Solution Manual For Essentials of Economics 12e Bradley Schiller and Karen Gebhardt

Solution Manual For Essentials of Economics 12e Bradley Schiller and Karen Gebhardt Chapter 1-17 CHAPTER 1: THE CHALLENGE OF ECONOMICS ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain the meaning of scarcity.

2 Define “opportunity cost.”

3 Recite society’s three core economic questions.

4 Discuss how market and command economies differ.

5 Describe the nature of market and government failures.

6 POLICY PERSPECTIVES Apply the concept of opportunity cost to health care.

QUESTIONS FOR DISCUSSION 1. As rich as America is, how can our resources possibly be “scarce?” LO1 Answer: Many believe that America has become rich because of the abundance of our natural resources. Others believe our democratic political system and our market-driven economic system play significant roles in our relative financial success. Regardless, as rich as America is, we still want more. The concept of scarcity, in the case of America, is the lack of enough resources to satisfy all American consumer desires. Therefore, resources are scarce in America because the desire for these resources is greater than the amount we possess.

2. What opportunity costs did you incur in reading this chapter? LO2 Answer: There are many other things you could have done with your time instead of reading this chapter. The most desired activity you gave up is the opportunity cost.

3. How would you answer the question in the News Wire “Future Living Standards”? Why? LO3 Answer: There was a spike of anxiety in 2008–2009 regarding the ability of the U.S. economy to crank out more goods continuously. Today many Americans still worry about the resiliency of our economic system and our many resource limitations. The general definition of economics—the study of how best to allocate scarce resources among competing uses— allows for the potential of brilliant minds to help the economy continue to grow. Additional resources, new technologies, insightful entrepreneurial strategies, and great minds working © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

on economic development provide tremendous hope for future growth in our economy and the associated increase in our standard of living.

4. How can China’s army be twice as large as North Korea’s when China spends only 1.9 percent of its output on the military and North Korea spends 19 percent? LO1 Answer: China has more resources than North Korea and has also chosen to produce at a different combination along its production possibilities curve. China’s larger population, larger land area, natural resources, education system (human capital) focused on technology, and the structure of its economy are such that it focuses more of its production on capital goods, as well as on consumer goods and services. These, in turn, enable it to maintain a large army while maintaining a focus on economic growth.

5. In a purely private market economy, how is the FOR WHOM question answered? Is that optimal? LO3 Answer: FOR WHOM is one of the three basic economic questions. The other two questions determine how large of an economic pie to bake (WHAT) and how we will bake it (HOW). This FOR WHOM question deals with how to slice the pie. Should some get larger or smaller slices than others? The focus is on how an economy’s output is distributed across members of society.

In a purely private market economy, those who are willing and able to purchase a slice of pie will receive the slice. Markets are efficient; however, neither markets nor governments always have the right answers. There are certainly times (market failure) when the market generates suboptimal economic outcomes.

6. Why doesn’t North Korea reduce its military and put more resources into food production (News Wire “Opportunity Cost”)? What is the optimal mix of “guns” and “butter” for a nation? LO3 Answer: North Korea doesn’t reduce its military and put more resources into food production because the North Korean government apparently believes that a large military establishment is essential to its well-being and security. The optimal mix of “guns” and “butter” depends on values and, therefore, the answer to this question will depend on the values of the individual or in this case, the government answering it.

7. Why would anyone object to giving unemployed workers an extra $400 a week, as President Biden proposed in early 2021? LO3 Answer: On one hand, providing payments to unemployed workers will help them purchase necessary goods and services. On the other hand, given the standard assumptions about market participant reactions, we would expect that those receiving the benefits may reconsider their choices between work and leisure. Since their reward for not working is not higher, they could be expected to work less. This decision entails trade-offs. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

8. What kind of knowledge must central planners possess to manage an economy efficiently?

LO4 Answer: A central planner will make all the decisions for an economy including what goods are produced, at what prices they are sold, and who gets to have them. For example, a central planner places workers at a bread factory, tells them how much bread to bake, and specifies who is allowed to eat this bread. The WHAT, HOW, and FOR WHOM outcomes are all directed by the central government (planner).

A central planner would need to be omniscient in order to manage an economy efficiently.

He/she would need to know the desires of consumers, consumers’ ability to pay, productivity of inputs (such as capital and labor), and technological capabilities. It is simply unreasonable to believe that a central planner could ever have such vast and comprehensive knowledge.

9. POLICY PERSPECTIVES Why can’t we produce at point X2 in Figure 1.6? Will we ever get there? LO5 Answer: X2 is beyond the resources available for production because it is outside of the curve.

The only way to get there would be to increase the resources available.

10. POLICY PERSPECTIVES To get from X1 to X2 in Figure 1.6, per President Biden’s proposals, entails a reduction in the output of “other goods.” How do higher taxes help that transition?

LO2 Answer: President Biden’s goal was to expand the health care industry and to increase access to health care for Americans and to get everyone vaccinated against COVID-19. However, producing more health care means that other goods or services would need to be given up; there is an opportunity cost involved. Higher taxes on “other goods” would decrease the quantity consumed of those other goods. These tax dollars could then be used to purchase and distribute more health care.

PROBLEMS 1. Iceland has no military. LO2 a. So, at what point in Figure 1.1 is Iceland producing? b. If Iceland decided to produce the quantity OE of military goods, how much consumer output would it have to give up?

Answer: a. If the country currently does not have a military, then the only output will be consumer goods (point A).

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b. If the country is now producing the quantity OE of military goods (equal to the combination of D consumer goods and E military goods), the country would reduce the production of consumption goods by the amount AD. 2. What percentage of total U.S. output consisted of military goods: LO2 a. in 1944? (Figure 1.2) b. in 2020? (Figure 1.2) Answer: a, b. According to the graph, the percentage of total U.S. output consisting of military goods was approximately 39 percent in 1944 and 3.4 percent in 2020.

3. Draw a production possibilities curve based on Table 1.1, labeling combinations A–F. What is the opportunity cost of increasing missile production LO2 a. from 50 to 100? b. from 100 to 150?

Answer: A production possibilities curve describes the various combinations of final goods and services that could be produced in a given time period with available resources and technology. Point A, for example, is an output combination of 0 missiles and 100 houses plotted on the vertical axis (0,100). Point F, on the other hand, is an output combination of 250 missiles and 0 houses plotted on the horizontal axis (250,0).

a, b. The opportunity cost of increasing the production of missiles is the loss of production of houses. For example, increasing missile production from 50 to 100 results in a loss of 15 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

houses (= 90 − 75), increasing missile production from 100 to 150 results in a loss of 20 houses (= 75 − 55), and so on.

4. Assume that it takes four hours of labor time to paint a room and two hours to sand a floor. If 24 hours were spent painting: LO1 a. How many rooms could be painted? b. If a decision were made to sand two floors, how many painted rooms would have to be given up? c. Illustrate with a production possibilities curve.

Answer: a. If 24 hours were spent painting rooms and a worker can paint a room in four hours, then this worker can paint 6 rooms (= 24 hours ÷ 4 hours per room). b. Because it takes two hours to sand a floor, it would take a worker four hours to sand 2 floors. Therefore, the worker must give up painting 1 room, which also takes four hours to complete. c. The various production possibilities are plotted with "Rooms Painted" on the vertical axis and "Floors Sanded" on the horizontal axis. Thus, if a worker spends all of his or her time painting rooms, 6 rooms can be painted (0 floors sanded and 6 rooms painted). On the other hand, if a worker spends all of his or her time sanding floors, 12 floors can be sanded (12 floors sanded and 0 rooms painted). The alternative production possibilities points in between those two extremes are (2 floors sanded and 5 rooms painted), (4 floors sanded and 4 rooms painted), (6 floors sanded and 3 rooms painted), (8 floors sanded and 2 rooms painted), and (10 floors sanded and 1 room painted). See the graph.

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5. Assume that it takes four hours of labor time to paint a room and two hours to sand a floor.

If two workers each spends 24 hours painting: LO2 a. How many rooms could be painted? b. If a decision were made to only sand floors, how many floors could be sanded? c. Illustrate with a production possibilities curve.

Answer: a. If two workers each spends 24 hours painting rooms and they can paint a room in four hours, then these workers can paint 12 rooms [= (24 hours × 2 workers) ÷ 4 hours per room]. b. If two workers each spends 24 hours sanding floors and they can sand a floor in two hours, then these workers can sand 24 floors [= (24 hours × 2 workers) ÷ 2 hours per floor]. c. The various production possibilities are plotted with "Rooms Painted" on the vertical axis and "Floors Sanded" on the horizontal axis. Since there are two workers, the production possibilities have doubled. If both workers spend all of their time painting rooms, 12 rooms can be painted (0 floors sanded and 12 rooms painted). On the other hand, if both workers spend all of their time sanding floors, 24 floors can be sanded (24 floors sanded and 0 rooms painted). Some of the alternative production possibilities points in between those two extremes are (4 floors sanded and 10 rooms painted), (8 floors sanded and 8 rooms painted), (12 floors sanded and 6 rooms painted), (16 floors sanded and 4 rooms painted), and (20 floors sanded and 2 rooms painted). See the graph.

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6. North Korea has a population of 26 million people, of whom 1.3 million are in the military.

South Korea has an army of 560,000 out of a population of 52 million. What percentage of the population is in the military in: LO2 a. North Korea? b. South Korea?

