 Note that in each case the supply curve is a straight line from the origin. As we mentioned in footnote #1 in the chapter, the elasticity of all such supply curves, no matter what the slope, is equal to one. c) As we saw in part (b), the elasticity of supply of each of the four supply curves is one. But the slopes of the four curves are different. The slope of the curve is measured by the change in price per unit change in quantity supplied. The slopes are: (i) 20/10 = 2; (ii) 20/5 = 4; (iii) 20/4 = 5; and 20/2 = 10. The difference between slope and elasticity is that the first is measured in absolute changes whereas the second is measured as percentage changes. This question should make it clear that this difference matters!

Question 9 a) The appropriate scale diagram is shown below.

b) The equilibrium price and quantity can be determined algebraically by solving the demand and supply system — 2 equations and 2 unknown variables. The equilibrium is where the two curves intersect. Algebraically, this occurs where the price on the demand curve is equal to the price on the supply curve. Thus, we set 80 – 5QD = 24 + 2QS

But at the equilibrium, the quantity on the demand curve will also equal the quantity on the supply curve, thus we set QD = QS = Q*. Our equation becomes 56 = 7Q* ⇒ Q* = 8 (million litres per month) Substituting this value for Q* back into either the demand curve or supply curve we can solve for the equilibrium price, p*. Using the demand curve, we get p* = 80 – (5×8) = 40 (cents per litre) c) With a tax of 14 cents per litre, there will be a 14-cent wedge between the price the consumer pays (the consumer price) and the price received by the producer (the seller price). Algebraically, we can solve for the new equilibrium by rewriting the demand and supply curves in terms of the consumer price (pC) and the seller price (pS). The demand and supply functions are now: pC = 80 – 5QD and pS = 24 + 2QS To solve for the equilibrium quantity in the presence of the tax, note that the consumer price minus the 14-cent tax must exactly equal the seller price. Thus, pC – 14 = pS. This gives: 80 – 5Q* – 14 = 24 + 2Q* ⇒ 42 = 7Q* ⇒ Q* = 6 To solve for the consumer and seller prices, simply substitute this value of Q* into the demand and supply curves. The consumer and seller prices are pC = 80 – (5×6) = 50 and pS = 24 + (2×6) = 36 The gasoline tax raises revenue equal to the number of litres sold (6 million litres per month) times the unit tax (14 cents per litre). Thus, the monthly tax revenue is $840,000. What share is paid by consumers and what share is paid by producers? The tax has raised the consumer price from 40 cents per litre to 50 cents per litre. Thus consumers are ‘paying’ 10 cents of each 14 cents of tax, or 71% of the total tax. The seller price fell from 40 cents per litre to 36 cents per litre, so they are ‘paying’ 4 cents of each 14 cents of tax, or 29% of the total tax.

Answers to Discussion Questions Question 1 a) Demand for wheat is inelastic since a decline in price leads to a decline in revenue for wheat farmers. b) Demand for bus travel is inelastic since total expenditure on bus travel declines as price declines. c) Demand for CD players is elastic since total expenditure on CD players rises as price declines. d) The speaker is asserting that he or she has a perfectly inelastic demand for coffee. This is possible over some, but not all, ranges of price –– how about at a price of $1000 per cup? Also, one person’s perfectly inelastic demand is not sufficient to make market demand perfectly inelastic. e) The demand for housing is increasing greatly in Vancouver. Therefore the demand curve is shifting outward. This causes the price to increase (as we move up along an upwardsloping, and

likely very inelastic, supply curve). As price rises, we also move (along) any given demand curve.

But this tells us nothing about the elasticity of demand.

Question 2 It sounds as if there is a high income elasticity of demand for home computers. Thus, the lower income levels in Mexico than in Canada, and in Newfoundland than in Alberta, make a big difference.

Question 3 a) Anything that increases the willingness of shoppers to come downtown will tend to help the central city shopping centers. The greater the price elasticity of demand for transport, the greater will be the effect of a decrease in the price of transport. But a “yes” answer requires only that the demand curve be downward sloping or that transport is a complementary good to the goods purchased, or that some part of the income effect of a decrease in the cost of transport is spent on shopping downtown. b) Raising the bulk postage rate will affect postal revenues according to the price elasticity of demand for postage, raising them if demand is inelastic and decreasing them if demand is price elastic. c) The relevant measure is the cross elasticity of demand between toothpaste and mouthwash. d) This is a hard question to answer in terms of elasticity. Strictly speaking, we are asking for the cross elasticity of demand between gasoline prices and the demand for cars that use propane. We are unlikely to know that. But we may know many of the elements such as the cross elasticity between gasoline and propane, the cross elasticity between propane and propaneusing cars, and the ordinary elasticity of demand for propane and for cars. But the general answer is easy enough. The cross elasticity should be positive (although possibly quite small), since a fall in the price of gasoline will decrease the relative attractiveness of propaneusing cars.

Question 4 a) Fuel and tractors are complementary goods with a negative cross elasticity. The quantitative increase in notill farming no doubt reflects the reduction in tractor use in response to the rising cost of tractor fuel. (Other influences are surely also at work, including costs of farm labour.) b) This relates to the price elasticity of demand for fertilizer, and the dismal year in the face of rising prices suggests a highly elastic demand. c) The concept here is income elasticity of demand. The fall in farmers’ income will reduce their purchases of many things sold in their local small towns (and local big towns as well). d) This again relates to income elasticity of demand. The development of the Hybernia oil fields generates income directly for those workers and firms involved in the development. This income leads to expenditures in local stores, restaurants, and so on.

Question 5 The opera thought its demand was elastic, the subway thought its demand was inelastic. Both may have been right but it is also possible that both were making kneejerk reactions for their financial problems.

____________________________ Chapter 5: Markets in Action ____________________________ Answers to Study Exercises Question 1 a) $5; 600 hats b) price ceiling at $3 c) excess demand; 400 d) price floor at $6 e) excess supply; 200 Question 2 a) With a binding price ceiling, the excess demand means that consumers must somehow be rationed by means other than price. This situation often encourages rationing by “sellers’ preferences”, including rationing by: • religious beliefs or affiliation • race • sexual preferences • occupation b) With a binding price floor, the government could choose to purchase the excess supply, thus transferring resources from taxpayers to producers. Alternatively, the government could introduce a quota system so that the producers face an upper limit on production equal to the quantity demanded at the floor price. c) If the government views the product in question as a necessity, it may introduce a price ceiling in the hope that it will improve consumers’ access to the product. However, to the extent that the quantity supplied will fall, overall access will be reduced by such a policy. d) If the government views the sellers of the product as deserving of support, a price floor may be seen as a desirable policy. (This is the motivation for a legislated minimum wage.) However, to the extent that quantity demanded for the product will fall, some sellers of the product may see their markets disappear.

Question 3 This is a straightforward application of the theory of price floors and ceilings that we discussed in the text. a) Since p1 is below the market-clearing price of p*, a price floor at this level will have no effect on the market equilibrium. It is not a binding price floor.

b) Since p2 is above p*, this will be a binding price floor. The equilibrium quantity will be determined by the short-side rule, where p2 hits the demand curve. c) Since p1 is below p*, this will be a binding price ceiling. The equilibrium quantity will be determined by the short-side rule, where p1 hits the supply curve. d) Since p2 is above p*, this will not be a binding price ceiling. It will have no effect on the market equilibrium.

Question 4 a) The free-market equilibrium is where quantity demanded equals quantity supplied. From the table this occurs at a price of $800 per month and a quantity of 70 000 units. b) Any ceiling on the price of rental apartments must be below the free-market equilibrium price to have any effect on the market. Thus the highest it can be is just below $800. c) At a ceiling of $500 per month, quantity demanded is 100 000 units and quantity supplied is 60 000 units. There is excess demand (a shortage) of 40 000 units. There has also been a reduction in the equilibrium quantity exchanged (from 70 000 to 60 000 units). d) At a quantity of 60 000 units, the maximum price that consumers are willing to pay is $900 per month for rental accommodation. If all units were supplied on the black market, $900 would be the black-market price.

Question 5 The supply of rental accommodation is more elastic in the long run than in the short run because it takes time to build new units or to convert private housing into rental units (or to let existing units physically depreciate). Therefore whatever housing shortage exists immediately after the imposition of rent controls only gets worse as time proceeds, as the quantity of rental housing supplied declines as landlords no longer find it profitable to maintain their rental units.

In terms of a diagram, when rent controls set a maximum price of pC, the housing shortage is Q1Q2 in the short run, but grows to Q3Q2 as the long-run supply elasticity becomes relevant. Note that the short-run supply curve is drawn very steep, indicating that the supply of rental housing is almost perfectly inelastic in the short run.

Question 6 a) For the supply curve: QS= 20 + 8p, the diagram is as follows:

b) As the world price of oil rises, two things are happening. First, more oil is being extracted from existing oil wells. Second, new oil wells are being explored and drilled. c) At a high price of $16 per barrel, Canadian supply equals 148 million barrels per month. The monthly income of producers is therefore $2.368 billion. At a low price of $9 per barrel, Canadian supply is 92 million barrels per month. Monthly income is therefore $828 million. On the diagram this is shown as the movement between points A and B on the Canadian supply curve.

Question 7 a) The bumper crop of European barley is shown in the world barley market as a straightforward rightward shift in the supply curve. The world price falls and the equilibrium quantity rises (though probably not by much since world demand for barley is likely to be quite inelastic).

b) For Canadian barley growers, the price they face is determined in the world market; they are price takers. The appropriate diagram for the Canadian barley growers shows their upward-sloping supply curve and the given world price. As the world price falls from p1 to p2, the quantity supplied

by Canadian barley growers falls from Q1 to Q2. Their collective income therefore falls by the amount of the shaded area.

c) This is just the same logic working in reverse. When other parts of the world experience a crop failure, the world supply curve for the crop shifts to the left and the world price rises. In this case, Canadian farmers (with no crop failure) increase their quantity supplied of the crop and benefit from an increase in income.

Question 8 This question requires the student to solve a system of demand and supply curves as is done in the box near the end of Chapter 3.

a) The free-market outcome is determined where quantity demanded equals quantity supplied, QD = QS. Setting p from the demand curve equal to p from the supply curve, we get 225 – 15Q = 25 + 35Q ⇒ 200 = 50Q

⇒ Q* = 4

Putting Q*=4 back into the demand curve we get p* = 225 – (15×4)

⇒ p* = 165

Thus the free-market price of milk is $1.65 per litre and the equilibrium quantity is 4 million litres per month. b) At the guaranteed price of $2.00 per litre, quantity demanded is given by 200 = 225 – (15×QD) ⇒ QD = 1.67 (1.67 million litres) At the same price, quantity supplied is given by 200 = 25 + 35QS

⇒ QS = 5

(5 million litres)

c) Since the government has guaranteed to purchase any amount that the producers cannot sell, the producers will produce the full 5 million litres per month. Thus, at the guaranteed price of $2.00 per litre, there is excess supply of 3.33 million litres per month. This amount will be purchased by the government at a cost (to taxpayers) of $6.66 million per month. d) The government purchase of milk is financed by taxpayers. Taxpayers are clearly harmed since they must foot the direct bill for this system of price supports. Consumers are also harmed since they consume less milk and must pay a higher price than would be available in the free market.

Milk producers are clearly better off. Not only do they get a higher price per litre, but their surplus production is all purchased by the government.

Question 9 This question relates to the previous question on milk production. The government issues quota for 1.67 million litres per month rather than using a direct price support. a) If milk producers produce the maximum allowed by the quotas, then production will be 1.67 million litres per month. Given the demand curve (p = 225 – 15QD), this implies a price of p = 225 – (15×1.67) ⇒ p = 200 cents (or $2.00) per litre. b) In the previous question with direct price supports, the price was $2.00 per litre and consumers purchased 1.67 million litres per month. That is also the case when this quota system is used. Thus, consumers do not detect a difference between the direct price supports and the quota system.

Taxpayers surely prefer the quota system since the government is not obliged to purchase the surplus production that would otherwise occur under the system of direct price supports. Finally, milk producers are clearly worse off under the quota system than under the direct price supports.

With the quota system, they produce 1.67 million litres per month and sell each litre at a price of $2.00. But with the direct price supports they produce 5 million litres per month and sell each litre at the same price. Their collective income is therefore higher by $6.66 million per month under the system of direct price controls.

Question 10 This is a good question to reinforce the idea of market linkages and also to remind the student of the effects of excise taxes (from Chapter 4). a) The demand and supply curves look as follows. For simplicity, we assume that in the initial situation the price of cigarettes is the same in both markets.

b) Following the arguments in the final section of Chapter 4, the reduction in cigarette taxes in the Eastern market leads to a rightward (or downward) shift in the supply curve from S to S′. The immediate effect is to reduce the equilibrium price to p1 and raise equilibrium quantity. This is the move from E0 to E1 in the right-hand diagram. c) Sellers in the Eastern market now notice that cigarettes are more expensive in the Western market because taxes there have not fallen. There is an incentive to smuggle cigarettes from the East to the West, selling them at the higher Western price. This is illegal in Canada (though it happened in the event described in 1994). The effects of large-scale smuggling would be to shift the supply curve in the East to the left and shift the supply curve in the West to the right. This is the movement to E2 in both diagrams, where the prices of cigarettes are again equalized across the two markets.

d) There are two limits on the extent of smuggling. First, it is illegal. The illegality of smuggling means that smugglers face some probability of being caught and punished. The second limit is the direct cost of smuggling, including transactions and transportation costs. Both aspects of smuggling mean that the price will not be exactly equalized across the two markets. However, if there were no such limits on smuggling, then we would expect the price to be exactly equalized.

Answers to Discussion Questions Question 1 Price controls are inefficient because people who would be willing to pay the market price for the product are denied that transaction. Controls are popular with consumers of a scarce good because they keep the price down for those who get the good. The same low prices, of course, increase scarcity in the long run; many who would like to purchase the good at the controlled price find that they cannot. The main reason for removing price controls is to let the market once again provide the signals and the incentives for shifting resources into areas where demand exceeds supply.

Question 2 a) Landlords and wouldbe tenants who cannot get accommodation. b) Taxpayers who do not receive the subsidy. c) Taxpayers and landlords (insofar as rentals of private dwellings are held down).

Question 3 Farmers can suffer from the weather in two different ways. First, bad weather can mean that particular farmers have little or nothing to send to market and therefore do not benefit greatly from the high prices earned by the lucky ones. Second, good weather that brings bumper crops may lead to such low prices (even if quantities are high) that profits are squeezed or eliminated.

Question 4 This policy will tend to increase the demand for residential property in flood-prone areas. By stepping in with disaster relief, the federal government is supplying free insurance to homeowners in areas that frequently flood. This essentially reduces the full price of the housing, since prospective buyers know they will not have to pay the full cost of rebuilding every few years. In general, since this policy is insulating prices from the social cost associated with the periodic destruction of resources, the policy reduces the efficiency of such real-estate markets.

Question 5 a) Subsidies to farmers make farming more profitable and thus increase the demand for agricultural land, thus driving up its price. To all farmers who already own their land at the time such subsidies are introduced, this increase in land value represents a windfall capital gain. The capital gain is equal to the present value of the higher stream of future profits

generated by the subsidies. To all farmers who enter the industry after the subsidies are introduced, however, they must purchase their land at the prices that include the capitalized value of the subsidies. The high cost of their land is exactly offset by the greater stream of future (operating) profits generated by the subsidies. Thus, new farmers do not benefit from the subsidy program. But they still want and need these subsidies –– indeed, they need the continuation of these subsidies to offset their high capital (land) costs. b) Production quotas do not solve this basic problem. A quota is essentially a license to produce and sell a given amount of the product, at a price that is higher than it would be in a free market.

Thus quotas are valuable assets and have considerable market prices (because they are transferable). To those farmers who are “in place” at the time the quota system is introduced, and receive their quota for free, they are receiving a valuable asset. But those farmers who come along later must purchase their quota from existing farmers, and thus must pay the high market price.

Like the case of subsidies, the increased profitability of production in the quota system is offset by the high price of the quota. Thus, the quota system suffers from the same basic problem as the subsidy system.