Answer: a. In North Korea, 5.00 percent of the population is in the military. Percentage of population in the military = (military ÷ population) × 100 = (1.3 million ÷ 26 million) × 100 = 5.00%. b. In South Korea, 1.08 percent of the population is in the military. Percentage of population in the military = (military ÷ population) × 100 = (0.560 million ÷ 52 million) × 100 = 1.08%.

7. The table below describes the production possibilities confronting an economy. Using that information: LO3 a. Calculate the opportunity costs of building hospitals. b. Draw the production possibilities curve. c. Why can’t more of both outputs be produced? d. Which point on the curve is the most desired one?

Potential Output Combinations A

Homeless Shelters 20

Hospitals 0

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B C D E

17 13 7 0

1 2 3 4

Answer: a. Calculating Opportunity Costs. Opportunity cost is the most desired goods and services that are forgone in order to obtain something else. In this economy, the opportunity cost of building more hospitals is giving up building homeless shelters.

• The opportunity cost of producing the first hospital is a reduction in the production of homeless shelters from 20 to 17, or 3 homeless shelters.

• The opportunity cost of producing the second hospital is a reduction in the production of homeless shelters from 17 to 13, or 4 homeless shelters.

• The opportunity cost of producing the third hospital is a reduction in the production of homeless shelters from 13 to 7, or 6 homeless shelters.

• The opportunity cost of producing the fourth hospital is a reduction in the production of homeless shelters from 7 to 0, or 7 homeless shelters. b. Graphing the Production Possibilities Curve. A production possibilities curve describes the various combinations of final goods or services that could be produced in a given time period with available resources and technology. For example, one combination of output is 20 homeless shelters and 0 hospitals, a second combination of output is 17 homeless shelters and 1 hospital, and so on. See the graph on the next page for an illustration of the production possibilities curve.

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c. Because all resources are scarce and therefore limited, we are not capable of producing more of both products. Although we might want more of both (or more of everything perhaps), we are not capable of producing everything that we want. d. This answer depends on the value judgments of a society. The most desired combination will vary based on the particular wants and needs of that particular society.

8. In 2020, the dollar value of total output was roughly $40 billion in North Korea and $1,600 billion in South Korea. South Korea devoted 2.5 percent of its output to defense, and North Korea devoted 19.0 percent of its output to defense. LO3 a. How much does North Korea spend on its military (in dollars)? b. Which nation spends more (in dollars)?

Answer: a. North Korea spent approximately $7.6 billion on its military. $40 billion × 19.0% = $40 billion × 0.190 = $7.6 billion.

South Korea spent approximately $46.4 billion on its military. $1,600 billion × 2.5% = $1,600 billion × 0.025 = $40.0 billion. b. South Korea spent more on its defense (in dollars) than North Korea.

9. According to the News Wire “Opportunity Cost,” what is the opportunity cost of a single missile test in terms of corn for each of North Korea’s 26 million people? LO4 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

Answer: According to the article, the $1.3 billion spent on the missile test is equivalent to acquiring 5 million tons of corn. This amounts to 0.19 tons of corn per person (= 5 million tons of corn ÷ 26 million people).

10. POLICY PERSPECTIVES In Figure 1.6, LO5 a. If as much health care as possible is provided, how many other goods will be provided? b. What is the opportunity cost of increasing health care from H1 to H2?

Answer: a. If a society uses all of its resources to produce health care, there are no resources remaining to produce other goods. b. When health care production increases from point H1 to point H2, the production of other goods decreases from O1 to O2. This decrease in the production of other goods is the opportunity cost of increasing production of health care.

11. POLICY PERSPECTIVES Suppose the following data reflect the production possibilities for providing health care and education: LO5

Health care Education

400 0

370 20

Units per Year 330 270 190 40 50 60

100 70

0 80

a. Graph the production possibilities curve. b. If maximum health care is provided, how much education will be provided? c. What is the opportunity cost of increasing health care from 190 to 270 units?

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Answer: a. A production possibilities curve describes the various combinations of final goods or services that could be produced in a given time period with available resources and technology. For example, one combination of output is 400 units of health care and 0 units of education, a second combination of output is 370 units of health care and 20 units of education, and so on. See the graph below for an illustration of the production possibilities curve.

b. If all resources are used to produce health care, there will be no resources available to produce education. c. Increasing health care from 190 units to 270 units results in an opportunity cost of 10 units of education (= 60 units of education − 50 units of education).

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CHAPTER 2: THE U.S. ECONOMY ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain how an economy’s size is measured.

2 Describe the absolute and relative size of the U.S. economy.

3 Explain why the U.S. economy can produce so much.

4 Recount how the mix of U.S. output has changed over time.

5 POLICY PERSPECTIVES Describe how (un)equally incomes are distributed.

QUESTIONS FOR DISCUSSION 1. Americans already enjoy living standards that far exceed world averages. Do we have enough?

Should we even try to produce more? LO2 Answer: The reality of human nature is that needs are culturally conditioned. There is never enough. Just to maintain living standards as population grows will require more output.

2. Why do we measure output in value terms rather than in physical terms? For that matter, why do we bother to measure output at all? LO1 Answer: Our economy produces thousands of different items, ranging from paper clips to sophisticated electronic equipment. Value estimates are a common denominator for measuring all of these different things. In addition, in our complex and decentralized market economy, it is impossible to account for every item of output produced. Sales records are more available for estimates of value than are output numbers across the economy. Measures of output provide benchmarks that show if growth is occurring and at what rate.

3. Why do people suggest that the United States needs to devote more resources to investment goods? Why not produce just consumption goods? LO3 Answer: Investment goods are capital goods such as machines and factories that help us produce more output. If we concentrated on only consumption goods, we would be unable to replace our machines as they wore out or to expand our productive capacity by producing more, and more efficient, machines.

4. The U.S. farm population has shrunk by over 25 million people since 1900. Where did they all go? Why did they move? LO4 Answer: They went to the cities to become factory workers and service workers because there were jobs available for them in those sectors of the economy. There were fewer and fewer jobs in the agricultural sector because of the advances of technology in that sector.

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5. Rich people have over 15 times as much income as poor people. Is that fair? How should output be distributed? LO5 Answer: Fair is generally considered to be a relative term. On an individual basis, many would consider it ―fair‖ if they personally received more or if someone else received less. In a market economy, the distribution of output (and therefore income) is determined primarily by the laws of supply and demand. This often results in an unequal distribution. However, in order to make sure that the distribution is not so unequal that we have people literally starving to death in the streets, the government steps in and lessens the degree of inequality through various programs and tax policies. Thus, at some point, fairness does become less subjective and more objective when the inequality causes lives being put at risk, which, once recognized, results in a redistribution of income.

6. If taxes were more progressive, would total output be affected? LO5

Answer: Taxes create a disincentive to engage in any activity that is being taxed. If taxes were more progressive, people who face the higher taxes would have less incentive to work.

As a result, total output would decline.

7. Why do income inequalities diminish as an economy develops? LO5

Answer: As an economy develops, more jobs become available, and thus more people will work and earn incomes. There will also be more capital available and therefore labor productivity—and income of workers—will rise. Although incomes will not likely be equalized, on average there should be, and generally is, less income disparity.

8. Why is per capita GDP so much higher in the United States than in Mexico? LO3

Answer: U.S. workers have much more capital, technology, and education to work with, which raises their productivity (output per worker) far above that of Mexican workers.

9. Do we need more or less government intervention to decide WHAT, HOW, and FOR WHOM? Give specific examples. LO4

Answer: It really depends on the type of goods and services society would like to see provided. Some products such as clean water and clean air are not usually provided well by private markets and more government intervention might be desired. Other products such as computers, food, etc. are usually best provided by markets and less government intervention might be desired.

10. POLICY PERSPECTIVES What can poor nations do to raise their living standards? LO3

Answer: This is a complicated issue. A few of the things that poor nations can do to raise their living standards include increasing their investment/consumption ratio, investing in human capital, and reducing illiteracy. Many believe that poor nations will need the assistance of the rich nations of the world to achieve this goal. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

PROBLEMS 1. Referring to the figure, LO1 a. What is the opportunity cost of increasing investment from 6 units to 8 units? b. What will happen to future production possibilities if investment increases now? c. What will happen to future production possibilities if only consumer goods are produced now?

Answer: a. The opportunity cost of increasing investment is the loss of consumer goods.

Specifically, when investment goods increase from 6 units to 8 units, consumer goods decrease from 6 units to 3 units, a decrease of 3 units. b. Investment goods include the plant, machinery, and equipment that are produced for use in the business sector. The economic growth that has lifted our living standards so high was fueled by past investments—the factories, telecommunications networks, and transportation systems built in the past. If investment increases, it will improve our stock of capital and will expand our production possibilities, causing our curve to shift outward (that is, increase). This requires us to limit our production of consumer goods (that is, save) so scarce resources can be used for investment.

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c. Consumer goods include everything consumers buy. If only consumer goods are produced, equipment and factories (for example) will not be replaced and production possibilities will diminish, leading to a shift inward (that is, decrease).

2. Suppose the following data describe output in two different years: LO1 Item Apples Bicycles Apps

Year 1 20,000 @ $0.25 each 700 @ $800 each 10,000 @ $1.00 each

Year 2 30,000 @ $0.30 each 650 @ $900 each 12,000 @ $2.00 each

a. Compute nominal GDP in each year. b. By what percentage did nominal GDP change between Year 1 and Year 2? c. Now compute real GDP in Year 2 by using the prices of Year 1. d. By what percentage did real GDP change between Year 1 and Year 2?

Answer: a. Nominal GDP is the value of output measured in current prices.

Nominal GDP Year 1 = (year 1 output) × (year 1 prices) Apples 20,000 × $0.25 = $5,000 Bicycles 700 × $800 = $560,000 Apps 10,000 × $1.00 = $10,000 GDP $575,000 Year 2 = (year 2 output) × (year 2 prices) Apples 30,000 × $0.30 = $9,000 Bicycles 650 × $900 = $585,000 Apps 12,000 × $2.00 = $24,000 GDP $618,000 b. From Year 1 to Year 2, GDP increased by $43,000. Using the percentage change formula = [(new value – original value) ÷ original value] × 100, this is a 7.5 percent increase (= [($618,000 – $575,000) ÷ $575,000] × 100 = 7.5%). c. Real GDP is the inflation-adjusted value of GDP: the value of output measured in constant prices.

Real GDP Real GDP Year 2 = (year 2 output) × (year 1 prices) Apples Bicycles Apps GDP

30,000 × $0.25 650 × $800 12,000 × $1.00

= = =

$7,500 $520,000 $12,000 $539,500

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d. Real GDP in Year 1 is equal to nominal GDP in Year 1, so real GDP in Year 1 is $575,000. In Year 2, it is $539,500, a decrease of $35,500 (= $539,500 – $575,000). Using the percentage change formula = [(new value – original value) ÷ original value] × 100, this represents a decline of 6.2 percent [(539,500 – 575,000) ÷ 575,000] × 100 = 6.2%.

3. GDP per capita in the United States was approximately $63,000 in 2020. Use the growth formula to answer the following questions: LO1 a. What will GDP per capita be in the year 2025 if it grows each year by 0 percent? b. What will GDP per capita be in the year 2025 if it grows each year by 2 percent?

Growth formula: (future value) = (present value) × (1 present value = this year's GDP per capita future value = GDP per capita in the future r = rate of growth (in decimal form) per year t = number of years of growth

r)t

Answer: Growth formula: (future value) = (present value) × (1 + r)t, where present value = this year's GDP per capita, future value = GDP per capita in the future, r = rate of growth (in decimal form) per year, and t = number of years of growth. a. GDP per capita will remain the same (= $63,000) in 2025 if the GDP per capita growth rate is 0 percent. Intuitively, if GDP per capita does not grow, then there will be no change in GDP per capita between 2020 and 2025. GDP per capita in 2025 = (GDP per capita in 2020) × (1 + r)t. (Note there are 5 years of growth between 2020 and 2025, the growth rate is 0 percent, and GDP per capita in 2020 is $63,000.)

GDP per capita in 2025 = $63,000 × (1 + 0)5 GDP per capita in 2025 = $63,000 × 1 GDP per capita in 2025 = $63,000 b. GDP per capita will increase to $69,552 in 2025 if the GDP per capita growth rate is 2 percent. GDP per capita in 2025 = (GDP per capita in 2020) × (1 + r)t. (Note there are 5 years of growth between 2020 and 2025, the growth rate is 2 percent, and GDP per capita in 2020 is $63,000.)

GDP per capita in 2025 = $63,000 × (1 + 0.02)5 GDP per capita in 2025 = $63,000 × (1.02)5 GDP per capita in 2025 = $63,000 × 1.104 GDP per capita in 2025 = $69,552 4. According to Figure 2.1, how much larger (in percentage terms) is America’s GDP than: LO2 a. Japan? b. Greece?

Answer: a. The United States' GDP is $21.43 trillion and Japan's GDP is $5.08 trillion. This means that U.S. GDP is 322 percent larger *= (U.S. GDP − Japan GDP) ÷ Japan GDP × 100 = ($21.43 trillion − $5.08 trillion) ÷ $5.08 trillion × 100+. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. The United States' GDP is $21.43 trillion and Greece's GDP is $0.21 trillion. This means that U.S. GDP is 10,105 percent larger [= (U.S. GDP − Greece GDP) ÷ Greece GDP × 100 = ($21.43 trillion − $0.21 trillion) ÷ $0.21 trillion × 100].

5. Using income data from Table 2.3, if a McDonald's Happy Meal costs $5, how many Happy Meals per week could: LO5 a. the average person in America afford? b. the average person in Haiti afford?

Answer: a. Per capita income in the United States was $63,051. If a McDonald's Happy Meal costs $5, the average person could afford 243 Happy Meals per week (= $63,051 ÷ 52 weeks ÷ $5 per Happy Meal = 243 Happy Meals per week). b. Per capita income in Haiti was $1,728. If a McDonald's Happy Meal costs $5, the average person could afford 7 Happy Meals per week (= $1,728 ÷ 52 weeks ÷ $5 per Happy Meal = 7 Happy Meals per week).

6. Assume that total output is determined by this formula: LO3 number of workers × productivity = total output a. If the workforce is growing by 1 percent a year but productivity doesn’t improve, how fast can output increase? b. If productivity increases by 3 percent and the number of workers increases by 1 percent a year, how fast will output grow?

Answer: Total output = number of workers × productivity = 100 × $100 = $10,000. a. If the number of workers grows by 1.0 percent a year (from 100 workers to 101 workers) and productivity doesn't change, then output can increase by: Total output = number of workers × productivity = 101 × $100 = $10,100.

Using the percentage change formula = [(new value − original value) ÷ original value] × 100, the percentage change in output is [($10,100 − $10,000) ÷ $10,000] × 100 = 1.0%. Therefore, output can increase by 1 percent. b. If productivity increases by 3 percent (from $100 to $103) and the number of workers increases by 1 percent a year (from 100 workers to 101 workers), then output can increase by: Total output = number of workers × productivity = 101 × $103 = $10,403.

Using the percentage change formula = [(new value − original value) ÷ original value] × 100, the percentage change in output is [($10,403 − $10,000) ÷ $10,000] × 100 = 4.0%. Therefore, output can increase by approximately 4.0 percent.

7. According to the News Wire “Manufacturing: Fewer Jobs, More Output,” since 2000: LO3 a. has manufacturing output increased or decreased? b. has employment increased or decreased? c. has productivity increased or decreased?

(Hint: Productivity = total output ÷ number of workers)

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Answer: According to the article, (a) manufacturing output has increased, (b) manufacturing employment has decreased, and (c) manufacturing productivity has increased.

8. According to Table 2.4: LO5 a. what is the average income in the United States? b. what percentage of the average household income of people in the highest fifth would have to be taxed away to bring them down to that average?

Answer: a. The average income in the United States is $98,080. To calculate this national average, you sum the averages of each fifth of the households and then divide by 5. Average household income = ($254,400 + $111,100 + $68,900 + $40,700 + $15,300) ÷ 5 = $98,080. b. The highest fifth of the U.S. population earns $254,400 on average. To bring this average income down to the national average income of $98,080, the tax must equal $156,320 (in other words, $156,320 must be "taxed away") (= $254,400 − $98,080 = $156,320). Using the percentage change formula, this represents a 61 percent decrease in household income.

Percentage change = [(new value − original value) ÷ (original value)] × 100 Percentage change = [($98,080 − $254,400) ÷ $254,400] × 100 Percentage change = [−$156,320 ÷ $254,400] × 100 Percentage change = 61 percent decrease 9. According to the News Wire “Global Inequalities,” what is the average per capita income in nations shown in the figure where the highest-income decile gets: LO5 a. at least half of total income? b. less than 30 percent of total income?

Answer:

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a. The average per capita income in nations listed in the table where the highest income gets at least 50 percent of total income is $12,920. Of the countries listed, Namibia, South Africa, and Botswana fit this criterion. To calculate the average per capita income of these three countries, we add their average per capita income and then divide by 3.

Average per capita income = ($10,380 + $12,870 + $15,510) ÷ 3 = $12,920. b. The average per capita income in nations listed in the table where the highest income is less than 30 percent of total income is $41,590. Of the countries listed, France, Spain, Great Britain, and Sweden fit this criterion. To calculate the average per capita income of these four countries, we add their average per capita income and then divide by 4.

Average per capita income = ($41,680 + $34,700 + $41,280 + $48,700) ÷ 4 = $41,590.

10. Complete the following table and answer the following questions: LO5

High-income family Middle-income family Low-income family

Before-Tax Income $500,000 $ 50,000 $ 20,000

Tax Rate 37% 20% 10%

Tax Paid $185,000 $ 10,000 $ 2,000

After-Tax Income $315,000 $ 40,000 $ 18,000

What is the ratio of a high-income family’s income to a low-income family’s income: a. before taxes and b. after taxes? c. Is this tax progressive?