Question 6 This is a good example of how resource constraints link seemingly unrelated markets, and the discussion here is very similar to the case of aerospace subsidies discussed in the web material “Linkages Between Markets”.

The government’s infrastructure program will certainly create jobs in the construction industry. As the government funds are spent to build infrastructure, the demand for labour in the construction industry will rise and increased employment will follow. But whether this will lead to an overall increase in employment in the economy depends on whether there are idle resources in the economy.

If resources are fully employed, then the new jobs in the construction industry will be matched by job losses in other industries. As the demand for labour rises in construction, wages there will be bid up. These higher wages will attract workers from other industries. But as they leave other industries and head for the construction industry, there will be a decline in labour supply in those other industries. This will push wages up there. The net result is higher wages overall, more jobs in the construction industry, and fewer jobs elsewhere. There will be no net job creation.

If there are initially unemployed resources in the economy, however, some of the new jobs in the construction industry may come from the pool of unemployed workers. In this case there would be some net creation of jobs. The mechanism in the previous paragraph will still be operating, and thus there will still be a redistribution of employment from other industries toward the construction industry. But some of the jobs created will be a net addition of jobs in the economy overall.

______________________________ Chapter 6: Consumer Behaviour ______________________________ Answers to Study Exercises Question 1 a) utility (or satisfaction); diminishes b) marginal utility; equalizes c) MUA/pA = MUB/pB d) quantity demanded; negatively sloped Question 2 a) The appropriate diagrams for (a) and (c) are shown below. Note that the horizontal scales for both diagrams are the same but the vertical scales are different. Note also that marginal utility is plotted between the integer values for the number of avocados consumed because marginal utility measures the change in utility from consuming one more avocado.

b) The marginal utility is the change in utility divided by the change in the number of units consumed. The marginal utilities are given in the following table: Change in Consumption

0th to 1st 1st to 2nd 2nd to 3rd 3rd to 4th 4th to 5th 5th to 6th 6th to 7th 7th to 8th

Marginal Utility 100 85 60 40 30 20 10 5

c) The graph of marginal utility is shown above. d) Brett likes avocados, and each extra avocado may well increase his total utility. But after some point (and perhaps right away, as in this case), each successive avocado adds less to his total utility (or satisfaction) than the previous one. That is, the utility that Brett gains from each extra avocado falls, though it may still be a positive amount. Most of us have experienced this phenomenon, whether it be with cold beverages on a sunny day, pieces of pizza, or meals at a nice restaurant.

Question 3 The key point here is to recognize that utility maximization requires that the marginal utility per dollar spent on each good should be equated across both goods. If this equality does not hold, then the pattern of expenditure can be changed in such a way as to increase total utility. The table below shows the computation of MU/p for each good and states whether consumption of X or Y should be changed.

Case

MUX/pX

MUY/pY

Change pattern of consumption?

A

2/10

3/5

B

4/12

2/4

C

1/3

2/6

D

2/4

2/4

E

4/8

3/4

Need to raise MUX/pX relative to MUY/pY. Consume less of X and more of Y. Need to raise MUX/pX relative to MUY/pY. Consume less of X and more of Y. MUX/pX equals MUY/pY. Do not change pattern of consumption.

MUX/pX equals MUY/pY. Do not change pattern of consumption.

Need to raise MUX/pX relative to MUY/pY. Consume less of X and more of Y.

Question 4 a) The sum of Rupert’s willingness to pay for the first five pizzas is 18 + 16 + 13 + 9 + 4 = $60.

Thus Rupert would be willing to pay $60 per week for these five pizzas — this is the total value that Rupert places on five weekly pizzas. b) Rupert will purchase pizzas until his willingness to pay for the next pizza is less than the market price. At a price of $10 per pizza, Rupert will buy three pizzas per week. c) The total value that Rupert places on the three pizzas is 18 + 16 + 13 = $47. The amount Rupert must spend to buy them is $10 per pizza times three pizzas, or $30. Thus Rupert’s consumer surplus is $17.

Question 5 a) Since salt is a very small element in most people’s consumption bundle, the income effect is likely to be very small, such that a 10% increase in price should have very little effect on the quantity demanded. Also, note that there are few good substitutes for salt, so demand tends to be relatively inelastic. b) Blue jeans are relatively expensive purchases, and are somewhat durable. Therefore, one might expect the income effect to be reasonably large, such that an increase in price is likely to elicit a reasonably large change in consumption. This is compounded by the fact that many people might view a large class of clothing as good substitutes for blue jeans, thus making the demand for jeans relatively inelastic. c) Canned vegetables make up a relatively small portion of the average consumer’s consumption bundle. This implies a small income effect and, for this reason, demand is likely to be quite inelastic. On the other hand, there are good substitutes to canned vegetables (especially fresh vegetables) and so this will generate a larger response of quantity demanded to a price change. The net effect is not obvious, though our guess is that the first effect dominates, making the demand for canned vegetables relatively inelastic. d) While gasoline consumes a significant portion of many people’s income, implying a large income effect, there are few viable substitutes. Consequently, gasoline may exhibit significant response to price increases, but smaller than one might expect from the pure income effect. e) Mini-vans are extremely large purchases and should possess very large income effects. Further, as a consumer durable, mini-vans may be repaired instead of replaced. Consequently, quantity demanded for mini-vans should exhibit very large responses to changes in price. Working in the same direction, large sedans and sport utility vehicles are, for many consumers, reasonably good substitutes for mini-vans, making demand even more elastic. f) The income effect from a change in rent for apartments is probably bigger than for most products since rent makes up a large portion of most people’s budget. Furthermore, if people want rental apartments partly because of the proximity it gives them to downtown areas, then substitutes (such as single-family houses) may not be readily available. Thus demand is likely to be quite inelastic. g) Luxury cars are expensive and will constitute a significant portion of the consumer’s income, except for very rich consumers. The income effect is therefore likely to be significant, making demand relatively elastic. However, available substitutes are limited, especially if the luxury car is

purchased to confer status and prestige, rather than just being a means of comfortable transportation. In the final analysis, it is probably best to segment the groups of consumers between the very rich and the not so rich. Demand among the first group is probably very inelastic; demand among the second group is probably quite elastic.

Question 6 a) Consumer surplus at price p0 is given by the triangle defined by points BCD. b) The new equilibrium price is p1 and quantity is Q1. Consumer surplus is now given by the triangle ACE. c) On the original Q0 units, the lower price means more consumer surplus, given by the rectangle ABDF. d) The triangle FDE is the new consumer surplus earned o the new (Q1-Q0) units.

Question 7 The substitution effect of a price change is always in the direction of increasing quantity demanded when the price falls (or reducing quantity demanded when the price rises). (In the extreme case of perfect complements, Leontief preferences, the substitution effect is precisely zero.)

The direction of the income effect depends on whether the good is normal or inferior. For a normal good, the income effect of a reduction in price is to increase real purchasing power and to increase quantity demanded; for an inferior good, the income effect of a reduction in price is to increase real purchasing power but reduce quantity demanded.

Putting the substitution and income effects together, we have: Normal goods:

Income and substitution effects work in the same direction

Inferior goods:

Income and substitution effects work in the opposite direction.

Question 8 This is a good question to emphasize the difference between total and marginal value and to clarify how changes in market price are related to changes in either total or marginal value. a) The rightward shift of the demand curve reflects the fact that consumers now place more total value on this item (or, in other words, more value for any given quantity). Thus, for any given quantity of the product, the area under the demand curve has increased. b) In equilibrium, the marginal value of X has not changed, even though the total value has. The reason is that, in this case, the supply curve is perfectly elastic, and so the equilibrium market price is unaffected by the increase in demand. So consumers still consume X until the marginal value is equal to the market price, but the latter is unchanged and thus so is the former. c) The total value that consumers place on a given quantity of Y is unchanged—the demand curve for Y has not moved.

d) The increase in supply drives down the price. The reduction in price leads consumers to consume more of Y until the marginal value is just equal to the price. But since the price has fallen, the value of Y at the margin has also fallen, even though there has been no change in preferences (the demand curve hasn’t moved at all).

Question 9 a) The demand and supply curves are plotted in the diagram below. To compute the equilibrium price and quantity algebraically, we must solve the system of equations. Equate the prices in the demand and supply functions to get 30 – 4Q* = 6 + 2 Q* ⇒ 24 = 6 Q* ⇒ Q* = 4 Substitute this value of Q* back into either the demand or supply curve to solve for p*. Using the demand curve to do so, we get p* = 30 – (4 × 4) = 14

b) The total value that consumers place on Q* units of the good is shown by the area under the demand curve up to Q = 14 units. This is shown by areas A + B + C. c) The value that consumers place on an additional unit of the good—the marginal value—is shown by the equilibrium market price, p* = 14. Given the market price, consumers consume the good until the last unit delivers utility equal to the market price. d) The new supply curve is p = 2 + 2QS. The new equilibrium quantity, Q** is found by 30 – 4Q** = 2 + 2Q** ⇒ 28 = 6Q** ⇒ Q** = 4.67 and p** = 30 – (4 × 4.67) = 11.33 Consumers’ marginal value of the good has now fallen, along with the equilibrium market price. e) Consumers have not changed the total value they place on any given amount of the good, but their marginal value has fallen. As the equilibrium price falls, consumers consume more of the product, thus diminishing the marginal value of the product.

Answers to Discussion Questions Question 1 One might get some pretty graphic answers here, describing the behaviour of someone that “drinks too much” by getting average utility down to zero. A less graphic answer is that if average utility is zero, so is total utility. Thus the positive utility achieved by the initial few drinks is offset by the negative utility received by the last few drinks. Getting marginal utility to zero involves stopping at the first drink with a negative contribution to utility.

Question 2 Both involve an income effect, although in the first case it is limited by food’s share in the consumer’s total expenditure. Of course, the fall in food prices may also involve a substantial substitution effect whereas the change in money income with prices held constant does not.

Question 3 This is another application of the labourleisure choice (first seen in Applying Economic Concepts 6-1). In simple terms, when wages rise the opportunity cost of sleep (one of many forms of leisure) rises, and people substitute away from it. The background to the study is the evidence that, in terms of the standard labourleisure choice, the income effect of rising real wages––which increases the demand for leisure if leisure is a normal good––outweighs the substitution effect. The key fact is that the average number of hours on the job has been falling steadily for over a century as average real wages have increased. The reduction in time spent sleeping noted by the two economists allows for both more time on the job and more leisure, although the evidence is, of course, that it went to increased leisure. Any income effects are likely to be very small––the little bit of evidence suggests that a tenfold increase in income accounted for only a 21minute increase in nightly sleeping.

Question 4 In this question, the student should begin to think about things that might not be held constant in many decisions. In this example, the economist is in a strange city and apparently has no information about the relative quality of restaurants. Since she knows that higher quality only comes from increased resource use, and that people are generally willing to pay more for higher quality products, she uses price as an indicator of quality and selects the higher priced restaurant.

Thus, quality (or expected quality) is implicitly not held constant between the two establishments.

Question 5 This is a good question to drive home the important difference between marginal and total value.

Given a downwardsloping demand for medical and hospital services, the unlimited governmentprovision at a zero price implies that the marginal value of these services will be driven

to zero. The total value, of course, will be quite high, but consumers will use these services up to the point where price (zero) equals marginal benefit. If the government then restricts supply (for whatever reason), the total value of services to consumers will fall but the marginal value will rise.

This simply reflects the fact that consumers will move up the demand curve. If the government maintains the zero price even when they restrict the supply, there will be excess demand for hospital and medical services. This leads to long queues, waiting lists, and perhaps even a black market in health-care services.

Answers to Appendix Study Exercises Question 1 a) The appropriate scale diagram is shown below.

b) Bundles c and i are on the same indifference curve, marked I1 in the figure. Bundles d, g and h are also on the same indifference curve (marked I2), but each is preferred to either c or i. Thus I2 lies above and to the right of I1. Bundle e is Katie’s favourite bundle of those shown, and so the indifference curve through this bundle (I3) must lie above and to the right of I2.

c) Katie clearly prefers bundle e to bundle g. How about comparing bundle f to bundle g? We know that Katie is indifferent between bundles d and g. Also, we can be sure that she prefers d to f, for the simple reason that d and f have the same amount of videos but d has more ice cream cones.

But this immediately means that she also prefers g to f. Thus, Katie’s ranking is: e is preferred to g, and g is preferred to f.

Question 2 a) The cost of each bundle is shown in the following table. Since Katie has $18 per month, she can afford only bundles a, c, f, g, and i. She cannot afford bundles b, d, e, and h.

a b c d e f g h i

Cost ($) 18 20 18 19 20 17 18 22 18

b) If Katie spends her entire $18 on ice cream cones, she can afford to buy 9 cones. This is the vertical intercept of the budget line shown below. If she spends her entire $18 on videos, she can afford to rent 6 videos. This is the horizontal intercept of the budget line. The (absolute value of the) slope of the budget line is equal to the “rise over the run”, which in this case is equal to 9/6, which is 1.5. This slope is equal to the relative price of videos to ice cream cones (= 3/2 = 1.5). c) Recall that Katie can only afford bundles a, c, f, g, and i. Which one will she choose? Recall from Question 1 that Katie prefers bundle g to bundle f, and she also prefers g to both c and i. So Katie definitely won’t choose c, f, or i. This leaves only bundle a. But from the figure of the

indifference curves above, it is also clear that bundle g is on a higher indifference curve than bundle a, so she won’t choose bundle a. Thus Katie’s utility-maximizing choice is bundle g.

Question 3 a) For the budget line given by Line 1, point A shows the tangency between the budget line and the indifference curve — this shows the highest level of utility that Debra can achieve. b) If the price of Coronas declined, then the maximum available amount of Coronas (with a given money income) would increase. This amount of Coronas is the horizontal intercept of the budget line. c) Point B shows the hypothetical consumption bundle that Debra would choose if the price of Coronas declined and her money income was reduced so that she could just achieve her original level of utility. The movement from A to B is the substitution effect of the reduction in the price of Coronas. It shows that the substitution effect of a decline in the price of a product is unambiguously to increase the consumption of that product and decrease the consumption of the other product. d) Point C is the new consumption bundle that Debra chooses after the actual reduction in the price of Coronas. If Coronas are a normal good, then an increase in real income must lead Debra to increase her consumption of Coronas. This implies that point C must lie to the right of point B (the movement from B to C being the pure income effect of the price change). The diagram as drawn does indeed satisfy this restriction.

Answers to Appendix Discussion Questions Question 1 In this case, an indifference curve drawn with alcohol on the horizontal axis and other goods on the vertical axis will be convex and upward sloping. Thus, consumption of an additional unit of alcohol would have to be accompanied by an additional unit of other goods in order for the person to maintain the same level of utility. That is, the marginal benefit of alcohol has become negative.

Question 2 One might expect that as a person has more and more income, her responses to an additional dollar, in terms of increased purchases of goods (other than savings), is likely to diminish. In fact, we allow the theoretical possibility that a person might have so much income that they are completely satisfied, and would simply not spend an additional dollar beyond this point on anything. In this case, the indifference curve would be a point, known as a “bliss point”.

Question 3 This is a good question for emphasizing which factors lie behind the shape of an indifference curve. Assuming that both items are “goods”, and thus the indifference curve is downward sloping, the key point is that the more substitutable are the two items in terms of providing utility, the flatter (less curved) is the indifference curve. Thus, with items that are close substitutes, even small changes in relative prices will lead to large changes in the utility-maximizing bundle—that is, there are large substitution effects.

Coke and chips are complementary goods, and so we would expect the indifference curves to be quite curved — in the extreme case of perfect complements, they would be L-shaped. For Coke and Pepsi, however, we expect the indifference curves to be rather flat since (for most people) Coke and Pepsi are close substitutes.

_____________________________________ Chapter 7: Producers in the Short Run _____________________________________ Answers to Study Exercises Question 1 a) production function

b) economic profits; opportunity cost

c) short run; long run Question 2 a) law of (eventually) diminishing returns (to the variable factor) b) marginal product (of the variable factor) c) above; below Question 3 a) minimum b) increase

c) capacity

Question 4 The table is completed below. Note that for marginal product (MP), the computation is done for the change in output and labour input between rows. Thus, the first value in the table for MP reflects the change in output from 0 to 2 and the change in labour from 0 to 1; the marginal product is therefore equal to ∆TP/∆L = 2/1 = 2.