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Answer: To complete the table: The tax paid by a high-income family equals $185,000 (= before-tax income × tax rate = $500,000 × 0.37). The after-tax income equals $315,000 (= before-tax income − tax paid = $500,000 − $185,000). The middle-income family pays a tax of $10,000 (= before-tax income × tax rate = $50,000 × 0.20). The after-tax income equals $40,000 (= before-tax income − tax paid = $50,000 − $10,000). The low-income family pays a tax of $2,000 (= before-tax income × tax rate = $20,000 × 0.10). The after-tax income equals $18,000 (= before-tax income − tax paid = $20,000 − $2,000). a. The before-tax ratio of a high-income family's income to a low-income family's income is 25 (= high-income, before-tax income ÷ low-income, before-tax income = $500,000 ÷ $20,000). b. The after-tax ratio of a high-income family's income to a low-income family's income is 17.5 (= high-income, after-tax income ÷ low-income, after-tax income = $315,000 ÷ $18,000). c. There are a couple of different ways to determine if a tax is progressive. First, a tax system in which average tax rates rise as incomes rise is a progressive tax system. In this example, higher incomes are taxed at a higher rate (low income is taxed at 10 percent, middle income is taxed at 20 percent, and high income is taxed at 37 percent). Second, a progressive tax makes after-tax incomes more equal than before-tax incomes. We can see this by comparing the before- and after-tax ratios. In this example, since the after-tax ratio is lower, this means the after-tax incomes are more equal than the before-tax incomes.

11. POLICY PERSPECTIVES In 2020, the United States devoted about 0.18 percent of its $21 trillion GDP to development assistance. LO2 a. How much money is that? b. How much aid does that imply for each of the 3 billion poor people in developing nations?

Answer: a. If the United States devotes 0.18 percent of its $21 trillion GDP to development assistance, this is equal to $38 billion going to development assistance. Remember that $21 trillion equals $21,000 billion. Amount of assistance = GDP × percent devoted to development assistance = $21 trillion × 0.18% = $21,000 billion × 0.0018 = $38 billion. b. This $38 billion is approximately $12.67 in aid for each of the 3 billion poor people in the developing nations. Per person aid = development assistance ÷ poor = $38 billion ÷ 3 billion people = $12.67 in aid on average per poor person.

CHAPTER 3: SUPPLY and DEMAND ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain why people participate in markets.

2 Describe what market demand and supply measure.

3 Depict how and why a market equilibrium is found.

4 Illustrate how and why demand and supply curves sometimes shift. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

5 Explain how market shortages and surpluses occur.

6 POLICY PERSPECTIVES Assess the effects of price ceilings.

QUESTIONS FOR DISCUSSION 1. What do the supply and demand for human kidneys look like? If a market in kidneys were legal, who would get them? How does a law prohibiting kidney sales affect the quantity of kidney transplants or their distribution? LO2 Answer: Currently, the demand for kidneys far exceeds the supply due to laws prohibiting donors of kidneys from being compensated. If a market in kidneys were legal, the recipients would be those who had the financial ability to acquire them, a market response just like any other good being offered for sale. The law prohibiting kidney sales keeps the supply down despite increasing demand.

On the other hand, the quantity supplied of kidneys would increase as the price increased. As the price increased, more people would be willing to give up a kidney. The supply curve would start out at the point on the x-axis at the quantity that is currently available at a price of zero.

These are mostly from people who have died and have signed organ donor cards. This quantity is lower than the quantity demanded and therefore results in a shortage of kidneys when their sale is prohibited by law.

If a market in kidneys were legal, the people who are most likely to get the kidneys are those who are willing and able to pay the going market price. People who do not have insurance coverage for new kidneys or who cannot afford to pay the market price will do without.

A law that prohibits kidney sales reduces the quantity of kidneys transplanted because the law reduces the quantity supplied of available kidneys. The allocation of kidneys relies on legal distribution through registered organ banks and on the black market for kidneys.

2. In the web tutoring market, what forces might cause: LO4 a. a rightward shift of demand? b. a leftward shift of demand? c. a rightward shift of supply? d. a leftward shift of supply? e. an increase in the equilibrium price?

Answer: a. An increase in any of the determinants of demand for web tutoring would cause the demand curve to shift to the right. Examples include an increased desire to create websites; increases in income, resulting in more people purchasing computers and connecting to the web; decreases in the prices of computers, resulting in more people purchasing computers and connecting to the web; decreases in the price of monthly web connection fees; and changes in the expectations of how many people will be accessing the web.

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b. A decrease in any of the determinants of demand for web tutoring would cause the demand curve to shift to the left. Examples include a decreased desire to create websites; decreases in income, resulting in fewer people purchasing computers and connecting to the web; increases in the prices of computers, resulting in fewer people purchasing computers and connecting to the web; increases in the price of monthly web connection fees; and changes in the expectations of how many people will be accessing the web. c. An increase in any of the determinants of supply for web tutoring would cause the supply curve to shift to the right. Examples include improvements in technology that make it easier to design websites, decreases in the prices of computers and web design software, a decrease in taxes on web design income, increases in expectations of income generated through web design, and increases in the number of sellers of web tutoring. d. A decrease in any of the determinants of supply for web tutoring would cause the supply curve to shift to the left. Examples include increases in the prices of computers and web design software, increases in taxes on web design income, decreases in expectations of income generated through web design, and decreases in the number of sellers of web tutoring. e. An increase in the equilibrium price of web services can be caused by either an increase in demand or a decrease in supply, ceteris paribus.

3. Did the price of tuition at your school change this year? What might have caused that? LO3 Answer: In almost all cases, the price of tuition at colleges and universities increased last year. A market explanation of this price increase would include an increase in the demand for a college education as more and more high school graduates decide to go to college. In addition, the cost of providing that education, such as salaries of faculty, staff, and administration, heating and cooling, rent on buildings, etc., all increased, causing supply to decrease. Also, a reduction in subsidies from state governments facing financial difficulties may have led to tuition increases in some cases.

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4. Illustrate the market shortage for tickets to the Pope’s New York City procession (see the News Wire “Market Shortage: Scalpers Profiting Greatly from Pope’s Visit”). LO5

PRICE (per ticket)

Supply

Face value price $0 SHORTAGE Market demand Answer: Since markets use trial and error to set prices, the below-market price may be due to bad guesses on the part of distributors. In this case, tickets were originally distributed by lottery. Those in the market for tickets applied, and then were selected, and received a ticket for free. Since the tickets were easily transferable, scalpers offered tickets for as much as $3,000 a pair. See the graph above for an illustration of the market shortage.

5. How does a reduction in the price of concert tickets affect: LO2 a. the quantity of tickets demanded? b. the desire of fans for tickets?

Answer: a. A reduction in the price of tickets increases quantity demanded. This is a movement along the demand curve. b. While the quantity of tickets demanded has increased, following the law of demand, the desire of fans for tickets will not change. In this case, only the price of the tickets has changed, not any of the other determinants of demand, such as the tastes and preferences of fans surrounding the desire for tickets. The desire for tickets is part of the tastes and preferences of the fans.

6. When concert tickets are priced below equilibrium, who gets them? Is this distribution of tickets fairer than a pure market distribution? Is it more efficient? Who gains or loses if all the tickets are resold (scalped) at the market-clearing price? LO5

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Answer: When tickets are priced below equilibrium, tickets are often distributed initially on a first-come, first-serve basis. It is often the case that these people then resell their tickets at a higher price for a profit. Whether the distribution of tickets is fairer than a pure market distribution system depends on your point of view. If you have the time to stand in line early or redial the phone continually until you get in on the telephone order line, you probably think the system is fair. If you do not have the time for these activities, you probably think the system is unfair. This system of distribution is less efficient in that the tickets are not being sold for their market value. If all the tickets are resold at the market-clearing price, then there are mostly gainers. Those people who originally purchased the tickets gain because they sell $28.50 tickets for a higher price and they earn a profit. Those people who purchase the tickets at a higher price gain because they are able to acquire tickets that they otherwise would not have been able to purchase. There are some people who may not be able to afford to pay the market-clearing price and thus cannot purchase the tickets.

7. Is there a shortage of on-campus parking at your school? How might the shortage be resolved? LO5 Answer: Most schools have an on-campus parking shortage. This shortage could be resolved in a number of ways. A non-market solution would be for the campus administration to intervene and restrict the number of cars allowed on campus. For example, some schools do not allow first- and second-year students to bring cars on campus. This method, of course, harms first- and second-year students who would otherwise bring cars to campus. A second method would be to utilize the market and sell parking privileges. If the price of parking permits is set appropriately, the parking problem will be resolved. Only those students who perceive the benefit of parking to be greater than or equal to the cost of parking will purchase the parking permit. Those who do not believe the benefits received from parking on campus are worth the price will either not bring cars to school or will park off campus.

8. If San Francisco eliminated rent controls (News Wire “Price Controls”), what would happen to the demand and supply for housing? LO5 Answer: Where the leaders of a city have both a commitment to solving the housing problems of the poor and political pressure to act quickly, rent controls do the job. They immediately put a lid on rents. Because this interference with the market decreases the profitability of rental housing, rent controls also tend to bring construction of new rental housing to a halt, so that the long-run housing problem will still exist. An alternative approach would be to utilize the market by either subsidizing the rents of low-income people, thereby enabling them to pay the “high” rents or subsidizing landlords, thereby increasing supply and lowering rents to a more acceptable level. Cities also increase the supply of rental housing by creating government-owned public housing.

9. Why did Apple set the initial price of the iPhone 12 Pro below equilibrium (see the News Wire “Market Shortage: Apple iPhone 12 Pro Sells Out”)? Should Apple have immediately raised the price? LO5 Answer: Apple might have been setting the price of its iPhone 12 Pro based on a long-term pricing strategy rather than a short-term pricing strategy. Although the initial price of $999 for the entry-level version was well below the equilibrium price during the initial release, Apple expected consumer demand and supply to reach an equilibrium level well below this level after the initial release.