Inputs of Labour (per week) 0 1 2 3 4 5 6 7 8

Question 5

Number of Snowboards (per week) 0 2 5 9 14 18 21 23 24

AP

MP

--2 2.5 3 3.5 3.6 3.5 3.3 3

2 3 4 5 4 3 2 1

a) As shown in Table 7-1 in the chapter, accounting profits are equal to revenues minus explicit costs, and do not include the opportunity cost of the owner’s financial capital. The total revenues shown equal $657 000. The total direct costs equal $542 000. Thus the accounting profit is the difference between the two, $115 000. b) If equally risky ventures in other industries can generate a 16% return, then the opportunity cost on Mr. Buford’s capital is 0.16 × ($400 000) = $64 000. c) Economic profits are equal to accounting profits minus the opportunity cost of the owner’s financial capital. Thus economic profits for Spruce Décor in 2003 are $115 000 – $64 000 = $51 000. d) If Spruce Décor is a typical firm in the industry then the typical firm is making positive economic profits. Thus profits in this industry are higher than what is available in equally risky ventures in other industries. Such positive economic profits will lead other firms to enter this industry.

Question 6 a) By substituting the values of K and L into the production function provided (Q = KL – .1L2), the values for Q are easily found. The answers are: K 10 10 10 10 10 10 10 10

L 5 10 15 20 25 30 40 50

Q = KL – .1L2 50 – .1(25) = 47.5 100 – .1(100) = 90 150 – .1(225) = 127.5 200 – .1(400) = 160 250 – .1(625) = 187.5 300 – .1(900) = 210 400 – .1(1600) = 240 500 – .1(2500) = 250

b) The following diagram shows the relationship between L and Q, for K fixed and equal to 10. Note that the curve goes through the origin because when L equals 0, Q also equals 0 (independent of the value of K).

c) If K increases to K = 20, then the values of Q will also increase (for any given value of L). The re-computed values for Q are in the table below. The new curve is shown in the diagram above, indicated by K = 20.

K 20 20 20 20 20 20 20 20

L 5 10 15 20 25 30 40 50

Q = KL – .1L2 100 – .1(25) = 97.5 200 – .1(100) = 190 300 – .1(225) = 277.5 400 – .1(400) = 360 500 – .1(625) = 437.5 600 – .1(900) = 510 800 – .1(1600) = 640 1000 – .1(2500) = 750

d) A larger capital stock means that any given amount of labour now has more capital to work with, and thus can produce more output. This increase in the average product of labour is reflected simply by the upward shift in the curve shown above. Note also, however, that in this case (and in many others), the increase in K also increases the marginal product of labour for any given level of labour input. This is shown by the increase in the slope of the curve for any level of L. For example, for L = 25, the slope of the K = 20 curve is greater than the slope of the K = 10 curve.

This shows that the increase in K has made labour more productive at the margin.

Question 7 a) The average product of labour is equal to total output divided by the number of units of labour input. The values are shown in the table below and the AP curve is plotted in the figure below. b) The marginal product of labour is equal to the change in total output divided by the change in labour input that brought it about. In the table above, we compute the marginal product according to the change in values from one row to the next, so the first row is left empty. The MP curve is plotted in the figure above. Note that the values are plotted at the midpoints of the units of labour.

Average Product AP = 200/100 = 2.0 AP = 260/120 = 2.17 AP = 350/140 = 2.5 AP = 580/160 = 3.63 AP = 720/180 = 4.0 AP = 780/200 = 3.9 AP = 800/220 = 3.64 AP = 810/240 = 3.38

Marginal Product MP = 60/20 = 3.0 MP = 90/20 = 4.5 MP = 230/20 = 11.5 MP = 140/20 = 7.0 MP = 60/20 = 3.0 MP = 20/20 = 1.0 MP = 10/20 = 0.5

c) The law of diminishing marginal returns is satisfied for labour because (eventually) the marginal product of labour falls as more and more labour is used. d) As we explained in the text, the average product of labour can only rise if the marginal product exceeds the average product. This relationship is seen clearly in the figure for levels of labour input below 180. Similarly, the average product of labour only falls when the marginal product is

less than the average product, as seen in the figure for values of labour above 180. It follows that the MP curve must intersect the AP curve at its maximum, as shown in the figure.

Question 8 a) Average fixed cost (AFC) is equal to total fixed cost (TFC) divided by the level of output. The values for AFC are shown in the table below. b) Average variable cost (AVC) is equal to total variable cost (TVC) divided by the level of output.

The values for AVC are shown in the table below. c) Average total cost (ATC) is equal to total cost (TVC + TFC) divided by the level of output. The values for ATC are shown in the table below. The firm’s “capacity” is the level of output at which ATC is minimized, which in this case is 8 (thousands) bicycles per year.

Output (000s per year) 1 2 3 4 5 6 7 8 9 10 11

AFC Average Fixed Cost ($)

AVC ATC Average Variable Average Cost ($) Total Cost ($)

200/1 = 200 200/2 = 100 200/3 = 66.7 200/4 = 50 200/5 = 40 200/6 = 33.3 200/7 = 28.6 200/8 = 25 200/9 = 22.2 200/10 = 20 200/11 = 18.2

40/1 = 40 70/2 = 35 105/3 = 35 120/4 = 30 135/5 = 27 155/6 = 25.8 185/7 = 26.4 230/8 = 28.8 290/9 = 32.2 350/10 = 35 425/11= 38.6

240 135 101.7 80 67 59.1 55.0 53.8 54.4 55 56.8

d) The scale diagram is shown below. Note that we have not graphed values greater than 70, so the top sections of the AFC and ATC curves are not shown.

Question 9 a) The relationships between output and the units of variable input can be described as follows: i) Output increases proportionally with the variable input. That is, an x percent increase in L leads to an x percent increase in total output. ii) Output is positive even when there is no L. And for each unit change in L there is a constant unit change in output. iii) Up to some critical level of L, output increases proportionally with increases in L. But beyond this critical level of L, further increases in L lead to no change in total output. iv) Output increases with every increase in L, but each successive unit increase in L leads to smaller increases in total output.

b) The average product curves for the four cases are shown in the figure below. In the first case, the AP is constant. In the second case, due to the positive vertical intercept of the TP curve, the AP curve falls as L increases. In the third case, up to the critical level of L, L*, the AP is constant. But beyond that point, since output does not increase but L does, the AP curve falls. In the fourth case, the AP curve is steadily declining.

c) The marginal product curves are also shown in the diagram above. In the first case, the slope of the TP curve is constant and so the MP curve is a horizontal line. In the second case, the MP is also constant, even though AP declines steadily. In the third case, the MP is positive and constant up to L*, after which point MP is zero. In the fourth case, MP steadily falls and is below AP. d) Note that in all four cases, AP is only falling if MP is below AP.

Question 10

The average products, calculated as an average over the fifteen-unit intervals, are shown below. We have calculated the marginal products over the same intervals, but note that the MP applies for the change from one row to the next.

Fertilizer Dose

Average Product

Marginal Product

0 15 30 45 60 75 90 105 120 135 150

--6.95 3.68 2.62 2.09 1.74 1.46 1.26 1.10 0.98 0.89

--0.280 0.413 0.507 0.487 0.327 0.080 0.033 0.027 0.013 0.02

Average product falls throughout, so diminishing average product sets in at a very low, perhaps even zero, dose. Marginal product rises for the first few intervals and then declines roughly steadily, so diminishing marginal product sets in somewhere between thirty and sixty doses.

Answers to Discussion Questions Question 1 a) This is the typical business’s concept of (accounting) profits, which is a satisfactory or normal return on capital. b) This is the economist’s concept of profits; only when there are positive economic profits will business have the incentive to expand production. c) This uses the accountant’s definition of profits. It may seem paradoxical to students that reducing a firm’s accounting profits is “profitable” to its owners. However, if a company is allowed to write off increased depreciation, this lowers its current (accounting) profits and postpones its tax payments until the future year when the depreciation has all been taken. Since money currently in the hands of the firm is valuable to it, this is an advantage to the firm.

Question 2 In a purely physical sense, it takes longer to increase capacity than to decrease it in many industries, because it takes longer to build and install new capital than to scrap (or simply not use) existing capital. As far as economic considerations are concerned, however, in many circumstances the short run is likely to be longer for decreasing capacity than for increasing it. If prices are sufficient to cover variable costs but not total cost, then we are in a shortrun situation, and while

capacity will be reduced in the long run, it will be used in the short run. Indeed, this capacity may be operated for a very long time until it physically wears out. Because it often takes longer for existing plant to wear out than it does to build new plant, the full longrun adjustment that requires a decline in capacity will take longer to occur than the full longrun adjustment that requires an increase in capacity.

The short run in an industry need not be the same length for all firms in that industry.

“Short runs” will differ among firms if they have different kinds of fixed factors or if they acquired them at different times. For example, a recent entrant with automated equipment may have a much longer “short run” in response to a fall in demand than an older, less mechanized firm.

Since some fixed factors are fixed for decades, while R&D activities can respond to increases in demand relatively quickly, it is quite possible that very-longrun changes could occur while an industry was still in the process of a longrun adjustment to a change in demand.

Question 3 a) Diminishing returns are not involved. b) Both average and marginal “returns” are declining. c) This concerns the very long run and has nothing to do with the hypothesis of diminishing returns — instead, it relates to long-run increases in labour productivity. Students may need to be reminded that the law of diminishing returns is a shortrun phenomenon with respect to application of more of a variable factor to one or more fixed factors (and constant technology). d) If this is a correct observation (perhaps for some developing country), then marginal returns are negative and total returns are falling.

Question 4 Among the obvious inputs are teachers, buildings, books, computers, pencils, etc. Among some less obvious ones are efforts of the individuals involved, intellectual capacity, and so on. What factors are fixed is partly a function of the time span involved. From the individual’s point of view the intellectual equipment that he or she brings to the task will tend to be fixed, although some parts of human capital (such as study habits) can be acquired.

Where diminishing returns set in depends in part on how we define returns. If we mean “units of knowledge” that can be absorbed, and if we could measure such a concept, then learning studies would be relevant. Studies of learning tend to show that one’s rate of learning remains positive for a long time but that it is much higher in elementary school than in high school and college. If returns relate to effectiveness at various intellectual tasks, there may be increasing marginal (and average) returns for quite some time as more and more “bits” of knowledge can be related to each other in ways that make the person increasingly effective. Knowing twice as many bits of knowledge may make a person more than twice as effective — maybe even more than twice as wise!

Albert Einstein, of course, learned at a higher absolute rate than most people, but his learning was no doubt also subject to diminishing marginal returns, sooner or later.

Question 5 Note that the opportunity cost of remaining in business is not only the $70 000 in explicit expenses the carpenter incurs, but also the income from the furniture factory that the carpenter cannot receive because he has made the decision to operate his own shop. If this forgone salary is any larger than $30 000, then the carpenter should go back to the factory. Another way to say this is that his (accounting) profits are $30 000 per year when he runs his own business. So if his salary at his first job is higher than $30 000, he should go back to the factory.

Question 6 For economists, capacity means the level of production at which capital operates with the most economic efficiency. Obviously, one can operate above this point. For some firms, such as hospitals, it is important to be able to service more patients than usual on a moment's notice, so that the hospital may be frequently operating “above capacity”.

___________________________________ Chapter 8: Producers in the Long Run ____________________________________ Answers to Study Exercises Question 1 Cost minimization is necessary but not sufficient for profit maximization. To see this, note that profits (Π) equal revenues (R) minus costs (C), or Π=R–C For any given level of output, Q, profit maximization therefore requires that the difference between R(Q) and C(Q) be maximized. If the firm is not minimizing its costs, then profits canbe increased for any given R(Q). Thus cost minimization is necessary for profit maximization.

To see why cost minimization is not sufficient for profit maximization, imagine a situation in which the firm has minimized C(Q) for any given level of Q. But if the firm has not maximized R(Q) for that same level of Q, then profits will not be maximized.

Question 2 a) The ratios of marginal products to factor prices in this case are: K:

MPK/pK = 80/2 = 40

L:

MPL/pL = 20/10 = 2

This firm is not minimizing its costs; to do so it should use more K and less L. b) The ratios in this case are: K:

MPK/pK = 80/20 = 4

L:

MPL/pL = 20/5 = 4

This firm is minimizing its costs. No further substitution is required. c) The ratios in this case are: K:

MPK/pK = 80/40 = 2

L:

MPL/pL = 20/5 = 4

This firm is not minimizing its costs; to do so it should use less K and more L. Question 3 a) Both price changes are working in the same direction — increasing the price of labour relative to computers. Firms are predicted to substitute away from labour and toward computers, as has been occurring in many industries in the past several years. b) Buildings are predicted to get taller over time. This tendency toward highrise construction in big cities has in fact occurred.

c) The higher relative wages in Canada suggests that new plants will be built in the southern U.S. states and Canadian plants will be phased out. d) The rise in wages is predicted to cause firms to substitute away from labour toward other factors of production. Thus more capital-intensive production methods will be used.

Question 4 a) Due to the property of diminishing marginal returns, we know that as the use of the factor increases, ceteris paribus, the marginal product of the factor declines. Thus, in the table, as we move from method A to method G, the production method is using more capital and less labour.

Thus, production is becoming more capital intensive. b) Cost minimization requires the firm to adjust capital and labour use until the ratio of marginal products equals the ratio of factor prices. In this case, pK/pL = 8/4 = 2. So the cost-minimizing production method is method B, which has MPK = 12 and MPL = 6. c) For method A, MPK/MPL = 14/3 which exceeds 2. Thus the firm should use more K and less L. For methods C through G, MPK/MPL is less than 2. In all these cases the firm should use less K and more L. d) At the new factor prices, pK/pL = 4/6 = 0.67. The new cost-minimizing production method is D which uses more K and less L than method B. It makes sense that as the price of capital falls relative to the price of labour, the cost-minimizing firm substitutes toward capital and away from labour. This is the principle of substitution.

Question 5 a) The level of output for which this plant size is optimal in the short run is the level of output that minimizes short-run average unit costs. This output is Q1 which is the capacity of the plant.

Average costs at Q1 are equal to c1. b) In the long run, it is optimal to be on the long-run average cost curve. Thus, this plant size is optimal in the long run only for the level of output Q0, because at this point the SRATC curve is tangent to the LRAC curve. Unit costs at this level of output are c0. c) Unit costs are minimized in the short run at an output of Q1 and costs equal to c1. At that level of output, the lowest possible costs (in the long run) are c4. Why is c1 greater than c4? The answer is that the capital stock that is required to achieve c4 in the long run is larger than the capital stock that would deliver c1 in the short run. That is, the plant size corresponding to the SRATC curve is optimal only for a lower level of output (Q0). To produce the higher level Q1, costs would be minimized by expanding the capital stock and building a larger plant. But if you maintain the current small plant, costs are higher. d) To increase output to Q2 in the short run, the firm need only hire more units of the variable factors of production. The firm will therefore move along its SRATC curve and unit costs will be c3.

e) To increase output to Q2 in the long run, the firm would increase its plant size. For this larger plant size there would be an associated SRATC curve that would be tangent to the LRAC curve at Q2 units of output. Unit costs in the long run would be c2.

Question 6 a) With Plant #1 and output Q1, average costs are equal to c1. b) At Q1, the firm is experiencing decreasing costs because at this output level the LRAC curve is

downward sloping. c) The decreasing costs in (b) are due to economies of scale. d) Now consider output Q2 with Plant #2: i) ii) iii)

average costs are c2 the LRAC curve is horizontal, and so there are constant costs no further economies of scale

With output Q3 and Plant #3: i) ii) iii)

average costs are c3 the LRAC curve is upward sloping and so there are increasing costs diseconomies of scale

Question 7 a) Diseconomies of scale refers to what happens to unit costs as all factors of production are increased by the same proportion. For example, if the firm increases its capital stock and its labour force by 10 percent, what happens to unit costs? Since all factors are variable in this exercise, it is clearly a long-run concept. The most often cited explanation for diseconomies of scale (unit costs increasing as scale rises) is that after some point the costs associated with planning, managing, and monitoring the operations of a large firm start to rise. It simply becomes difficult to keep everything running smoothly, and unit costs rise as a result of organizational and management mistakes.