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Instead of alienating consumers on this new product, Apple set a price that allowed consumers who were willing and able to purchase the product at $999 to have access to the product while still enticing other potential consumers with the possibility of purchasing a higher GB version for a higher price.

In so doing, it kept potential consumers in the market waiting for the shortage to be alleviated. It also was able to use the shortage as a marketing strategy to demonstrate its product to would-be buyers and get them to purchase a higher-priced, higher-GB phone.

10. POLICY PERSPECTIVES In the wake of Hurricane Harvey, gasoline prices doubled at many locations, with prices reaching as high as $20 per gallon. Who got gas at those prices? Should the government have put a lid on prices? If it did, who would have gotten the available gasoline? LO6 Answer: In the wake of Hurricane Harvey, those who were willing and able to pay the higher gas prices up to $20 per gallon were the people who actually received the gasoline. Those prices created an incentive for producers to supply more gasoline in the area and an incentive for consumers to use less gasoline. Both of these dynamics of the response of producers and consumers to change their quantities supplied and quantities demanded would over time allow the price of gasoline to fall. If the government intervened and capped the price of gas at a price less than the $20 market price, producers would have supplied an even lower quantity of gasoline. This would have created a shortage in the market, since consumers would increase their quantity demanded at the lower price point, leading to lines at gas stations and other alternative forms of rationing. Those consumers who would wait in line or who could afford the alternative forms of rationing would receive the gasoline.

PROBLEMS 1. Using the “new demand” in Figure 3.7 as a guide, determine the size of the market surplus or shortage that would exist at a price of: LO5 a. $40. b. $20.

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Answer: a. At a price of $40, quantity supplied is 125 and quantity demanded is 75. Since quantity supplied is greater than quantity demanded, a surplus of 50 hours of tutoring exists (= 125 hours − 75 hours = 50 hours). b. At a price of $20, quantity supplied is 37.5 and quantity demanded is 125. Since quantity demanded is greater than quantity supplied, a shortage of 87.5 hours of tutoring exists (= 125 hours − 37.5 hours = 87.5 hours).

2. Based on the News Wire “Supply Shift,” LO3, LO5 a. what is the initial (pre-hurricane) equilibrium rent per month? b. what is the pre-hurricane equilibrium quantity? c. how large is the pre-hurricane shortage? d. what is the post-hurricane equilibrium rent? e. what is the post-hurricane equilibrium quantity? f. how large is the post-hurricane shortage at the pre-hurricane equilibrium rent?

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Answer:

a. The initial (pre-hurricane) equilibrium rent is $1,000 per month. It is where the prehurricane supply intersects with the market demand curve. b. The pre-hurricane equilibrium quantity is 100 thousand units per month. It is where the pre-hurricane supply intersects with the market demand curve. c. There is no shortage or surplus before the hurricane because the market is in equilibrium. d. The post-hurricane equilibrium rent is $1,200 per month. It is where the post-hurricane supply intersects with the market demand curve. e. The post-hurricane equilibrium quantity is 85 thousand units per month. It is where the post-hurricane supply intersects with the market demand curve. f. The post-hurricane shortage at the pre-hurricane equilibrium price is 25 thousand units per month. It is the difference in the quantity demanded at $1,000 on the market demand curve and the quantity supplied at $1,000 on the post-hurricane supply curve. The quantity demanded is 100 thousand units per month and the quantity supplied is 75 thousand units per month, leading to a shortage of 25 thousand units per month (= 100 thousand units per month − 75 thousand units per month).

3. According to the News Wire “Market Shortage: Scalpers Profiting Greatly from Pope’s Visit,” LO5

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a. how large was the market shortage at the Church-set price of $0? b. if the Church had sold the tickets for $100, how would have the quantity demanded changed (increased, decreased, not changed)? c. if the Church sold the tickets for $100, would the market shortage have been larger or smaller? d. if the Church sold the tickets for the equilibrium price, would a market shortage exist?

Answer: a. The market shortage is the amount by which quantity demanded exceeds quantity supplied at a given price. According to the News Wire, there was a shortage of 53,000 tickets (= 93,000 tickets demanded − 40,000 tickets supplied). b. The law of demand tells us that the quantity of a good demanded in a given time period decreases as its price increases, ceteris paribus. If the Church sold the tickets for $100 instead of giving them away for free, then we would predict that because the price is higher, the quantity demanded will decrease. c. The market shortage would be smaller if the tickets were sold for $100. At a price of $100, the quantity demanded would be less than 93,000 tickets, so the shortage (the difference between the quantity demanded and the quantity supplied) would be smaller. d. At the equilibrium price, there is no shortage or surplus. At the equilibrium price, quantity demanded exactly equals quantity supplied.

4. In September 2014 Apple was selling a gold version of the 128GB iPhone 6 for $949. Two days later that phone was advertised on eBay for a starting bid of $1,625. LO5 a. Was this evidence of a market shortage or a market surplus? b. Graph this situation.

Answer: a. This is an example of a market shortage. When a market shortage exists, not all consumer demand can be satisfied. Some people who are willing to buy the iPhone at the going price ($949) will not be able to do so. If there is a shortage, quantity demanded exceeds quantity supplied, and the price will start to rise, sometimes dramatically. b. To illustrate a shortage, the current price must be below the equilibrium price. Graphically, the price of $949 will be below where the supply and demand curves intersect.

See the graph on the next page for an illustration of this situation.

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5. Given the following data: LO2 a. complete the following tables; b. construct market supply and demand curves; c. identify the equilibrium price; and d. identify the amount of shortage or surplus that would exist at a price of $3.

Participant Price Demand side Al Betsy Casey Daisy Eddie Market Total

Quantity Demanded (per Week) $5 $4 $3 $2 $1

Price Supply side Firm A Firm B

Quantity Supplied (per Week) $5 $4 $3 $2 $1 3 3 3 3 3 7 5 4 4 2

1 1 2 2 2 __

2 2 2 3 2 __

3 2 3 4 2 __

4 2 3 4 3 __

5 3 4 6 5 __

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Firm C Firm D Firm E Market total

6 6 4 __

4 5 3 __

3 4 3 __

3 3 3 __

1 0 2 __

Answer: a. Market totals are developed by simply summing the quantities participants want to purchase at each price. In other words, we sum each column. For example, on the demand side, at a price of $5, the market total is equal to 8 (= 1 + 1 + 2 + 2 + 2). b. In order to construct market supply and demand curves, market totals with their corresponding prices (calculated in the table) are plotted. For example, one point on the market supply curve is at a price of $5 and market supply of 26. The other points along both curves are plotted in a similar manner.

c. The equilibrium price is the price at which quantity supplied is equal to quantity demanded.

Equilibrium price can be found one of two ways. First, the equilibrium price can be found graphically by identifying where the supply curve and demand curve intersect. Second, using the tables of supply and demand data, identify the price where market quantity demanded equals market quantity supplied. In this example, we can see graphically and using the tables that at a price of $2, quantity supplied is 16 units and quantity demanded is 16 units. Thus, $2 is the equilibrium price and the equilibrium quantity is 16.

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d. At a price of $3, quantity supplied is 17 units while quantity demanded is 14. Since the quantity supplied is greater than the quantity demanded, a surplus of 3 units exists (= 17 − 14).

6. If a product becomes more popular, LO4 a. which curve will shift? b. along which curve will price and quantity move?

At the new equilibrium price, will: c. price be higher or lower? d. quantity be higher or lower?

Answer: a. When a product becomes more popular, consumers' tastes change, and they become more interested in purchasing this new product. This change in tastes will cause demand to increase. In other words, demand will shift to the right. b. An increase in demand moves price and quantity along the unchanging supply curve. c, d. A rightward shift of the demand curve indicates that consumers are willing and able to buy a larger quantity at every price. As a consequence, a new equilibrium is established at a higher price and greater quantity.

7. Which curve shifts, and in what direction, when the following events occur in the domestic car market? LO4 a. The U.S. economy falls into a recession. b. U.S. autoworkers go on strike. c. Imported cars become more expensive. d. The price of gasoline increases.

Answer: a. When the U.S. economy falls into a recession, consumer incomes in the United States are lower, and thus demand for cars, including domestic cars, decreases. In other words, demand shifts to the left. b. If U.S. autoworkers go on strike, domestic car production slows or comes to a halt, decreasing the supply of domestic cars. In other words, supply shifts to the left. c. Imported and domestic cars are substitute goods in consumption. This means that when a consumer wants to buy a car, he or she can choose from an imported or a domestically produced car. When imported cars become more expensive, people are more likely to buy the relatively less expensive domestic cars, increasing demand for domestic cars. In other words, demand shifts to the right. d. Gasoline and cars are complementary goods in consumption. Most cars require gasoline to run. If one of the complementary goods becomes more expensive, it will cause a decrease in demand for the other good. In this example, an increasing price of gasoline will lead to a decrease in demand for domestic cars. In other words, demand for domestic cars will shift to the left.

8. Assume the following data describe the gasoline market: LO3 Price per gallon

$3.50 $3.25 $3.00 $2.75 $2.50 $2.25 $2.00

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Quantity demanded Quantity supplied

30 36

31 34

32 32

33 30

34 28

35 26

36 24

a. Graph the demand and supply curves. b. What is the equilibrium price? c. If quantity supplied at every price is reduced by 6 gallons, what is the new equilibrium price? d. If the government freezes the price of gasoline at its initial equilibrium price found in part a, how much of a surplus or shortage will exist when supply is reduced as described in part c?

Answer: a. The demand curve is graphed with price on the vertical axis and quantity on the horizontal axis. Each corresponding pair is then plotted. For example, one point is at a price of $2.00 and a quantity demanded of 36, another point is at a price of $2.25 and a quantity demanded of 35, and so on. The supply curve is plotted in the same way where the corresponding pairs of price and quantity supplied are used. b. Equilibrium price is the price at which quantity demanded is equal to quantity supplied. In this case, the equilibrium price is $3.00, where quantity demanded (= 32 gallons) is equal to quantity supplied (= 32 gallons). c. To answer this question, it can help to create another data table. The following data table shows the original supply curve, the new supply curve (with quantity supplied decreasing by 6 gallons at every price), and the demand curve. The new equilibrium price is $3.50, which is the price where quantity demanded (= 30 gallons) is equal to the new quantity supplied (= 30 gallons).

Price $3.50 3.25 3.00 2.75 2.50 2.25 2.00

Quantity Supplied (Original) 36 34 32 30 28 26 24

Quantity Supplied (New) 36 − 6 = 30 34 − 6 = 28 32 − 6 = 26 30 − 6 = 24 28 − 6 = 22 26 − 6 = 20 24 − 6 = 18

Quantity Demanded (Unchanging) 30 31 32 33 34 35 36

d. Looking again at our table in part c, comparing the quantity demanded and the quantity supplied using the new quantity supplied at the initial equilibrium price of $3.00, quantity demanded is 32 gallons and quantity supplied is 26 gallons. Thus, a shortage of 6 gallons would exist (= 32 − 26).

9. Using the News Wire “Law of Demand,” answer the following questions: LO2 a. According to the Harvard study, what would be the response of students to a tax on alcohol that raises the price of alcoholic drinks by $1? b. Graph the response of students to higher alcohol prices.

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Answer: a. According to the study, students faced with a $1 increase above the average drink price will be 33 percent less likely to drink at all or as much. b. In the graph, the price that students will pay will be higher and the quantity of alcohol consumed would be lower.

10. If the equilibrium price for tickets to a Taylor Swift concert is $100 each, and she sells them for $80, LO5 a. Does she create a market surplus or shortage? b. Suppose scalpers buy 10,000 tickets and resell them for $100 each. How much profit do the scalpers earn?

Answers: a. Because the market price is less than the equilibrium price, quantity demanded will be greater than quantity supplied, so a shortage will exist. b. Scalpers can earn $20 profit per ticket resold (= $100 resale price − $80 purchase price) for a total profit of $200,000 (= $20 profit per ticket × 10,000 tickets).

11. POLICY PERSPECTIVES Hurricane Harvey damaged water systems, cutting off water to thousands in Houston. LO6 a. What was the immediate impact on demand for bottled water? b. If the government capped the price of bottled water at $1, what would have happened?

Answer: a. Many people living in Houston no longer had access to water in their homes, so there was a big increase in demand for bottled water. b. If the price of bottled water was capped, it would have made the shortage worse than it was. When the price is below the equilibrium price, a shortage exists, and the very low price of $1 would have resulted in an even larger shortage of bottled water.

CHAPTER 4: CONSUMER DEMAND ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain why demand curves slope downward.

2 Describe what the price elasticity of demand measures.

3 Depict the relationship of price elasticity, price, and total revenue.

4 Recite the factors that influence the degree of price elasticity.

5 POLICY PERSPECTIVES Discuss how advertising affects consumer demand.

QUESTIONS FOR DISCUSSION

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1. Why do people routinely stuff themselves at all-you-can-eat buffets? Explain in terms of both utility and demand theories. LO1 Answer: The law of demand states that as the price of an item decreases a consumer will purchase more of a product. In this case, the cost of entry is the only price paid. Once paid, all additional trips to the buffet line have a price of zero. As a result, a consumer is making a rational choice to consume until the marginal utility of the last bite consumed is zero.

2. What does the demand for education at your college look like? What is on each axis? Is the demand elastic or inelastic? How could you find out? LO1 Answer: A graph constructed for this problem would have tuition on the vertical axis and number of students who apply for college on the horizontal axis. The demand curve would look like most demand curves, sloping downward from left to right in accordance with the law of demand. However, as the elasticity of the curve might vary from institution to institution and person to person, its location and shape would vary. To determine whether demand is elastic or inelastic, you could calculate the elasticity by finding out how enrollment responded when tuition last increased (keeping in mind the ceteris paribus assumption).

3. What would happen to unit sales and total revenue for this textbook if the publisher reduced its price? LO3 Answer: According to the law of demand, as price goes down, quantity (unit sales) increases.

What happens to total revenue, however, depends on the price elasticity of demand. In general, the price elasticity of demand for textbooks has an absolute value less than one.

If that is the case, the percentage increase in quantity sold is less than the percentage decline in price and, as a result, the total revenue from sales would decline. In other words, the decrease in price more than offsets the increase in quantity and therefore total revenue (price times quantity) declines.

4. Should Starbucks have increased its prices in 2021? Should it raise prices again? (See the News Wire “Inelastic Demand.”) LO4 Answer: Starbucks increased its prices in 2021 to cover rising costs. The price increase will enable Starbucks to cover those costs if and only if, as anticipated, it faces inelastic demand.

If customers are loyal and demand is inelastic, then as price increases, total revenue will increase, and this will enable Starbucks to use the revenue gained from higher prices to cover its costs. Whether or not it should raise prices again depends on whether Starbucks customers remain loyal and whether it continues to face rising costs and inelastic demand.

5. Identify three goods for which your demand is elastic and inelastic. What accounts for the differences in elasticity? LO2

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Answer: Goods with elastic demand include, in general, large-budget items such as new cars or items with many substitutes, such as specific vacation sites and specific food items (chicken, beef, pork, etc.). Goods with inelastic demand most likely include small-budget items such as table salt or items with few good substitutes such as gasoline and very broad categories of food (meat, vegetables, fruit, etc.). Elasticities can differ between products due to differences in prices relative to a consumer’s income, the number of substitutes available, and the length of the time to respond.

6. Utility companies routinely ask state commissions for permission to raise utility rates. What does this suggest about the price elasticity of demand? Why is demand so (in)elastic? LO3 Answer: When a price increase results in an increase in revenue, demand is relatively inelastic. Since utilities are asking for a rate (price) increase presumably to increase revenue, this suggests that the demand for gas, electricity, and local telephone service is inelastic. This inelasticity is generated by the fact that these services tend to be necessities, have few good substitutes, and, for some people, may be a relatively small portion of income.

7. Why is the demand for Oregon’s cigarettes so much more price elastic than the overall market demand for cigarettes (see the News Wire “Tax Hikes and Demand”)? LO4 Answer: The price elasticity of demand for cigarettes in Oregon is more elastic than that in the overall market because smokers can purchase cigarettes elsewhere. In general, the more substitutes, the greater the price elasticity of demand.

8. When gasoline prices go up, how is demand for the following products affected? LO4 a. SUVs b. electric cars c. beach hotels d. Netflix Answer: a. Fall. Gas and SUVs are complementary goods. b. Rise. Electric cars and SUVs are substitute goods; electric cars don’t rely on gas, and in this instance, the cost of their fuel would be relatively cheaper. c. Fall. With transportation costs increasing due to the higher price of gas and fuel, there will be less demand for expensive beach vacations since it will cost more to get to the beach. d. No change (unrelated goods).

9. What goods do people buy a lot more of when their incomes go up? What goods are unaffected by income changes? LO4 Answer: People buy a lot more of luxuries (such as beach houses) when their incomes go up.

They aren’t likely to buy more necessities (such as prosthetic limbs).

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10. If Apple cuts the price of the AirPods, what will happen to unit sales and total revenue?

Should Apple do it? LO3 Answer: The law of demand predicts that unit sales will increase when the price is cut. The quantity demanded will increase. Total revenue will increase only if demand is elastic. Apple should cut the price of AirPods only if it is facing a market where demand is elastic, so that it will receive an increase in total revenue by cutting its prices. If Apple is facing an inelastic market demand, cutting the price will actually cause its revenue to fall.

11. POLICY PERSPECTIVES If all soda advertisement were banned, how would Pepsi sales be affected? How about total soda consumption? LO5 Answer: The main purpose of advertising is to increase demand. If all soda advertising were banned, then we would expect a decrease in demand, resulting in both a decrease in sales for Pepsi and a decrease in total consumption of soda, although the demand for Pepsi would probably be less affected since it is a well-known brand.

PROBLEMS 1. a. In Figure 4.2, which box of popcorn first shows diminished marginal utility? b. In the cartoon “You can have too much of a good thing,” which pizza slice first yields negative marginal utility? LO1 Answer: a. The second box of popcorn provides less utility than the first. Therefore, the second box shows diminished marginal utility. b. The man states that after eating five slices of pizza, he doesn't want to eat another bite.

Therefore, the sixth slice will yield negative marginal utility. He will not eat that sixth slice of pizza because he has studied economics and makes rational consumption decisions (see his T-shirt).