Diminishing marginal product refers to the relationship between changes in output and changes in one variable factor when other factors of production are being held constant. Since one or more factors are fixed in this exercise, this is clearly a short-run concept. b) See the diagram below that shows an LRAC curve as well as an SRATC curve. At output equal to Q*, long-run average costs are rising, indicating diseconomies of scale. Also, at Q* short-run average total costs are rising. Recall that SRATC rises if MC is above SRATC, and MC rises when there is diminishing marginal product of the variable factor. Thus, we draw MC rising at Q* so there is diminishing marginal returns.

Question 8 a) Economies of scale refers to what happens to unit costs as all factors of production are increased by the same proportion. For example, if the firm increases its capital stock and its labour force by 10 percent, what happens to unit costs? Since all factors are variable in this exercise, it is clearly a long-run concept. The most often cited explanation for economies of scale (unit costs decreasing as scale rises) is that as the scale of operation increases, the firm is better able to take advantage of the benefits of specialization and the division of labour. These productivity gains imply a reduction in unit costs.

The spreading of overhead refers to the behaviour of average fixed costs as the level of output rises. For a given amount of fixed costs (capital costs, product development costs, etc.), average fixed costs clearly decline as the level of output rises. Since this concept clearly relies on the existence of fixed costs (which means there are some fixed factors of production), it is clearly a short-run concept. This is an important reason for declining average total costs in the short run.

Even if average variable costs have started to rise due to diminishing marginal product, a large enough decline in AFC can still make ATC decline. b) See the diagram below that shows an LRAC curve as well as an SRATC curve. At output equal to Q*, long-run average costs are falling, indicating economies of scale. Also, at Q* short-run average total costs are falling. Note that even though MC is shown to be rising at Q*, and thus diminishing returns to the variable factor has already set in, SRATC is still falling. This must be due to the continued spreading of overhead, as reflected by an AFC curve that is falling as Q rises (not shown).

Question 9 a) See the diagram below. Economies of scale (long run) mean that we are on the downwardsloping portion of the LRAC curve. Diminishing marginal product (short run) means that we are on the upward-sloping portion of the SRATC curve. The left-hand diagram has the output level Q* which satisfies both conditions. b) See the diagram below. Diseconomies of scale (long run) mean that we are on the upward-sloping portion of the LRAC curve. But falling short-run total costs means that the effect from spreading one’s overhead is offsetting the falling marginal product of the variable factor. The right-hand diagram has the output level Q* which satisfies both conditions.

Question 10 a) Total cost is simply the cost of capital plus the cost of labour. The completed table is shown below.

Total Cost A B C D E F

110×$3 + 20×$6 = $330 + $120 = $450 90×$3 + 25×$6 = $270 + $150 = $420 70×$3 + 33×$6 = $210 + $198 = $408 50×$3 + 43×$6 = $150 + $258 = $408 30×$3 + 55×$6 = $90 + $330 = $420 10×$3 + 70×$6 = $30 + $420 = $450

b) Clearly, methods C and D are lower-cost production methods than any of the others. c) An isoquant is a curve that shows the various combinations of K and L that can be used to produce a given level of output — 500 tires per day in this case. The diagram below shows this particular isoquant. d) See the diagram below. The (absolute value of the) slope of the isocost line is the ratio of factor prices, pL/pK = 3/6 = 0.5. The cost-minimizing production method at these factor prices is either method C or D (since they are the same). Thus the isocost line passes through both points C and D in the diagram above, but lies below points A, B, E, and F. The interpretation is that production methods A, B, E, and F cannot be achieved at the same low cost as methods C and D. The horizontal and vertical intercepts of the isocost line are K = 408/6 = 68; and L = 408/3 = 136. e) If the price of labour rises from $3 to $5 per unit, a cost-minimizing firm will substitute away

from labour and toward capital. In the diagram above, this will be a movement up and to the left along the isoquant (we are told it still wants to produce 500 tires per day). With the new factor prices, it is easy to recompute the total costs in the table above. The isocost line becomes steeper—

its new slope will be 5/6 = 0.833. The cost-minimizing method of production is now method F, with a total cost of $470. (Remember that the rise in the price of labour makes all production methods more expensive, but the least expensive is now the most capital-intensive method.)

Answers to Discussion Questions Question 1 The key difference, taking the quote at face value, is that the American firms made an adjustment that we have classified as a longrun response, essentially maintaining their existing technology but substituting one factor (expensive domestic labour) for another (less expensive foreign labour). In contrast, the Japanese firms made an adjustment that we have classified as a verylongrun response, innovating to develop new technology that reduced their reliance on the expensive factor.

Question 2 Consider the profitmaximizing level of output. If the way in which that output is produced is not the leastcost way, then the firm is not maximizing its profit, because any reduction in costs would increase profits (since profit equals revenue minus costs). Thus, whatever output ultimately is chosen, it is a necessary condition of profit maximization that it be produced in the leastcost way.

If one’s objective is something other than profit maximization, there is nothing crucial about cost minimization. For example, an organization might choose an overly labourintensive method (in terms of economic efficiency) in order to provide employment for more people in times of unemployment.

Many objectives, however, can be best achieved by minimizing total costs. For example, a non-profit religious publisher operating under a budget constraint would maximize its dissemination of religious information by minimizing its cost of producing any material that it did decide to produce. With a given amount to spend, by minimizing unit costs it would be possible to produce more material.

Question 3 Consider any point on a longrun cost curve. This method of production uses some quantity of each factor. Suppose now that the quantity of capital is fixed at this quantity. The point is thus also a point on the shortrun cost curve using that quantity of capital. Changing the amounts of the variable factors used with this amount of capital now generates a shortrun cost curve along which the firm measures the effect on cost of changing output with the fixed quantity of capital.

Two points on the longrun cost curve represent different plant sizes. To move from the most efficient plant for producing 100 units to the most efficient plant for producing 110 units may mean a total redesign of the plant, not a marginal addition to the old plant.

The shortrun cost curve describes moving from one level of output to another level of output, while holding constant the amount of capital (plant size). The longrun cost curve concerns alternative designs of plant to achieve minimum costs of producing any specified output.

Question 4 Opposition may be expected from any group that will feel an immediate adverse impact. The following list is of only the most obvious groups: a) The labourers and labour unions whose labour is “saved”. b) Both workers and their families with respect to work safety, and consumers with respect to product safety. c) The answer here depends on what happens to government spending and other taxes as a result of the revenue loss due to the reduction in corporate taxes. For example, if government welfare programs were cut to maintain the budget balance, welfare recipients would be upset. If personal income taxes were increased, taxpayers that were not significant shareholders might be expected to object.

Question 5 The Canadian and U.S. health-care systems generally contain two kinds of inefficiency identified in the chapter. First, since we often hear that physicians practice defensive medicine, too many tests per visit are used. Also, the presence of full insurance means that a hospital patient might stay too many days, see too many doctors, and consume too many pills.

Both examples are ones of technical inefficiency. Recent arguments suggest that this inefficiency is worse in Canada than in the United States because neither the doctor nor the patient in Canada have the incentive to economize on resources, whereas for-profit hospitals and HMOs in the United States do have that incentive.

In terms of economic efficiency, which means choosing the least-cost production method, many economists argue that Canada’s single-insurer system reduces costs relative to the U.S. system in which many more resources are spent on hospital administration because of the presence of many competing insurance companies. This economic inefficiency of the U.S. system is often argued in terms of the much higher percentage of GDP that gets spent on health care in the U.S. relative to that in Canada.

Question 6 a) No. The lumber companies may well be profit maximizers (taking as given their capital stock and their technology). But when Asian demand falls off, even the profit-maximizing lumber companies may be making economic (or accounting) losses. If they could cut their costs, then they might be able to become profitable. There are three ways they might cut costs.

First, if they aren’t already being technically efficient, then by becoming technically efficient they can reduce costs. But if they were indeed maximizing their profits before, then they must have been technically efficient. Second, they could increase their plant size and move down their LRAC curve, reducing their unit costs. Third, they can innovate in such a way that they improve their productivity and reduce their costs. b) They could move down their LRAC curves, but this requires both time and money. In order for firms to want to spend the resources necessary to expand their production facilities, they

must be convinced that such investments will be profitable in the future. In this case, future profitability will depend on their expectations regarding the recovery of Asian demand.

Question 7 “Necessity is the mother of invention” simply captures the idea (in this context) that when firms are faced with a problem they need to solve, such as reducing their costs or improving the demand for their product, they will very often come up with a solution. The solution may be simple enough but, until they actually have a need to come up with it, the “solution” does not occur to the owners or managers. This type of behaviour is at the heart of the idea that firms often innovate their way around increases in factor prices or the unavailability of certain factors of production.

______________________________ Chapter 9: Competitive Markets ______________________________ Answers to Study Exercises Question 1 a) perfectly elastic (horizontal) b) marginal revenue; average revenue c) price; quantity; total revenue; output; the change in total revenue; the change in output d) fixed cost Question 2 a) average variable costs b) shut down and exit the industry c) reduce d) equal; maximized e) greater than; increase Question 3 a) AVC

b) ATC; AVC

c) ATC; enter

Question 4 a) Let the equilibrium market price be p*. Any firm that tried to charge a higher price would make no sales whatsoever, since consumers would simply make their purchases from other (lower-price) sellers. b) Each firm can sell as much as it wants at the price p*. Thus selling at a lower price would not increase sales but would reduce profits. So no firm has the incentive to charge any price below p*. c) Each individual firm is very small relative to the market (check Figure 9-1 again and compare the units on the quantity axes in the two parts of the figure). Thus for any change in output that is realistic for the firm, there would be no significant or noticeable effect on the industry level of output and thus no significant effect on the market price. Thus, each firm sees that it can sell any reasonable amount at the given market price. (Read Applying Economic Concepts 9-1 to see an application — we show that even though the market demand for wheat is quite inelastic, the demand for any individual farmer’s wheat is almost perfectly elastic.)

Question 5

a) The completed table is shown below. Recall that total revenue is equal to price times quantity.

Price ($)

Quantity

Total Revenue ($)

Average Revenue ($)

Marginal Revenue ($)

2 2 2 2 2

150 175 200 225 250

300 350 400 450 500

300/150 = 2 350/175 = 2 400/200 = 2 450/225 = 2 500/250 = 2

50/25 = 2 50/25 = 2 50/25 = 2 50/25 = 2

b) See the table above. Average revenue is equal to total revenue divided by quantity. Marginal revenue is equal to the change in total revenue divided by the change in quantity; it is computed using the change from one row to the next. c) A perfectly competitive firm is a price taker. It can sell any amount at the given market price, which in this case is $2. Since every unit it sells is sold at the price of $2, it follows that its average revenue is $2 but also its marginal revenue is $2. d) See the figure below. Note that the vertical scales on the two diagrams are different, though both are measured in dollars. The slope of the TR curve is the change in total revenue divided by the change in quantity, ∆TR/∆Q. This is marginal revenue and is equal to 2.

Question 6 a) The completed table is shown below. The firm’s supply curve is determined by its MC curve above the minimum of the AVC curve. Profits are determined by the difference between price and average total cost, ATC. Price ($) Firm’s Output

Is price > ATC?

Is Price > AVC?

Profits positive?

3

No

No

No profits

Do not produce

4 5 6 7 8 9 10

130 units 145 units 155 units 165 units 175 units 185 units 195 units

No No No Yes Yes Yes Yes

Price = AVC Yes Yes Yes Yes Yes Yes

Negative profits Negative profits Negative profits Positive profits Positive profits Positive profits Positive profits

b) The firm shuts down when the market price falls below the minimum of the AVC curve. In this case, when the price falls below $4, the firm will shut down. The reason is that when price < AVC, the firm cannot cover even its variable costs, and so the firm is better off to close down rather than produce and increase its losses. c) The firm’s supply curve is its MC curve above the minimum point of AVC. There will be no production when price < AVC, for the reason given in part (b). For prices above AVC, profit maximization requires the firm to produce until marginal revenue (which equals market price) is equal to marginal cost. Thus the MC curve above the AVC curve is the firm’s supply curve.

Question 7 a) Total industry supply at each price is simply equal to the sum of the quantities supplied by all of the individual firms. The completed table is shown below.

Market price ($)

Industry Quantity Supplied

2.50 3.00 3.50 4.00 4.50 5.00 5.50 6.00

100 + 0 + 0 = 100 125 + 0 + 0 = 125 150 + 100 + 0 = 250 175 + 150 + 0 = 325 200 + 200 + 100 = 500 225 + 250 + 175 = 650 250 + 300 + 250 = 800 275 + 350 + 325 = 950

b) The scale diagrams are shown below. Note that the vertical scales are the same in all four figures, but the horizontal axis for the Industry figure is different from the other three figures.

c) Firm B produces no output at prices of $3.00 or below because those prices do not cover Firm B’s average

variable costs. Similarly for Firm C and prices at or below $4.00.

Question 8 a) The diagrams are shown below. The left-hand diagram shows the initial industry equilibrium at price p0 and quantity Q0.

b) The right-hand diagram above shows a typical firm when the industry is in long-run equilibrium. The typical firm is producing q0 units of output. It is not only earning zero economic profits (p = SRATC), but it also has no unexploited economies of scale — that is, it is at the minimum of its LRAC curve. c) See the diagram above. The increase in demand for barley shifts the demand curve to D′ and raises the short-run equilibrium price to p1. The increase in market price causes each firm to increase its own output along its MC curve, to output q1 for the typical firm shown. The profits at this new high price are shown by the shaded area. d) The positive profit in part (c) leads other firms to enter this industry. As new barley farmers enter the industry, the industry supply curve shifts to the right and reduces the equilibrium market price. Entry continues until existing firms are not making any economic profits. As long as technology has not changed, firms’ cost curves do not shift and so supply shifts eventually to S′, where the market price has returned to p0. At this point, the typical firms are again making zero economic profits. (The assumption of a constant-cost industry ensures that the change in scale of the industry does not lead to changes in the firms’ cost curves.)

Question 9 a) With a constant-cost industry, the statement is correct. In the left-hand diagram below, suppose that E 0 is the initial long-run equilibrium. If there is an increase in demand to D′, the short-run equilibrium price will rise, and so both demand and supply determine the price. But this high price will generate positive profits that, in turn, will cause new firms to enter this industry. The new entry will shift the supply curve to S′ and price will fall back again.

Because it is a constant-cost industry, the scale of the industry does not affect firms’ costs, so the new long-run, zero-profit equilibrium E2 will be at the initial price. Thus demand and supply both determine price in the short run but only supply (technology) determines price in the long run.

b) With an increasing-cost industry, the statement is false. In the right-hand diagram above, suppose that E0 is the initial long-run equilibrium. If there is an increase in demand to D′, the short-run equilibrium price will rise, and so both demand and supply determine the price. But this high price will generate positive profits that, in turn, will cause new firms to enter this industry. The new entry will shift the supply curve to S′ and price will fall back again.

Because it is an increasing-cost industry, the scale of the industry affects firms’ costs, driving them up as the industry expands. So the new long-run, zero-profit equilibrium E2 will be at a higher price than the initial price.

Thus, unlike in the constant-cost case in (a), demand plays a role in the long run because an increase in demand, by increasing the size of the industry, will affect costs and thus the long-run equilibrium price.

Answers to Discussion Questions Question 1 It is important for students to understand that impersonal market forces can produce this result.

Indeed, this will always be the case in perfect competition since a firm that charges more than the going market price will sell nothing. Thus the closer is an industry to perfect competition, the more likely it is that price dispersion will be minimal. (Of course, in a differentiated oligopoly, very similar prices might indicate a lack of competition –– but they could also indicate intense price competition with all price cuts being followed by all firms.)

Question 2 This is a good question to help students understand which real-world observations about markets are consistent with perfect competition. It also helps to reinforce the important distinction between a competitive market and competitive behaviour.

Item (c) is plainly inconsistent, since price takers would not advertise. Item (e) is probably inconsistent since the two largest firms will have significant market power. However, if the products really are identical and MES is large, then this industry could still be competitive.

As for the others, (a) is not inconsistent, since different methods will always be found when embodied changes in technological knowledge are occurring. Item (b) is also consistent since it

is the trade association’s attempt to shift the market demand curve rather than an individual firm’s attempt to shift its own demand curve. Fact (d) is not necessarily inconsistent since it is quite possible that 24 firms selling a homogeneous product could each act as if they were price takers. Item (f) is not inconsistent since large profits may merely mean that an increase in demand has left existing firms earning profits in an industry that is not yet in longrun equilibrium where entry will have eliminated the profits.

Question 3 Competitive behaviour can be expected in manufacturing, parts of agriculture, wholesale and retail trades, and criminal activity. There is also competitive behaviour in transportation and public utilities, but where scale economies dictate one or even a few firms, monopoly or collusive behaviour may be common in the absence of government regulation. Competitive structure can be expected in parts of agriculture, and in many wholesale trades. In retailing it might occur as long as there are enough outlets for each different product.

Question 4 The second-hand price of older computers depends on their productivity relative to new machines.

If they are only half as productive as new computers they will, ceteris paribus, sell for half the price of a new machine. The economic value of machines that are no longer used is zero. If the unused computers had any positive economic value they would be used (or would be sold to someone who would use them).

Question 5 a) Entry is probably restricted although it is possible (if unlikely) that demand has continued to rise at a rate that has been unanticipated over the last two decades. It could also mean that because of exceptional risk in the industry, accounting profits are high although economic profits are zero. b) This tells us nothing. This is consistent with a perfectly competitive industry in which technological change is increasing the capacity of existing firms at the same rate that demand is growing (which includes the special case of zero change). Students might find it instructive to draw the case in which cost changes offset a demand shift so that the number of firms in the industry in longrun equilibrium does not change. c) It looks like there has been quite a bit of new entry in recent years. d) If existing plants are using equipment of very different vintages, it suggests heavy capital, long useful life, and possibly low variable costs. It also suggests that firms are able to expand their operations (new equipment) and in this sense there is relatively easy entry. e) This plainly suggests slow exit, possibly for the same reasons as in (d), but it says nothing about ease of entry.

Question 6 As the agricultural industry expands, there is more demand for factor inputs such as fertilizer and farm machinery. If the farmmachinery industry has unexploited scale economies, then the expansion of demand in that industry permits firms to build larger plants and thus reduce their average costs (and eventually prices). As the price of farm machinery falls, the cost curves in the agricultural industry shift downward. Thus, unexploited scale economies in the farmmachinery industry can be the “external scale economies” for the agricultural industry that lead to its being a decliningcost industry. Note that this example requires imperfect competition in the farmmachinery industry since it relied on the existence of unexploited scale economies.

_____________________ Chapter 10: Monopoly _____________________ Answers to Study Exercise Question 1 a) horizontal; downward sloping b) marginal revenue; marginal cost; equals; is greater than c) greater than d) less than Question 2 a) Total revenue (along the demand curve) is equal to price times quantity demanded. Average revenue is equal to total revenue divided by quantity. So note that average revenue is simply equal to price. The completed table is shown below.

Price ($)

Quantity

Total Revenue ($)

Average Revenue ($)

Marginal Revenue ($)

20 18 16 14 12 10 8 6 4

100 125 150 175 200 225 250 275 300

20 × 100 = 2000 18 × 125 = 2250 16 × 150 = 2400 14 × 175 = 2450 12 × 200 = 2400 10 × 225 = 2250 8 × 250 = 2000 6 × 275 = 1650 4 × 300 = 1200

2000/100 = 20 2250/125 = 18 2400/150 = 16 2450/175 = 14 2400/200 = 12 2250/225 = 10 2000/250 = 8 1650/275 = 6 1200/300 = 4

250/25 = 10 150/25 = 6 50/25 = 2 –50/25 = –2 –150/25 = –6 –250/25 = –10 –350/25 = –14 –450/25 = –18

b) Marginal revenue is equal to the change in total revenue divided by the change in quantity. In the table above it is shown for a change from one row to the next. For any given quantity, marginal revenue is less than price. This is because in order to sell more output, price on all units must fall.

Thus the price on the new units is not equal to marginal revenue — we must subtract from this new price the amount that we lose on the previous units by having to reduce their price. c) The scale diagram is shown below. Note that the MR curve is plotted at the midpoint of the intervals of quantity demanded. d) The scale diagram is shown below. When TR reaches its maximum, an increase in quantity (and a reduction in price) leads to no change in total revenue. Thus marginal revenue at this point is exactly zero. At larger quantities than this, marginal revenue is negative.

Question 3 a) The profit-maximizing quantity is where MR=MC, at 400 games per week. The profitmaximizing price is $60 per game. b) The ATC at Q = 400 is $30 per game. c) At the profit-maximizing price and quantity, the profit is given by the rectangle defined by points acef. The total profit is ($30 per game) × (400 games per week) = $12 000 per week.

Question 4 a) For any firm, profits are maximized at that level of output where marginal revenue equals marginal cost. In the diagram, MR equals MC at output of Q0. At this level of output, the monopolist charges the price p4. b) Profits per unit are equal to price minus average total cost. Thus the profits are the rectangle defined by the points p2p4BC. Since price exceeds average total cost, the monopolist’s profits are positive. c) Consumer surplus is the triangle defined by the points p4AB. As always, it is the area below the demand curve and above the price line. d) If the industry were instead a perfectly competitive one, equilibrium price and quantity would be determined by the intersection of demand and supply, where the industry supply curve would be given by the summation of the firms’ MC curves. Thus point D would be the competitive equilibrium, with price p3 and quantity Q2. e) Consumer surplus in part (d) would be the triangle defined by points p3AD, the area under the demand curve and above the (competitive) price line.

Question 5 a) The diagram is shown below. The demand curve and its associated marginal revenue curve are conventional. The monopolist’s MC curve is the horizontal axis, since we are told that the firm has no variable costs whatsoever.

b) The profitmaximizing output is where MR = MC. But in this case it is where MR equals zero since MC is always equal to zero in this example. In the diagram the profit-maximizing output is Q* and the price is p*. c) The marginal value of the water to society is given by the current market price, p*. The marginal cost to society is zero. Thus allocative efficiency is not achieved with this outcome, as is usual in the case of a monopolist. The problem is that producing more than Q* would benefit society by more than it would cost society, and so society as a whole would be better off if the price were lower and quantity were higher. The monopolist (only part of society) is better off to restrict output and raise price.

Question 6 a) The two diagrams are shown below. Note that the horizontal scale is different on the two diagrams. The left-hand diagram shows industry output, Q; the right-hand diagram shows the firm’s level of output, q.

b) If the farmers could successfully collude to restrict output, they would collectively act like a monopolist, choosing output such that MR equals MC. They would collectively produce output equal to QM and charge price pM. c) In the right-hand diagram, we see that the cartel’s restriction of output requires the typical farmer to produce output equal to only qM. (Since QM is roughly one-half of Q0, it must be the case that for the typical firm qM is roughly half of q0, as shown in the right-hand diagram.) The high price of pM means that the typical farmer earns profits given by the light shaded area. d) Yes, it is definitely profitable for each individual farmer to increase its output rather to leave output at qM. Given that all other farmers are restricting their output, the industry price of pM becomes each individual farmer’s MR curve. But MC is much lower than pM, so each individual farmer would like to cheat on the agreement and produce more. e) Given the cartel price of pM, each individual farmer has the incentive to increase output all the way to q*, where the cartel price is equal to MC. In this case, profits for the individual cheating farmer would be the sum of the two shaded areas.

f) If all firms cheated in this way, the industry output would rise significantly and the market price would fall below the cartel price pM. This is exactly why cartels tend to be unstable; all individual cartel members have the incentive to cheat on the agreement, and this cheating essentially eliminates the output-restricting behaviour of the cartel.

Question 7 Remember that price differences are discriminatory only if not justified by cost differences. a) It seems clear that airline pricing is discriminatory, discriminating “against” business travellers who travel mostly during the week and have inelastic demands. b) The price differences between business class and economy class are partly discriminatory but are also partly based on cost differences. For example, the use of 50 percent more space would appear to justify prices 50 percent higher. But space occupied is not the only cost. It would be surprising, however, if there were not a good bit of price discrimination included in businessclass fares, reflecting the greater willingness to pay on the part of those having expense accounts, or those who like the snob appeal. c) These price differences are clearly discriminatory. The sales personnel are trying to extract as much consumer surplus as possible from each consumer. For those customers that like to bargain and show that they are prepared to walk out the door and purchase from other firms, a lower price is surely available. But for those who dislike bargaining and want to make a quick purchase, their inelastic demand will result in a higher price being paid. In this case of “hurdle pricing”, the hurdle that must be cleared in order to get the low price is to actively bargain with the sales personnel. d) We cannot tell without knowing how the costs differ in economics and in law — which they probably do to some extent. Given that law graduates can expect higher incomes than economics graduates, one would expect the market solution to be to extract some of the consumer surplus for the suppliers of the training.

Question 8 a) With perfect price discrimination, the monopolist would choose output where the demand curve intersects the MC curve, and so would sell 600 games per week. The price on the last game would be $40. b) Without price discrimination, the single-price monopoly output yields consumer surplus given by the triangle cde. c) With perfect price discrimination, the consumer surplus is zero because each unit is sold at the highest price consumers are willing to pay for that unit (the height of the demand curve). d) It is difficult to practise perfect price discrimination because the monopolist would need to know consumers’ willingness to pay for every unit and would also have to be able to prevent arbitrage.

More likely forms of price discrimination might include: • different prices for different customer "groups" such as business vs. leisure • different price on different days of the week • different prices for different times of the day

• “bulk purchase” discounts in which customers buy several games in advance for a lower price per game than is available when customers buy a single game Question 9 a) The two scale diagrams are shown below. Note that both the vertical and horizontal scales are different on the two diagrams.

b) The MR curves are also shown in the diagrams above. Notice that the horizontal intercept of the MR curve is exactly half of that for the demand curve, and that the vertical intercept is the same as that for the demand curve. c) The MC curve is horizontal at $15 in both diagrams. The horizontal MC curve reflects the assumption that the scale of production does not affect Levi’s cost for producing an additional unit (though any fixed costs would imply that average costs decline as output rises). d) To solve for the profit-maximizing level of output in each market segment, we must set MR = MC in each segment separately. Since the markets are completely segmented, this problem is just like having two independent monopoly problems, the solution to each being to have MR = MC. Keeping in mind that the MR curve is twice as steep and has half the horizontal intercept as its associated straight-line demand curve, the equations for the two MR curves are: QD = 75 – (0.5)MRE and

QD = 125 – 2MRA

For the European market, we set MRE = 15. This gives QD = 75 – 7.5 = 67.5. At this quantity, the price in Europe is given by the demand curve (QD = 150 – p) which gives p* = 82.5. For the American market, we set MRA =15. This gives QD = 125 – 30 = 95. At this quantity, the price in America is given by the demand curve (QD = 250 – 4p) which gives p* = 38.75. e) Own-price elasticity of demand at the profit-maximizing point is given by: η = (∆Q/∆p)×(p/Q) In Europe, the measure of elasticity is ηE = (–1) × (82.5/67.5) = –1.22. In America, the measure of elasticity is ηA = (–4) × (38.75/95) = –1.63. Thus American demand is more elastic than European demand and, as we explained in the text, the price in America is therefore lower than the price in Europe.

Question 10 a) Arbitrage is prevented because the product (movie viewing) is a service rather than a good; an “adult” can not purchase a “senior” ticket and then see the movie because the ticket will easily be checked at the theatre entrance. Without price discrimination, seniors would be worse off and adults would be better off because the single price would probably be between the two discriminatory prices. b) This is “hurdle pricing”, where the hurdle that must be cleared to get the low price is to wait 612 months before buying the book. Impatient people (inelastic demand) will buy the hardcover book at a high price; patient people (elastic demand) will wait and buy the paperback book at a low price. Note that in this case the products are also slightly different, and thus the price differential partly reflects differences in cost (hardcover books are more expensive to produce than paperbacks). It is difficult to determine who would be better off and worse off without price discrimination in this case because there is a difference in the products. If publishers were forced to sell only one type of book (at a single price), then the single price would likely be between the hardcover and paperback prices. c) This is “hurdle pricing” where the hurdle is to reveal that you are prepared to haggle. Each side of the transaction (buyer and seller) typically tries to extract as much surplus as possible from the other side, and the relative success in haggling determines the final price. It is not clear what a single price (no price discrimination) means in this situation, since most garage sales have only one unit of a large number of goods. However, you might wonder what prices would be like if garagesale operators committed to posting a single price for each good and not haggling. That single posted price would probably be less than what would otherwise be the “starting” price, but greater than what the final (after haggling) price would be. Thus successful hagglers would be worse off with the single posted price, and poor hagglers would be better off. d) Typical business travellers do not want to stay over the Saturday night whereas typical nonbusiness travellers do. The former have less elastic demands, and so this pricing scheme is aimed at segmenting the two groups of customers. Without price discrimination, the single price would probably be less than the discriminatory business price and greater than the discriminatory nonbusiness price. Thus business travellers would be better off and non-business travellers would be worse off without the price discrimination.

Answers to Discussion Questions Question 1 Though the solitary professor clearly has some power over students who wish to take economics at that school, that individual is in competition for students who can take other subjects, or who can study economics at other institutions. Obviously, the professor cannot exact any price from students. But nor can a monopoly firm selling a welldefined product exact any price from consumers. The degree of monopoly power depends in both cases on the elasticity of demand for the product, which in this case depends on the ability of the students to substitute away from the economics course and take other courses instead.

Increasing the number of professors to three will give students a competitive choice only if the three professors act independently and with different standards. If they adopt a common policy (tacitly or overtly), they may provide no increase in choice on the matter covered. Of course, being different people with different personalities, they can not help but provide some “product differentiation”.

Question 2 Presumably one would like to monopolize the one with the largest potential monopoly profits, which depend on both volume of sales and profit per unit. These depend on level of demand and closeness of substitutes. Licorice candy is a poor candidate on both grounds. Coal has an enormous dollar volume of sales, but profits per unit have tended historically to be kept small by competition from other fuels. Large supplies of coal throughout the world would tend to limit the monopoly mark-up to the amount of transport charges per ton from other producing countries (unless the government cooperated by imposing import restrictions). Outboard motors have no close substitute, but the size of the market is relatively smaller than that of coal or copper wire. Few local newspapers are highly profitable these days. Copper wire, despite the competition of aluminium, is probably the second best choice after coal. (The answers are obviously not clear-cut — all we want students to do is to recognize the issues.)

Consumers might object most strenuously to a different one than the one that a profit maximizer would wish to monopolize, for either of two main reasons. First, their own purchase plans are important — for example, a particular consumer might never intend to buy an outboard motor but might be a building contractor who purchases lots of copper wire and who dotes on licorice. Second, non-economic considerations also matter — for example, competition in newspapers is believed by many to be essential to their political freedom.

Question 3 One would certainly expect movie prices to be higher in Monopolia in the short run. Whether they would be higher in the long run will depend on whether entry occurs in the monopoly town. (The above answer assumes that 100 km is too far for people to travel to avoid the higher prices.)

Though a movie in one city is a different product than the same movie in a different location from the point of view of moviegoers, it may not be to distributors. The two issues that students should recognize as important whenever price discrimination is debated are whether the products are the

same and whether the differences in prices can be explained by differences in cost. In this case, since there is no obvious difference in costs, the price differential should probably be viewed as price discrimination.

Question 4 We need to know if differences in price are associated with differences in cost. For example, if marginal costs for airlines are lower in winter because of empty seats on regularly scheduled flights, lower airline fares may be non-discriminatory. Similar considerations might apply in each case. Of course, it is not enough that there be some cost differences; the differences must be sufficient to account for the price differences.

Question 5 This can be considered price discrimination since Acme is selling the same product to different customers at different prices. The department store is able to do this since, by requiring customers who want the discount to bring in some old luggage, they can segment the market. And since one group is willing to bring in old luggage and the other is not, the two classes of customers obviously have different elasticities of demand –– those who bring in the suitcases have more elastic demand.