2. Using the demand schedule below, plot the demand curve on the graph and answer four questions about demand and elasticity: LO3 Price (per pair) $120 $100 $80 Quantity demanded (in pairs per year) 6 10 15

$60 20

$40 26

a. Illustrate the demand curve on the following graph. b. Calculate total revenue from shoe sales at each of the following prices: (i) $120 (ii) $100 (iii) $80

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(iv) $60 (v) $40 Referencing the total revenue calculated in part b, determine if demand is elastic, unitary elastic, or inelastic as the price changes: c. from $120 to $100 a pair. d. from $80 to $60 a pair. e. from $60 to $40 a pair.

Answer: a. The various points along the demand curve are plotted with quantity demanded on the horizontal axis and price on the vertical axis. Thus, one point along the demand curve is at a quantity demanded of 6 and a price of $120. A second point is at a quantity demanded of 10 and a price of $100. The final three points are (15, $80), (20, $60), and (26, $40), respectively.

See the graph on the next page for an illustration of the demand curve.

b. (i) Consumers will purchase 6 pairs of shoes at $120 each for a total of $720 (= 6 × $120). (ii) Consumers will purchase 10 pairs of shoes at $100 each for a total of $1,000 (= 10 × $100).

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(iii) Consumers will purchase 15 pairs of shoes at $80 each for a total of $1,200 (= 15 × $80). (iv) Consumers will purchase 20 pairs of shoes at $60 each for a total of $1,200 (= 20 × $60). (v) Consumers will purchase 26 pairs of shoes at $40 each for a total of $1,040 (= 26 × $40).

To determine if the consumer response to a price cut is elastic, inelastic, or unitary elastic, you can observe the change in total revenue (total revenue = price × quantity) when the price changes.

If Demand Is: Elastic (E > 1) Inelastic (E < 1) Unitary elastic (E = 1)

When Price Decreases, Total Revenue Will: Increase Decrease Not change

Since we have already calculated total revenue, we can infer if the elasticity of the demand responds at the price changes. c. Calculating the change in total revenue: As price decreases from $120 to $100, total revenue increases from $720 to $1,000. This implies an elastic demand. A price cut increases total revenue if demand is elastic. d. Calculating the change in total revenue: As price decreases from $80 to $60, total revenue does not change (it remains at $1,200), implying demand is unitary elastic. e. Calculating the change in total revenue: As price decreases from $60 to $40, total revenue falls from $1,200 to $1,040, implying demand is inelastic. A price cut reduces total revenue if demand is inelastic.

3. According to the elasticity computation, for popcorn of 0.5 (in absolute value), by how much would popcorn sales fall if the price increased by: LO2 a. 10 percent? b. 30 percent?

Answer: Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value). Remember that there is an inverse relationship between price and quantity demanded: • If price increases, quantity demanded decreases.

• If price decreases, quantity demanded increases.

Because price and quantity demanded always move in opposite directions (the law of demand), the price elasticity of demand (= E) is a negative value (−0.5, in this case). For convenience, however, we use the absolute value of E (without the minus sign).

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a. According to the computation for price elasticity of demand, the popcorn example equals 0.5 (in absolute value). If the percentage change in price is 10 percent, the percentage change in quantity demanded is 5 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.5 = percentage change in quantity demanded ÷ 10% 0.5 × 10% = 5% b. According to the computation for price elasticity of demand, the popcorn example equals 0.5 (in absolute value). If the percentage change in price is 30 percent, the percentage change in quantity demanded is 15 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.5 = percentage change in quantity demanded ÷ 30% 0.5 × 30% = 15% 4. a. According to Table 4.1, if price increases by 10 percent, how much will unit sales decline for (i) coffee, (ii) shoes, and (iii) airline travel? LO3 b. Will total revenue increase or decrease for (i) coffee, (ii) shoes, and (iii) airline travel?

Answer: Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value).

If Demand Is: When Price Increases, Total Revenue Will: Elastic (E > 1) Decrease Inelastic (E < 1) Increase Unitary elastic (E = 1) Not change Airline Travel: Airline travel has a price elasticity of demand equal to 2.4. If the price of airline travel increases by 10 percent, quantity demanded decreases by 24 percent.

E = percentage change in quantity demanded ÷ percentage change in price 2.4 = percentage change in quantity demanded ÷ 10% 2.4 × 10% = 24% Airline travel is elastic. In this case, a price increase will lead to a decrease in total revenue.

Shoes: Shoes have a price elasticity of demand equal to 0.9. When the price increases by 10 percent, quantity demanded decreases by 9 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.9 = percentage change in quantity demanded ÷ 10% 0.9 × 10% = 9%

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Shoes are slightly inelastic. Thus, a price increase will lead to a small increase in total revenue.

Coffee: According to the table, coffee has a price elasticity of demand equal to 0.3. If the price increases by 10 percent, quantity demanded decreases by 3 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.3 = percentage change in quantity demanded ÷ 10% 0.3 × 10% = 3% Coffee is inelastic. Thus, a price increase will lead to an increase in total revenue.

5. a. According to Table 4.1, by how much would coffee sales decline if the price of coffee increased 10 percent? LO4 b. If your local coffee shop raised its coffee prices by the same amount (10 percent), would sales decline by more, less, or the same amount as calculated in part a?

Answer: Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value). a. The price elasticity of demand for coffee is 0.3. If the price of coffee increases by 10 percent, quantity demanded decreases by 3 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.3 = percentage change in quantity demanded ÷ 10% 0.3 × 10% = 3% b. One determinant of price elasticity is the availability of substitutes. Your local coffee shop is a specific type of coffee with many substitutes, such as Starbucks, making coffee at home, or getting a cup at a nearby gas station. Since there are many substitutes for your local coffee shop's coffee, we would expect that the price elasticity of demand would be more elastic. Thus, the quantity demanded will decline by more than 3 percent with the same 10 percent increase in price.

6. According to the News Wire “Tax Hikes and Demand,” LO2 a. By what percentage did the state tax hike cause retail cigarette prices to increase? b. If the price elasticity of demand for retail cigarettes in Oregon is 0.4, by how much will consumption of retail cigarettes decrease because of the tax hike? c. Suppose Oregonians can get cigarettes easily online and out of state. Will the sale of retail cigarettes in Oregon decrease more than, as much as, or less than calculated in part b?

Answer: a. According to the article, the tax increase of $2.00 per pack caused retail cigarette prices to increase from $6.33 to $8.33 a pack, which is a 31.6 percent increase *= ($8.33 − $6.33) ÷ $6.33 ×100]. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value). According to the article, a 10 percent price increase typically reduces cigarette consumption by 4 percent, implying a price elasticity of demand equal to 0.4.

E = percentage change in quantity demanded ÷ percentage change in price = 4% ÷ 10% = 0.4 If the average cigarette price rose by 31.6 percent, smoking would be expected to decline by 12.6 percent.

E = percentage change in quantity demanded ÷ percentage change in price 0.4 = percentage change in quantity demanded ÷ 31.6% 0.4 × 31.6% = 12.6% c. When there are more substitutes available, the elasticity response will be larger. The drop in unit sales may be larger in Oregon, as residents will have the option of purchasing smokes from other states, Indian reservations, and online.

7. Suppose the following table reflects the total satisfaction (utility) derived from eating slices of pizza: LO1 Quantity consumed Total utility

1 47

2 92

3 122

4 135

5 137

6 120

7 70

a. What is the marginal utility of each slice of pizza? b. When does marginal utility first diminish? c. When does marginal utility first turn negative?

Answer: a. Marginal utility (MU) is the satisfaction obtained by consuming one additional (marginal) unit of a good or service. In our example, marginal utility is the satisfaction obtained by consuming one extra slice of pizza. It is calculated as the change in total utility divided by the change in quantity.

• MU for the first slice of pizza = (total utility of first slice − total utility of no slices) ÷ (one more slice) = (47 − 0) ÷ 1 = 47.

• MU for the second slice of pizza = (total utility of second slice − total utility of first slice) ÷ (one more slice) = (92 − 47) ÷ 1 = 45.

• MU for the third slice of pizza = (total utility of third slice − total utility of second slice) ÷ (one more slice) = (122 − 92) ÷ 1 = 30.

• MU for the fourth slice of pizza = (total utility of fourth slice − total utility of third slice) ÷ (one more slice) = (135 − 122) ÷ 1 = 13. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

• MU for the fifth slice of pizza = (total utility of fifth slice − total utility of fourth slice) ÷ (one more slice) = (137 − 135) ÷ 1 = 2.

• MU for the sixth slice of pizza = (total utility of sixth slice − total utility of fifth slice) ÷ (one more slice) = (120 − 137) ÷ 1 = −17.

• MU for the seventh slice of pizza = (total utility of seventh slice − total utility of sixth slice) ÷ (one more slice) = (70 − 120) ÷ 1 = −50. b. Marginal utility diminishes when consuming an additional slice of pizza provides less utility than the previous one. In this case, the second slice of pizza provides marginal utility of 45 whereas the first slice of pizza provides 47. Thus, the second slice of pizza provides a diminished marginal utility. c. Marginal utility first turns negative with the sixth slice of pizza, −17.

8. According to the News Wire “Inelastic Demand,” LO3 a. By what percent did Starbucks raise brewed coffee prices? b. Based on the analyst predictions, would this price increase cause total revenue to stay the same, increase, or decrease?