Finally, although the store cannot prevent resale, this activity would be relatively costly for customers to undertake, given the price of luggage. Another familiar example of the same type of price discrimination is the “coupon special” that frequently appears in most grocery stores. People who bother to clip the coupons from their weekly grocery-store flyers (those with elastic demand) get better deals than those who can’t be bothered to spend the time (those with inelastic demand).

Question 6 This is a classic question (and a good example) of why cartels tend to break down. a) The article suggests that the cartel (the Association of Coffee Producing Countries) will reduce shipments by about 14 percent. With a relatively inelastic world demand for coffee (at least in the short run), this could increase coffee prices and thus revenues for these countries quite considerably. But given this higher price, each country within the cartel has the incentive to (quietly) increase their own shipments and thus benefit even more than the other cartel members. With each cartel member facing this temptation, it would not be surprising that one or more of them succumb, thus driving down world coffee prices and effectively ending the cartel. b) By 2002 the price was $1 per pound, just the same as before the cartel was created. So it appears that the attempt to restrict output did not help the coffee producers. Although, keep in mind that we do not know what the price would have been in the absence of the cartel ─ perhaps a reduction in world demand would have driven the price well below $1, and the actions of the cartel were successful in keep the price from dropping. However, in the absence of any evidence that there was a reduction in the demand for coffee, one is tempted to conclude that the actions of the cartel were not successful.

_____________________________________________________ Chapter 11: Imperfect Competition and Strategic Behaviour ______________________________________________________ Answers to Study Exercises Question 1 a) monopolistic competition, oligopoly with differentiated products, monopoly b) monopolistic competition, oligopoly with differentiated products, monopoly c) perfect competition d) monopoly and oligopoly if there are sufficient entry barriers e) perfect competition, some oligopoly (those producing commodities such as newsprint or steel) f) monopolistic competition, oligopoly g) all profit-maximizing firms h) perfect competition i) perfect competition, monopolistic competition j) monopolistic competition, often oligopoly Question 2 a) The (domestic) four-firm concentration ratio is equal to the sales of the four largest firms expressed as a fraction of the total industry sales. The concentration ratios are: Forestry products: (185 + 167 + 98 + 47)/550 = 497/550 = 90.3% Chemicals: (27 + 24 + 9 + 4)/172 = 64/172 = 37.2% Women’s clothing: (6 + 5 + 4 + 2)/94 = 17/94 = 18.1% Pharmaceuticals: (44 + 37 + 22 + 19)/297 = 122/297 = 41.1% b) The most concentrated industry is Forestry products, and then Pharmaceuticals, followed by Chemicals and then Women’s clothing. c) If Canada trades with the world in these industries, then the relevant market must be taken to be the world market.

In this case, the concentration ratios will be lower than in part (a). The modified concentration ratios are: Forestry products: 497/1368 = 36.3% Chemicals: 64/2452 = 2.6% Women’s clothing: 17/3688 = 0.5% Pharmaceuticals: 122/2135 = 5.7%

Question 3 a) The missing columns are completed below.

Total Revenue 30 000 31 900 33 600 35 100 36 400 37 500 38 400 39 100 39 600

Marginal Revenue 19 17 15 13 11 9 7 5

Average Total Cost 25 23.6 22.7 21.9 21.4 21.5 21.9 22.6 23.9

Marginal Cost 10 12 13 15 22 28 35 45

Profit (per unit) 5 5.4 5.3 5.1 4.6 3.5 2.1 0.4 -1.9

b) The curves are plotted in the diagram below.

c) The profit-maximizing number of car washes is 1300 per month. This is where the MR and MC curves intersect. d) The profit-maximizing price is $27 per car wash. e) Profits are given by total revenues minus total costs, or $6600 per month.

f) Product differentiation might occur in any number of ways, including: • offering free coffee and newspapers for customers while they wait • offering nice lounges for customers while they wait • locating nearby to stores that customers like to shop in while they wait

Question 4 In both the short run and the long run, the firm is profit maximizing by choosing output where marginal revenue equals marginal cost. In the short run, the firm is shown to have positive profits (since at Q* price exceeds ATC).

These profits attract new firms to enter the industry. As new firms enter, the demand curve shifts to the left and becomes flatter, because total industry output must now be divided among a larger number of firms. Entry occurs until firms have zero profit in the long-run equilibrium, shown as a tangency between ATC and the demand curve.

Question 5 a) The only difference between perfectly competitive and monopolistically competitive markets is that in the latter each firm produces a differentiated product, whereas in the former all firms produce an identical product. The product differentiation gives each firm some market power (a downward-sloping demand curve), but the availability of many close substitutes ensures that demand is quite elastic. b) As is true for any firm, profits are maximized at that level of output where MR = MC. In the figure, this occurs at point c. c) Given the output defined in part (b), the price is given by point a on the demand curve. Thus the firm charges price equal to p0. Since this price is greater than average total costs (given by point b), the firm is earning positive economic profits. Profits are shown by the rectangle defined by p1p0ab. d) There is free entry and exit in monopolistically competitive industries. The positive profits earned in part (c) will attract new entry. As new firms enter the industry, existing firms will find demand for their own product declining, reducing their profits.

Question 6 a) Free entry and exit implies that firms will enter if existing firms are making positive profits, and this entry will dissipate those profits. Conversely, firms will exit if they are making negative profits (losses), and the exit will increase the profits (reduce the losses) of the remaining firms. Thus, firms in the long-run equilibrium of a

monopolistically competitive industry will have zero profits. At point A, price is equal to average total costs, and so profits are zero. b) Point B is the long-run equilibrium market price that would exist if the industry were perfectly competitive, since it is at the minimum of the average cost curve. c) This firm’s long-run equilibrium price, pA, is greater than the price that minimizes its average costs, and in this sense there is an inefficiency compared to perfect competition. But as we argued in the text, the higher unit cost is the price we pay for greater product diversity, and it may well be the case that consumers benefit more from the diversity than they lose from the higher prices, in which case we could not say that monopolistic competition is unambiguously worse than perfect competition.

Question 7 a) Car repair. There are many small car repair centres, each of which offers slightly differentiated service, guarantees, etc. There is unlikely to be much strategic behaviour, except perhaps among those located very closely together. Entry and exit is easy. Monopolistic competition rather than oligopoly. b) Haircuts. Lots of product differentiation here, especially in terms of the individual barber or stylist that provides the service. Like car repair, location is probably a very important factor to the consumer. Entry and exit is easy.

Monopolistic competition rather than oligopoly. c) Dry cleaning. There is less product differentiation here than in the first two examples, but location is still very important. Entry and exit are easy. Because non-price competition may be less important, there may be some strategic behaviour between dry cleaners that are located close to one another. But otherwise monopolistic competition is probably a better description. d) Soft drinks. There are a very small number of firms that produce the vast majority of soft drinks. There is brand proliferation and massive advertising that makes large entry barriers. There is lots of room for strategic behaviour in pricing, special deals, and promotions. This is a classic case of oligopoly. e) Breakfast cereals. Exactly the same reasoning as for soft drinks. Oligopoly. f) Restaurant meals. There is lots of product differentiation, and relatively easy entry and exit. But location is also very important, and so there may be strategic behaviour within localized markets. But the large number of restaurants within most localities suggests limited strategic behaviour, and so monopolistic competition is a good description. g) Automobiles. There is a small number of producers and lots of product differentiation. Advertising is very important. Lots of strategic behaviour in terms of new model features and pricing. Definitely oligopoly.

Question 8 a) There are two Nash equilibria in this game. One is that both firms bid $10 000. The other is that both bid $5000.

In both cases, neither firm would want to change its behaviour given the behaviour of the other firm. b) See above. c) If the two firms could cooperate, they would clearly both prefer the high-bid equilibrium to the low-bid equilibrium, for the simple reason that they both get a higher payoff in the high-bid case. So we would predict cooperation (collusion) to lead to the outcome that both firms bid $10 000 and end up sharing the contract.

Question 9 a) If both Honda and Toyota build a large plant and produce many cars, the industry quantity will be high and the price will be low. Thus profits for both firms are low (414 million each). If both build only a small plant, industry output will be low and price will be high; in this case both firms earn high profits ($20 million each). The third possibility is that one firm builds a small plant and the other builds a large plant. In this case, industry output is “medium” and price is also “medium”. But the firm that builds the large plant gets the most profit because it

dominates the market and benefits from the other firm’s restriction of output that keeps market price higher than otherwise. b) The cooperative outcome is that the two firms agree to build small plants, thus keeping total output low and prices high. The problem is that once such an agreement is made, each firm has an incentive to “cheat” by building a large plant instead. A binding contract might help ─ except that it would almost certainly be against the law! c) Honda’s best action is to build a large plant ─ independent of what Toyota does. Thus building a large plant is a dominant strategy for Honda. d) Toyota’s best action is to build a large plant ─ independent of what Honda does. Thus building a large plant is a dominant strategy for Toyota. e) The non-cooperative outcome is that both firms build a large plant. This is the only Nash Equilibrium in this game.

Answers to Discussion Questions Question 1 No doubt all customers could be served with gas and drugs with fewer outlets for these products — but so could everyone be clothed with fewer types of clothing, or fed with fewer types of food products. Given that some of the markets for these outlets are fairly local, reducing the number of outlets might reduce competition and raise prices. On the other hand, if reducing the number of outlets allowed each outlet to produce more with the same capital investment (excess capacity reduced), there is a social gain in reduced costs to be set against the loss of some diversity. The saving also needs to be quantified. How many cents, for example, could be cut off the retail price of gasoline if the number of gas stations in a big city were cut by 20 percent? Students should see that establishing a qualitative case is not enough. The magnitude of the gains needs to be estimated in order to set them against the costs of achieving those gains.

Question 2 a) Textbooks of a particular type, such as firstyear university economics texts, are a differentiated product. There is freedom of entry and unexploited economies of scale –– the fixed costs of writing, editing, and printing can be spread over more and more books with only a relatively small variable cost. One would expect, therefore, that the return (royalties plus any reputation effects) would just repay the opportunity cost of each academic’s time in writing his or her book, and that entry would continue until the available market was so divided among competing texts that benefits just equal costs. Of course, the occasional superb writers would gain economic rents on their scarce talents. So as a first approximation for beginning students, the industry looks close to monopolistically competitive.

Upon further examination, however, it is clear that the various books are distributed in a manydimensional characteristic space (one dimension being the continuum from the “soft” to the “hard” ends of the economics textbook market) with a few close competitors and many more distant ones. Chamberlin’s symmetry assumption therefore will not apply. The entry of a successful new book into the “soft” end of the market will seriously affect the demands for other soft books, will less affect the demands for middlerange books, and only slightly affect the demands for books at the “hard” end of the market. Thus a model of overlapping oligopolies, distributed in characteristic space, may be more appropriate than the model of monopolistic competition.

b) Again, a model of monopolistic competition will get quite far with this one. Colleges and universities, however, have larger fixed costs than textbooks. Again, a model of overlapping oligopolies with enough indivisibilities that profits might persist in the long run may be appropriate. c) Given the evidence that the MES in cigarettes is small, the industry might have become monopolistically competitive. However, most brands are produced by a few firms who do much to discourage or prevent entry. The cigarette industry is an oligopoly producing a differentiated commodity –– as are most consumer goods industries. In many cases, however, scale effects make the industry naturally oligopolistic. Where the MES is small, as with cigarettes, however, the puzzle is why the industry evolved as an oligopoly rather than as a case of (large group) monopolistic competition. d) Free entry, high fixed costs, and a differentiated product characterize the restaurant market.

Differentiation according to spatial location and quality make the symmetry assumption dubious.

The high fixed costs and the spatial location may mean that there are significant pure profits because of the lumpiness of entry in any particular niche of the market. e) Much the same as restaurants.

Question 3 This question is designed to get students thinking about just how subtle are the substitution possibilities that lie behind one aspect of the economy’s reaction to a price shock.

In many poorer countries, consumers shifted from motorcycles and cheap cars to bicycles to satisfy some or all of their transport needs. Even in richer countries some people were induced to use bicycles rather than cars for some shorter journeys. Car pools, by raising the average number of persons transported per car, reduced the total demand for gasoline to accomplish a given amount of transportation. Moving closer to work reduced miles travelled and hence gasoline used. Cable TV made it more attractive to stay home rather than to drive to some entertainment outside of the home; it thus reduced the demand for gas as a complementary product to some non-home leisure activities. Since, on average, Japanese cars use less gasoline per mile than North American cars (or, at least, they did in the 1970s and early 1980s), a rise in the demand for Japanese cars reduces the demand for the complementary product, gasoline.

Question 4 Rivalrous competition in a number of dimensions — including price, product, quality, and service — can account for low profits since resources devoted to such competition will increase costs.

Question 5 On the surface, it may appear that the key difference between monopolistic competition and oligopoly is that the former has many more firms than the latter. This is certainly true, but the source of this difference is the freedom of entry/exit that exists for monopolistically competitive industries. If you were in a monopolistically competitive industry, then one manner in which profits may be secured is by raising entry barriers. One mechanism that

could be used is to lobby your government for a licensing requirement. For example, you may be able to convince your government that the public interest is only served if barbers are required to take many hours of training and get a license to cut hair; otherwise civilization (or at least, good taste) is in extreme jeopardy. With such entry barriers, firms would be able to keep more of their profits, and so would begin to exhibit one of the characteristics of oligopoly.

Question 6 a) The barriers to entry are: brewing: capital costs to establish national distribution, brand proliferation, advertising airlines: large capital costs, ownership of scarce routes and landing rights railways: large capital costs, ownership of right of way (on scarce land) banking: large range of products, large capital costs to establish system of branches, lots of advertising, reputation and brand loyalty b) Technology is changing in the following ways that will tend to circumvent these entry barriers: brewing: development of regional micro breweries to satisfy niche markets airlines: development of small regional jets allows regional airlines to develop railways: technological change (development of containers), but not to allow circumvention of entry barriers banking: development of internet and telephone banking allows banks to establish a market presence without extensive network of branches

_____________________________________________________ Chapter 16: Market Failures and Government Intervention _____________________________________________________ Answers to Study Exercises Question 1 a) marginal cost; allocatively efficient b) free markets: • are flexible in response to shocks • provide incentives for innovation • permit the decentralization of economic power c) a market failure d) monopoly (or market) power; externalities; asymmetric information; missing markets Question 2 a) private marginal cost; social marginal cost; externalities b) equal

c) negative; greater than; many

d) positive; less than; few

e) negotiate; transactions costs

Question 3 a) private; free market b) common property resource; private market participants c) zero; zero

d) public goods; free-rider

e) asymmetric information

f) moral hazard

Question 4 The key to this question is to clearly identify the “action” in question, and then to determine whether this action imposes costs or confers benefits on third parties. The relevant action is shown in boldface and the MCS and MCP apply to this action.

Positive or Negative Externality?

MCS greater than or less than MCP?

Blow smoke in others’ faces.

Smoking generates a negative externality (assuming that the others do not like the smoke in their faces).

There is a cost to others, so MCS > MCP.

Cut your lawn early on Sunday morning.

Cutting your lawn generates a negative externality (assuming that others want to sleep on Sunday mornings).

There is a cost to others, so MCS > MCP.

A firm conducts R&D and generates basic knowledge that is freely available.

Investing in R&D generates a positive externality (assuming that the knowledge created is of value).

The benefit to others is viewed as a “negative cost” to others, so MCS < MCP.

A firm produces aluminum and toxic waste as a byproduct.

Producing aluminum generates a negative externality (assuming that the toxic waste is harmful to some water, air, etc.).

There is a cost to others, so MCS > MCP.

Question 5 a) The competitive equilibrium in the newsprint market is where quantity demanded equals quantity supplied. Call this outcome pC and QC in the figure below.

b) The toxic chemicals that are dumped in public streams represent a negative externality

associated with the production of newsprint. Each unit of newsprint generates $100 worth of external cost, so the MCS curve lies above the MCP curve by $100. c) Allocative efficiency is achieved when the level of output is such that the marginal benefits to society of an extra unit of newsprint exactly equal the marginal costs to society of an extra unit of newsprint. Since producing newsprint involves generating costly toxic wastes, the relevant MC curve is MCS. Thus the allocatively efficient level of output is Q*, where MCS = MB. (Note that since there is no externality associated with the consumption of newsprint, MBP = MBS which we simply call MB.) Question 6 A good is rivalrous if one person’s consumption of the good diminishes the amount available for others. A good is excludable if there is some way to prevent an individual from using it.

CD player: This is a private good. It is both excludable and rivalrous.

Clothing: This is a private good. It is both excludable and rivalrous.

Library: It is excludable because entrance fees could be charged (even though they almost never are). As long as it is not filled to capacity, it is non-rivalrous. However, any individual book within the library is rivalrous (at any given time).

Lighthouse: It is non-excludable because once it is operating there is no way to prevent someone from benefiting from the light. It is also non-rivalrous since my use of the light does not reduce the amount available for others.

Medical services: It is excludable because user fees could be charged (even though they generally are not charged in Canada). It is also rivalrous since one person’s use of a doctor’s time (or the hospital’s equipment) means that it cannot simultaneously be used for others.

Published product safety information: In principle, this is excludable because individuals could be charged for the information. But it is difficult to see how individuals could be prevented from posting this information on the Internet, thus making it non-excludable. It is non-rivalrous

because all people (who have the information) can use it simultaneously and not diminish the amount available for others.

Pacific salmon: In principle, this is excludable because the owner (the government) can require fishermen to purchase licences (though enforcement is difficult). It is certainly rivalrous because one fish caught by one person cannot then be caught by another (unless sport fishermen are using a catch-and-release strategy which does not hurt the fish). a) Which are public goods? This requires both non-excludability and non-rivalry. Lighthouses are probably a pure public good in this sense. Product-standards information is a public good if excludability is not feasible. c) Common-property resources display non-excludability and rivalry. Pacific salmon are clearly a common-property resource. A medical system with zero fees (at the margin) will also look like a common-property resource, though positive user fees make it appear like a private good.

Question 7 a) For allocative efficiency, all goods should be produced (or consumed) until the marginal cost to society equals the marginal benefit to society. Uncrowded museums or highways have a marginal cost of zero because an extra person using the good does not increase costs for society. Thus, the price should equal zero so that consumers will use the good until their MB equals zero. b) Private firms will always charge a positive price because they need to make at least zero economic profits if they are to remain in the industry. And since providing these goods is costly (on average, but not at the margin), positive prices are required to break even. But the positive price immediately implies that consumers will consume less than what is socially optimal (MB will be greater than MC, which equals zero).Thus, if private firms provide these goods, allocative efficiency will not be achieved. c) Crowded museums and highways mean that marginal cost is positive because one additional person using the good imposes congestion costs on the other users. In these cases, allocative efficiency requires a positive price so consumers will reduce their consumption to the point where MB equals MC, which is positive because of the congestion.

Question 8 a) The total value placed on the park by the 100 residents is $32 000. If the cost to build the park is $35 000, then the town should not do it because even if all residents used the park it would not generate total benefits to cover the total costs. b) If the park costs only $20 000 to build, then the town should do it because the total value to the residents is $32 000. Thus there would be $12 000 of net benefits. The city would pay for the construction of the park by levying general taxes (on income, property, or sales, for example) and then financing the park out of general tax revenues. c) If the town builds the park and then charges residents $50 for an annual pass, only those residents that value the park at or above $50 will purchase the pass (and use the park). From an accounting perspective, the park will make a loss since it costs $20 000 to build but the revenue from the annual passes will be only $50 × 90 = $4500. Moreover, allocative efficiency is not

achieved since the marginal benefit (the benefit of the marginal resident) equals $50 which exceeds the marginal cost to society, which is zero. This is a case of inefficient exclusion.

Question 9 a) From the discussion in Chapter 13, economic rent is a payment to a factor of production over and above what is necessary to keep that factor in its current use. When the pig farmers lobby the government for financial assistance, there is unquestionably a perceived need for assistance to the pig farmers — when the world price of pork declines, profits for pig farmers decline and some may be making economic losses. But some of the payments that might get paid to the pig farmers are probably economic rent in the sense that some of the pig farmers would continue to be pig farmers even in the absence of financial support. This type of lobbying is therefore called rent seeking. b) Lobbying for financial assistance may be privately productive but it is not socially productive.

Successful lobbying may have a private payoff in terms of generating a payment from the government to the pig farmers, and it is this expected payoff that leads farmers to lobby. But the financial assistance is a redistribution of income from taxpayers to farmers, and so the private gains to farmers are matched by financial losses to other parties (taxpayers). If the farmers spend $500 000 and get nothing from the government, the cost to society of the lobbying is the $500 000 of resources that is wasted. c) If the $500 000 is spent and leads to a change in government policy, then the overall cost of the lobbying is the $500 000 in direct lobbying costs plus any costs (or minus any benefits) created by the policy change. In the case where the policy is a pure lump-sum redistribution of money from taxpayers to farmers, the overall cost of the lobbying is the $500 000 direct cost of the lobbying (since the redistribution generates no net gains or losses for society). But if the change in policy assists pig farmers in a distortionary manner (as would probably be the case), then the cost of the lobbying is the direct cost of $500 000 plus the costs of the distortions created by the change in policy.

Answers to Discussion Questions Question 1 Each of these examples can be treated at length as a policy question, or in more limited fashion.

We think it is worth pushing discussion in every case to the point where students come to realize the real choices involved in balancing benefits against costs. They should also realize that some of their views of the proper action may depend on who actually bears the costs and who they think should bear the costs.

Smoking is interesting because it raises the question of whether damage that people may do to themselves and to others constitutes a neglected social cost. There is room for debate here. The danger that the smoker (or his or her family) will become a public charge is a slim reed on which to base a policy of interfering with free choice, but the argument has been used. The notion that the old man with lung cancer is a different person than the young man that he was twenty years earlier may provide an appealing basis for calling this an externality. Evidence that second-hand smoke is a health danger to non-smokers clearly strengthens the externality argument and thus strengthens the case for intervention.

The debate over the private and social costs of a university education is interesting, and students ought to be exposed to thinking through this issue. The issue hinges on the extent of positive externalities that accompany the post-secondary education of an individual. Some economists argue that the benefits from an individual’s education accrue mostly to that individual

in the form of higher wages or improved employment prospects. Others argue that society receives benefits over and above what the individual gets in the form of the benefits that flow from a more educated electorate. Empirically, this issue is far from settled — indeed, it is difficult to measure the external benefits from education and thus difficult to empirically determine the size of the positive externalities.

In the cases of gun ownership and drilling for offshore oil the adverse externality is obvious. What are the costs of avoiding each? A general issue lies in how to distinguish between an activity that one wishes to permit (e.g., drilling for oil) and one that one wishes to prohibit (e.g., drilling for oil carelessly in a way which creates oil spills). What determines the distinction? Partly it is the balance of private gain against public danger in the activity, partly it rests on the ability to devise alternatives if the activity is prohibited. The prohibition of the use of offshore oil would raise costs of domestic oil. Gun control is a matter on which people feel strongly, with important regional differences.

Question 2 a) This is a very common proposal, and students usually enjoy considering it. The rationale is the congestion externalities that motorists create, and the benefits that would result from reducing the number of motorists in the downtown areas and inducing them onto less externalitycreating public transport. The adverse effects involve such things as more governmental intervention in free choice and more inconvenience to many that now drive. b) Medical malpractice suits have become a major problem in the United States and are becoming more serious in Canada. Clearly one wants doctors to be responsible for their mistakes, and this argues in favour of allowing large malpractice awards. But jury awards of enormous amounts for alleged malpractice may threaten the workings of the medical system. In some U.S. states, some doctors are reported to be giving up their practices because of the enormous cost of liability insurance. The former trust between patient and doctor is being eroded and a crisis in medical delivery is threatened. Students should be encouraged to think about the dynamics of the situation.

Is the legal system threatening to destroy the underpinnings of the medical system or is the present system just a transition toward a new system of medical responsibility? Suppose doctors let some patients die while applying the orthodox methods, rather than taking unorthodox risks that would save some patients’ lives, but would expose the doctors to malpractice suits? Does it make sense?

How could it be prevented? On the other hand, of course, there is the possibility that limiting malpractice awards could reduce the care that doctors take. How can these effects be balanced? c) A large proportion of all insurance premiums goes to support administration and litigation to decide who is at fault in specific cases. Since, on average, each insurance company will have roughly the same proportion of drivers who are at fault in accidents, the costs of such litigation are in aggregate wasteful. Nofault insurance avoids these costs and allows a higher proportion of the insurance premiums paid to be used for payouts to people involved in particular accidents. This is an example of a fruitful use of the statistical law of large numbers. But note that the use of no-fault insurance introduces a moral hazard problem. If nofault insurance reduces the incentive for careful driving, it gives rise to its own wastes.

Question 3

The first thing to ask is “productive of what?” These costs were unproductive in the sense that the amount of resources required to produce a tire were increased, but at the same time they presumably produced safer driving and working conditions and less pollution. Students should then be encouraged to think of whether the lost output elsewhere (when extra resources were devoted to tire production) was really worth the gain. Of course, there are limited resources in the economy, and when new investment is devoted to preventing pollution or increasing safety, this must represent a decrease in resources that are available for other purposes. On the other hand, the funds spent usually produce results that are desirable. The question, as always, is to balance the desirable direct effects against the losses in terms of opportunity costs elsewhere in the economy.

Question 4 Discussion of the roles that particular publicly provided goods and services play can begin with considering what things would be like if these goods and services were not provided publicly.

What would the private response (if any) be? How would it likely differ from the way in which public provision works? Proceeding in this way, one can identify the market failures (if any) that appear when constructing the hypothetical world in which there is only private provision of the specified goods and services.

Police departments. Without a publicly provided police department, it is difficult to see how public laws could be generally and equitably enforced. Individuals might hire private police to protect their persons and property. Indeed, private security guards do just this sort of thing, but they do so within the framework of public laws. Moreover, general “law and order” is to some extent a public good; everyone benefits from an environment that is known to be generally secure.

Similarly, there is a negative externality (hence the phrase “innocent bystander”) associated with crime. For police, then, we have an externality and two public goods (law and order and equitable application of the law) one of which (equitable application) is derived from preferences about a social goal that is not primarily economic. A private police force would provide too little of the public good “law and order”, but it would also provide a kind of police protection that paid little or no attention to social values about the administration of justice.

Fire departments. In urban settings, including small towns, the negative externality from fires is potentially very large, large enough so that for many purposes rapid response to fires is a public good. In a purely private setting, the owner of a building would have to decide whether it was worth paying the fire department to put out a fire. Meanwhile, a fire that started in that owner’s building could consume a whole block or more. (For the very libertarian, notice that if the building owner is subject to strict liability for the damage done to other buildings, the private system still might work. But as a practical matter, bankruptcy is likely to interfere).

Public libraries. Books have a lot of potential as imperfect public goods. Although two people cannot easily read the same book at the same time, a given book can be read many times before it is worn out. Thus the marginal cost of making a book available to one more person is very low, and this is an attribute of public goods. One could easily imagine, however, private lending libraries that charged a small fraction of a book’s price in order to allow users to rent the book for a week or two. Indeed, such libraries exist. There is some market failure in them because they charge more than marginal cost, because they have to cover fixed cost. Public libraries also promote the social goal of making knowledge generally available to citizens. This, too, can be thought of as a public good. Finally, the existence of some library, such as the U.S. Library of Congress, as a store

of knowledge is a nearly pure public good. The fixed costs are high, and the marginal cost of making the resource available to another user is tiny.

Question 5 The existence of the test creates an opportunity for adverse selection. People who discover that they have the disease with high probability will want to insure against it; those who find that they have the disease with only low probability will want to exclude it from the coverage, saving the extra premium. If the probability of having the disease times the average cost of treatment exceeds $100, healthy testtakers will, by revealing the result of their tests, be able to achieve reduction in their premiums of more than $100. This outcome will lead to the inference, via adverse selection, that those who do not reveal test results to the insurance company have the disease, and on efficiency grounds should be charged accordingly.

Question 6 The private returns to higher education are high enough so that without public support, people would still generally find it profitable to acquire education. The question is whether they would acquire, on average, “too little”. Arguably, there is a positive externality arising from having a population that is generally well educated. This would justify some subsidy. Also, much research is undertaken in universities, and there is a publicgood component to research. Finally, the social norm of equal opportunity is supported by subsidy to lowincome students.

In principle, one would want to compare the world without subsidy with the current state of affairs. More practically, one could evaluate particular subsidies against the benefits discussed above. Do public universities make sense? Would needsbased tuition grants and expanded public support for research do just as well? What would be the important differences among such schemes? The point here is to get students thinking about public policy issues from an economic perspective, and the issue is a good one because, as university students, they will all be somewhat familiar with it.

___________________________________________ Chapter 33: The Gains from International Trade ___________________________________________ Answers to Study Exercises Question 1 a) efficiently (at low cost); efficiently

b)

global

output

(and

therefore

consumption) c) absolute advantage; absolute advantage d) opportunity costs e) absolute advantage

f) increase

g) comparative advantage; gains from trade Question 2 a) one price; a single

b) supply; export; less than

c) demand; world; domestic

d) exports; imports; improvement

e) imports; exports Question 3 a) Note that because the production possibilities boundary is a straight line, we know that the opportunity cost of either good is constant, no matter how much of it is being produced. The opportunity cost of producing more fish is the ice that is not produced. From the diagram, it is clear that as we move from point A to point B, we produce 15 more tonnes of fish by giving up 100 tonnes of ice. Since the boundary is linear, it follows that to produce only 10 more tonnes of fish, we would have to give up (2/3) × 100 = 66.7 tonnes of ice. b) The opportunity cost of producing more ice is the fish that are not produced. By moving from point B to point A, we produce 100 more tonnes of ice and we must forgo producing 15 tonnes of fish.

Question 4 a) Brazil has the absolute advantage in both goods because the same amount of resources (1 million acres of land) can produce more of both goods than is possible in Mexico. b) The country with the comparative advantage in wheat is the country that produces wheat with the lowest opportunity cost — that is, the country that gives up the least corn for each bushel of wheat produced. Brazil must give up 1/3 of a bushel of corn to produce each bushel of wheat.

Mexico must give up 2/5 of a bushel of corn to produce each bushel of wheat. Since 2/5 exceeds 1/3, it is clear that Brazil has a comparative advantage in wheat production. Using the same logic we see that Mexico has a comparative advantage in corn production.

c) It is certainly possible for a country to have an absolute advantage in both goods — this only requires that the country be more efficient than the other country in the production of both goods.

Here, by “more efficient” we mean less input per unit of output. In this case, Brazil is more efficient in both wheat and corn and so it has the absolute advantage in both goods. But comparative advantage is based on the idea of opportunity cost — what must be given up in the production of one good to get more of the other good. The opportunity cost is revealed by the slope of the production possibilities boundary. And if a country has a lower opportunity cost for one good then it must have a higher opportunity cost for the other good. Graphically, this simply says that if the PPB is steeper in one country than in another with respect to one axis, then it must be flatter in the first country than in the second with respect to the other axis. d) See the figure below. Note that each country has 1 million acres of land. So the most wheat that Brazil could produce is 90 million bushels; and the most corn it could produce is 30 million bushels. Similarly, Mexico could never produce more than 50 million bushels of wheat or 20 million bushels of corn. e) The slope of a country’s production possibilities boundary shows the opportunity cost in that

country for each good. For example, the slope of Brazil’s PPB in the figure above is (negative) 1/3 (note the different scales on the two axes). This is the opportunity cost of one bushel of wheat in Brazil, meaning that Brazil must forgo 1/3 of a bushel of corn in order to produce an extra bushel of wheat. The inverse of the slope is (negative) 3, which is the opportunity cost of one bushel of corn in Brazil.

Question 5 a) The slopes of the PPBs show the opportunity costs in each country. The steeper PPB in France than in Canada shows that France must give up more wine per unit of lumber produced than is necessary in Canada. Equivalently, Canada must give up more lumber per unit of wine produced than is necessary in France. Thus Canada has the comparative advantage in lumber and France has the comparative advantage in wine. b) See part (a).

c) With the relative prices shown by the slope of the dashed line, Canadian producers will specialize in the production of lumber, thereby maximizing Canada’s income. Similarly, French producers will specialize in the production of wine, thereby maximizing France’s income. d) With specialization as in part (c), but consumers in both countries still wanting to consume both goods, there is only one possible pattern of trade. Canada will export lumber to France and import wine from France.

Question 6 a) In both markets, the absence of international trade implies that the equilibrium price will be the one that clears the domestic market. In the figure below, these prices are denoted pC.

b) Now suppose that Canada is open to world trade, and the world price of each product is denoted pW. In the newsprint market, the world price exceeds the domestic Canadian price. But the law of one price applies and so only the single world price applies (since Canada is a small player in the much larger world economy). At the high world price, Canadian producers increase their quantity supplied to Q1 and Canadian consumers reduce their quantity demanded to Q2. The balance is exported to the rest of the world. c) In the machinery market, the world price is less than the domestic Canadian price. But the law of one price applies and so only the single world price applies. At the low world price, Canadian producers reduce their quantity supplied to Q2 and Canadian consumers increase their quantity demanded to Q1. The balance is imported from the rest of the world.

Question 7 a) The terms of trade is equal to

Terms of Trade = (Index of Export Prices/Index of Import Prices) × 100 See the table below.

Year

Import Prices

Export Prices

Terms of Trade

1998 1999 2000 2001 2002 2003 2004

90 95 98 100 102 100 103

110 87 83 100 105 112 118

(110/90) × 100 = 122.2 (87/95) × 100 = 91.6 (83/98) × 100 = 84.7 (100/100) × 100 = 100.0 (105/102) × 100 = 102.9 (112/100) × 100 = 112.0 (118/103) × 100 = 114.6

b) An improvement in the terms of trade means that export prices are rising relative to import prices. Put another way, this means that the country needs to sell fewer units of its exports in order to get one unit of imports. A terms-of-trade improvement occurs every year in this case beginning in 2001 — the terms of trade continually increase for those years. c) The terms of trade deteriorate — fall — from 1998 through 2000. d) See (b).

Question 8 a) The damage of Brazil’s coffee crop will lead to an increase in the world price of coffee. Coffee is an imported good for Canada, and thus this shock leads to a terms-of-trade deterioration for Canada. b) The OPEC output restriction will lead to an increase in the world price of oil. Canada produces and exports oil, but it also imports oil. However, Canada is a net exporter of oil and so the rise in the price of oil should have a larger effect on Canada’s export price index than on its import price index. Thus Canada’s terms of trade should improve. c) The development of copper mines in Chile will reduce the world price of copper. Canada is a net exporter of copper and so this will lead to a deterioration of Canada’s terms of trade. d) The Asian recession leads to a reduction in pork demand and thus to a reduction in the world price of pork. Pork is an important Canadian export, so the decline in its price is a terms-of-trade deterioration for Canada.

Answers to Discussion Questions Question 1 This is the essence of the gains from trade. A nation that refuses to engage in foreign trade forgoes the full amount of any possible gains from such trade. Especially for a small island country such as the United Kingdom, the advantages of specialization and international trade were (and still are) large.

Question 2 The quote reflects the oftheard view that one country can only benefit or gain from trade at the expense of its trading partner –– that is, that international trade is a “zerosum” proposition. This chapter formalizes the proposition that international trade gives rise to benefits to both trading countries –– that is, international trade is a “positivesum” activity.

Question 3 This question invites students to think about the “strategic trade” issues that arise in the face of the potential for dynamic comparative advantage. Many students see the potential benefits from interventionist policies much more quickly than the potential problems. They could profitably be directed to the relevant discussion in the next chapter.

Question 4 No, it does not. It is the comparative cost of products, not the absolute cost of labour that determines comparative advantage. A highly industrialized industry can be very efficient, pay high wages, and have a large export potential. The relevant comparison is the domestic cost of production of some good relative to its cost in other countries.

Question 5 The terms of trade reflect the opportunity costs of imports and exports and thus are critically affected by the expected price changes caused by each of the events. A rise in the price of one’s exports is an improvement in the terms of trade; a rise in the price of imports is a deterioration in the terms of trade. The probable effects on relative prices are: a) Favourable change in the terms of trade of coffee exporters, unfavourable change for coffee

importers. b) Fall in the price of Korean steel relative to Canadian steel. This improves the terms of trade for

Canada and worsens the terms of trade for Korea. c) No effect predicted since a general inflation should not change relative prices in any systematic

way. d) Terms of trade worsen for oil exporters, and improve for oil importers.

Question 6 Specialization and trade is almost always beneficial. However, the more disparate the comparative advantages, the more potent specialization becomes with respect to raising joint production. For example, assume Country A can produce either 9 units of beans per acre or 2 units of lettuce, and that Country B can produce either 3 units of beans per acre or 1 unit of lettuce. In this case, specialization can only marginally increase joint production. (In the extreme case where opportunity costs are identical across the two countries, there are no gains from specialization and trade.) However, if instead, Country B could produce either 1 unit of beans per acre or 10 units of lettuce, then the opportunity costs across the two countries are quite different and so the gains from specialization are large.

_______________________ Chapter 34: Trade Policy _______________________ Answers to Study Exercises Question 1 a) infant industry

b) fallacious; exported

c) trade; employment

Question 2 a) increase; decrease; increase; fall b) domestic producers; the government; domestic consumers; foreign producers c) reduction; deadweight d) increase; fall’ increase e) domestic producers; foreign producers; domestic consumers f) reduction; deadweight

Question 3 a) trade creation b) trade diversion; countries outside the group c) national treatment; domestic; foreign

Question 4

a) See the figure below. The demand and supply curves are for Canadian consumers and Canadian producers, respectively. The world price, pw, is shown below the price that would exist in Canada if Canada were a closed economy, pc. Canada produces Q1 units of steel and consumes Q2 units of steel, importing the difference from abroad.

b) We assume here that we are talking about one particular grade of steel, so that the foreign steel is identical to the domestic steel. With a tariff of t dollars per unit on imported steel, the price in Canada of imported steel will now be pw+t. But the law of one price says that identical products will sell for the same price, so the price of domestic steel will also rise by t dollars per unit (the price in the rest of the world will not be affected by the Canadian tariff since Canada is a small country). The Canadian price rises to pw+t. The quantity supplied domestically rises to Q3 while the quantity demanded domestically falls to Q4. Imports therefore fall from Q1Q2 to Q3Q4. c) Domestic consumers clearly lose since they consume less steel and pay a higher price per unit.

The loss of consumer surplus is shown by areas 1 plus 2 plus 3 plus 4. Canadian steel producers (and their workers) gain from the tariff since it raises the price and allows them to increase sales.

The gain in producer surplus is shown by area 1. The taxpayers benefit by the amount shown in area 3, since this is the revenue raised by the tariff. Thus, area 1 is simply a redistribution away from consumers toward producers, and area 3 is a redistribution away from consumers toward taxpayers. We are left with areas 2 and 4 as a net loss to society — this is the deadweight loss of the tariff.

Question 5 a) Before the tariff is imposed, the price of shoes is pw and Q1 units are produced in Canada. But Q2 units are consumed in Canada, so the difference, Q1Q2, is imported. After the tariff is imposed, the price is pw+t, and imports fall to Q3Q4. b) Canadian shoe production rises from Q1 to Q3 as a result of the tariff being imposed. The producer surplus of Canadian shoe producers increases by area A. c) The tariff raises the domestic price and reduces consumer surplus in Canada by areas A + B + C + D.

d) The tariff revenue is equal to the per-unit tariff times the quantity of imports. This tariff revenue is shown by area C. Question 6 a) At the world price of pw, Canadian consumers demand Q2 units of shoes, Q1Q2 of which must come from imports. If the government restricts the quantity of imports to Q3Q4, there will be an excess demand for shoes in Canada at the price pw. This excess demand forces up the Canadian price. The equilibrium is reached when at the new price the demand for imported shoes just equals Q3Q4 units. (Note that as the Canadian price rises, two things reduce the quantity of imports demanded — an increase in domestic production and a reduction in domestic consumption.) From the diagram it is clear that this new price must be exactly equal to pw+t.

Note also that the law of one price is not violated here, although it may appear to be. The high price in Canada is caused by the import quota. There is no way that arbitrageurs could buy shoes at the low world price and then sell them at the high Canadian price because such arbitrage would violate the import quota and thus be illegal. So it is the obstacle to arbitrage that permits the price differential to exist. b) With a tariff, area C would be the tariff revenue. But with an import quota equal to Q3Q4 units, there is no tariff revenue. It is the foreign producers who now earn area C — they earn a higher price on their Q3Q4 exports to Canada than they earn on their other units. Having the right to sell in the import-restricted market is valuable! c) The effect on consumers is the same with a tariff or a quota — consumers face a higher price and their consumption falls in both cases. It is also the same for Canadian producers — they produce and sell more and also benefit from a higher price. The only difference is area C. With a tariff, this area is the tariff revenue for Canadian taxpayers. With a quota, this area is revenue for foreign producers. For Canada overall, therefore, the tariff is preferable to the import quota.

Question 7 a) Voluntary Export Restrictions (VERs) are voluntary because they raise profits for the foreign producers. Similar to the case of the import quota in the previous question, the VERs had the effect of restricting the volume of imports of Japanese cars into North America. By creating an “artificial” scarcity of cars, the VER drove up the price of all cars in North America. The result is that the Japanese producers are able to earn higher profits. The VER effectively gives the Japanese producers some monopoly power that they might not have otherwise had. b) See the analysis in Question 6(b). With the VERs, the Japanese producers get extra revenue per car. In contrast, with a tariff the premium paid by the consumers would be collected by their own government in the form of tariff revenue. c) North American consumers are paying for the benefits to the Japanese producers (and to the domestic producers and their workers).

Question 8

Note that these data are for trade in goods, but not services. a) In 2002, Canada’s exports of goods to the United States equalled $346.9 billion. Canada exported $22.7 billion of goods to the European Union. b) In 2002, Canada’s imports of goods from the United States were $254.9 billion. From the EU, Canada imported $36.1 billion in goods. c) The volume of trade between Canada and the United States was $601.8 billion in 2002, up from $453.9 billion in 1997. This is an increase of 33 percent. In contrast, national income (in nominal terms) increased by 29.5 percent from 1997 to 2002 (from $882 billion to $1142 billion). Therefore the volume of trade has grown slightly faster than national income over this period.

Question 9 a) With a 20 percent tariff on all imported towels, the lowest-price towels are those made in Canada. Canada will produce its own towels — none will be imported. b) With no tariffs at all, the cheapest towels are the Malaysian ones. So Malaysian towels get imported into Canada. This is “trade creation”. c) With free trade between Canada and the United States, but a 20 percent tariff on goods from other countries, the U.S. towels now become the cheapest towels in the Canadian market. Canada imports U.S. towels and stops importing Malaysian towels. This is “trade diversion”. d) Part (b) is trade creation. It is beneficial because Canada is buying from the cheapest producer rather than producing towels domestically at a higher price. Part (c) is trade diversion. It is not beneficial because trade is diverted from the genuinely low-cost producer (Malaysia) toward a higher-cost producer (the United States) because of the tariff that applies only to Malaysia.

Answers to Discussion Questions Question 1 These successive points are designed to show the student that the fear of cheap Mexican goods flooding into Canada (or the United States) and causing a major loss of Canadian (or U.S.) jobs is probably highly unwarranted. a) Clearly, the imposition or removal of a 10 percent tariff is not the major determinant of Mexican comparative advantage –– this depends on related unit labour costs, which is a combination of wage rates and labour productivity. The statement suggests that Mexican workers were cheap (per hour), but quite unproductive, and so expensive (per unit of output produced). b) The theory, and the experience of world trade and tariff reductions since 1947, shows that rich countries do not have to fear trading with poor countries. The gains from trade are generally shared (not necessarily equally) among the trading partners. c) As time passes, more and more production passes into this category where wage costs are a very low proportion of total costs. For such products, location will be mainly determined by factors other than relative wage rates.

Question 2 If imports from China are restricted, then presumably we will buy substitute goods from elsewhere, and pay higher prices (or get lower quality). Otherwise we wouldn’t have been buying them from China in the first place. Thus domestic consumers lose from this policy, and the domestic importcompeting firms win. (Indeed, advocating the imposition of import restrictions on countries with poor human rights records is often a convenient, but more popular, way of advocating protection for specific industries.)

Other losers may include the workers in China who were employed in the industries producing the goods that were previously exported to Canada. On the other hand, if such trade sanctions (as those imposed on South Africa in the 1980s) are effective in bringing about political reform that reduces the human rights abuses, then the Chinese workers may be better off in the long term.

Question 3 The first part of this question is discussed in the text in connection with Figure 34-2. Industries that face sharp competition from foreign producers tend to favour restrictions on trade, including quotas; users of imported goods tend to oppose limits on trade. Labour unions, too, differ. Unions in the shoe industry support quotas, because foreign competition threatens their jobs. Unions in industries that depend on foreign supplies oppose quotas if the quotas decrease the employment opportunities for them. Autoworkers and steelworkers, for example, view imports of Japanese steel very differently. Not surprisingly, on issues such as trade policy, there is a community of interest that binds labour and management in a particular industry, even though on issues such as wage rates they may be adversaries.

Question 4 Japanese cars manufactured in Canada will not be imports for Canada, but will still be considered “foreign” cars, even though they will be built with many Canadianmade materials and by Canadian workers, because the profits will be repatriated to Japan. With parts, labour and technology coming from various places all over the world, it is getting more and more difficult to define a product in terms of its origin. Increasingly, a product’s “pedigree” is determined by where the profits go!

Question 5 This is a good question to make students think through the various types of trade polices that are available. It is important for students to see who gains and who loses from the alternative policies. a) The consumers in Houseland are made worse off, since the price of lumber will rise. These consumers will generally include firms that use lumber as an input. The lumber producers (and workers) in Houseland are better off, since they are protected and can sell their product at a higher price than before. The lumber producers and workers in Forestland are worse off since the tariff reduces the demand for their product. b) The export tax imposed by Forestland reduces the supply of lumber to Houseland and thus drives up the price of lumber in Houseland. The consumers in Houseland are worse off, just as in case (a). The lumber producers and workers in Houseland are better off, just as in case (a), since the price of their product is driven up. The lumber producers and workers in Forestland are also worse off, just as in case (a) — their product sells for a higher price in Houseland, but this benefit gets taxed away by their home government, leaving them with only the costs associated with reduced output levels. The one important difference from case (a), however, is that with the export tax the government of Forestland collects the tax revenue, whereas with the import tariff the government of Houseland collects the tariff (tax) revenue. c) The agreement to restrict exports from Forestland drives up the price of lumber in Houseland.

Consumers in Houseland are worse off. Lumber producers and workers in Houseland are better off. Lumber producers and workers in Forestland are now better off, since they are effectively imposing some monopoly power — by restricting output they are driving the price up. The extent of the price rise, of course, will depend on the elasticity of demand for lumber in Houseland. d) Which policy will get the most political support? In Houseland, all three policies are bad for consumers and good for the lumber producers and workers. So there will naturally be disagreement between these two groups over any of the policies. In Forestland, the lumber producers would probably favour the voluntary export restriction, but the government may feel it necessary to use an export tax in order to enforce such a restriction.

Question 6 a) The Canadian consumers benefit from the dumping of the foreign steel in Canada because they are able to buy steel at a lower price than they otherwise could. Canadian steel producers (and their workers) are clearly harmed, since they lose sales to the foreign steel companies.

b) By placing antidumping duties on the steel, the domestic steel producers are protected — they are clearly better off. Canadian consumers are now forced to pay a higher price than what would otherwise be the case — they are worse off. c) The simple view of dumping is that the foreign producers are offering (for whatever reason) low-priced products, and the standard theory of the gains from trade suggest that Canada is better off overall to trade freely, and thus to welcome the dumped steel with open arms. Canadian steel producers can then reallocate their resources toward the production of goods for which Canada has a comparative advantage.

A contrary view emphasizes that such dumping is rarely permanent. If the foreign firms are dumping the steel as a means of driving the Canadian producers out of business, then the long-run effect will be less competition and higher prices in Canada.