Suppose unit sales fell by 3 percent after this price increase. c. Calculate price elasticity. d. In the case presented in part c, is demand elastic or inelastic? e. In the case presented in part c, would total revenue have increased or decreased?

Answer: a. According to the article, Starbucks' price hike of 10 cents will raise prices for a brewed cup of coffee from $2.35 to $2.45, which is a 4.3 percent increase *= ($2.45 − $2.35) ÷ $2.35 ×100]. b. Analysts predicted that the price hike wouldn’t deter most customers, as company loyalty is extremely high. Whatever sales might be lost for price-sensitive customers would be more than offset by higher revenues from loyal customers. This means that total revenue was expected to rise. c. If unit sales fell by 3 percent after this price increase, then the price elasticity of demand would equal 0.70. Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value).

E = 3% ÷ 4.3% = 0.70. d. Demand is inelastic if the price elasticity of demand is less than 1 (in absolute value). e. If demand is inelastic, total revenue will increase when the price is raised.

If Demand Is: Elastic (E > 1) Inelastic (E < 1) Unitary elastic (E = 1)

When Price Increases, Total Revenue Will: Decrease Increase Not change

9. According to the News Wire “Price Elasticity,” what was the predicted price elasticity of demand for the iPhone 11? LO2 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

Answer: According to the News Wire, the price of the iPhone 11 was decreased by $100, from $699 to $599. This was a 14 percent decrease in price *= ($599 − $699) ÷ $699 ×100+.

Apple expected unit sales of the iPhone 11 to increase by 17 percent in response to the lower price. Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value).

E = 17% ÷ 14% = 1.21.

10. Economists estimate price elasticities more precisely by using average price and quantity to compute percentage changes. Thus, LO3

Using this formula, compute E for a popcorn price increase from 15 cents to 25 cents per ounce (Figure 4.4).

Answer: Price Elasticity of Demand, Midpoint Formula: E = percentage change in quantity demanded ÷ percentage change in price, in absolute value where, percentage change in quantity demanded = (Q2 − Q1) ÷ [(Q1 + Q2) ÷ 2] percentage change in price = (P2 − P1) ÷ [(P1 + P2) ÷ 2] Note that the denominator in each part uses the average quantity or the average price.

According to the formula provided, the percentage change in quantity demanded is (12 − 20) ÷ [(20 + 12) ÷ 2] = 8 ÷ 16 = 0.5, in absolute value. According to the formula provided, the percentage change in price is ($0.25 − $0.15) ÷ *($0.15 + $0.25) ÷ 2+ = $0.10 ÷ $0.20 = 0.5%, in absolute value. Therefore, the price elasticity of demand E = 0.5 ÷ 0.5 = 1.0.

11. POLICY PERSPECTIVES Suppose the following demand exists for iPhone apps: LO5 Price (per app) Quantity demanded (millions)

$10 2

$9 3

$8 4

$7 5

$6 6

$5 7

$4 8

$3 9

a. At $9, what quantity is demanded? b. If the price drops to $6, what quantity is demanded? c. Is demand elastic or inelastic in that price range? d. If advertising convinces people to demand 3 million more apps at every price, how many apps will be demanded at a price of $9? e. Graph the above answers, using point A for (a), point B for (b) and point C for (d).

Answer: a. According to the table provided, quantity demanded is 3 million apps when the price is $9. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. Quantity demanded increases to 6 million apps when the price falls to $6. c. There are two methods to determine if the consumer response to a price cut is elastic, inelastic, or unitary elastic: First, by calculating elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value).

Percentage change in quantity demanded = (new Q − old Q) ÷ (old Q) × 100 Percentage change in price = (new P − old P) ÷ (old P) × 100 Second, by calculating the change in total revenue (total revenue = price × quantity).

If Demand Is: Elastic (E > 1) Inelastic (E < 1) Unitary elastic (E = 1)

When Price Decreases, Total Revenue Will: Increase Decrease Not change

Using the price elasticity of demand formula: Percentage change in quantity demanded = (new Q − old Q) ÷ (old Q) × 100 = (6 − 3) ÷ 3 × 100 = 1. Percentage change in price = (new P − old P) ÷ (old P) × 100 = ($6 − $9) ÷ $9 × 100 = 33 percent.

E = percentage change in quantity demanded ÷ percentage change in price = 1 ÷ 0.33 = 3 Calculating the change in total revenue: Initially, total revenue is $27 million (= $9 × 3 million apps) and increases to $36 million (= $6 × 6 million apps). A price cut increases total revenue if demand is elastic. d. If advertising convinces people to demand 3 million more apps at every price, 6 million apps (= 3 million + 3 million) would be demanded at a price of $9. e. Quantity demanded is plotted with price on the vertical axis and quantity demanded on the horizontal axis. Point A is plotted with the price/quantity combination of $9 and 3 (million) apps, point B has the combination $6 and 6 (million) apps, and point C has the combination $9 and 6 (million) apps.

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CHAPTER 5: SUPPLY DECISIONS ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain what the production function reveals.

2 Explain the law of diminishing returns.

3 Describe the nature of fixed, variable, and marginal costs.

4 Illustrate the difference between production and investment decisions.

5 Discuss how accounting costs and economic costs differ.

6 POLICY PERSPECTIVES Explain how to increase productivity.

QUESTIONS FOR DISCUSSION 1. Is your school currently producing at capacity (i.e., teaching as many students as possible)?

What considerations might inhibit full capacity utilization? LO1

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Answer: There may be empty seats in your classroom that indicate unused capacity.

Although it would be impractical to offer classes around the clock, capacity utilization has increased as many schools have added early morning, night, and weekend classes to traditional Monday through Friday daytime classes. It is difficult to enroll the exact number of students to fill up each classroom for every course, and even if it were possible, some students would still drop out of specific classes or even the school. Due to the nature of our educational system, these students cannot be replaced during the middle of a semester.

2. What are the production costs of your economics class? What are the fixed costs? The variable costs? What is the marginal cost of enrolling more students? LO3 Answer: The fixed costs are the costs of providing the classroom and its equipment, some level of utilities, and the prorated share of the university's infrastructure attributed to this class. The variable costs include the cost of the instructor, materials (markers, handouts, etc.), and some additional utilities. The marginal cost of enrolling one more student is nearly zero as long as there is a seat available in the classroom.

3. Suppose you set up a lawn-mowing service and recruit friends to help you. Would the law of diminishing returns apply? Explain. LO2 Answer: In the short run, yes. As more and more friends helped, there would be capital constraints such as a limited number of lawn mowers, rakes, etc. Sharing the tools reduces each worker’s productivity. Also, your friends might tend to get in each other’s way and bicker and fuss. The result would be to decrease the output of each added worker over that of the previous worker.

4. What are the fixed and variable costs of: LO3 a. a pizza shop? b. a corn farm? c. a movie theater? d. Netflix? e. Which needs the highest sales volume to earn a profit?

Answer: a. The fixed costs of a pizza shop include rent on the building (even if you own the building there is an opportunity cost), insurance, some minimal level of utilities (for example, for security and signage), ovens and other equipment, delivery cars, etc. The variable costs of the pizza shop include labor and the cost of the inputs for making pizza dough and pizza toppings. b. The fixed costs of a corn farm include the land, buildings, tractors, combines, and other equipment. The variable costs of the farm include labor, seeds, pesticides, irrigation, and related inputs.

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c. The fixed costs of a movie theater include rent on the building (even if you own the building there is an opportunity cost), insurance, utilities, and equipment such as projectors and screens. The theater’s variable costs include food for concessions, labor, advertising, and fees paid to distributors of and for creators of the films, among others. d. The fixed costs of Netflix include rent on office space, insurance, utilities, and the technology needed to service its customers. The variable costs of Netflix include labor, advertising, and fees paid to distributors of and for creators of the films and entertainment, among others. e. Whichever business has the highest fixed costs needs the highest sales volume to earn a profit.

5. How do marginal costs “put a brake on production decisions”? LO3 Answer: As production increases, marginal costs tend to rise (law of diminishing returns).

Eventually, marginal cost will rise to the level of price, making additional units of output more expensive to produce than their price.

6. Is it possible for a company to show an accounting profit even while it is incurring an economic loss? How? What might happen with such a company? LO5 Answer: Accounting costs often neglect the opportunity costs of capital. As a result, accounting profits will exceed economic profits and may even conceal an economic loss. Such a company is a ripe target for investors who might want to buy it, then redeploy its assets in more profitable endeavors.

7. Why does marginal physical product decline at a fast-food outlet (e.g., McDonald’s) when more employees are hired? What are the fixed input constraints that limit worker productivity? LO2 Answer: The law of diminishing returns states that the marginal physical product of labor declines as more of it is employed with a given quantity of other fixed inputs. For example, if McDonald’s has one ice cream machine and 6 employees, one of which is a cook, another that is a cashier, and the other four prepare the side dishes including the ice cream, space will be tight and still only one ice cream can be prepared at one time. This “crowding” reduces marginal physical product. Hiring another worker might not increase ice cream production.

Fixed input constraints at an establishment such as McDonald’s would include food dispensers such as ice cream machines, cola dispensers, and deep fat fryers. A limited number of grills, microwaves, and cash registers would also be considered limiting inputs. Finally, the counter space and space behind the counter also have the potential to place considerable constraints on worker productivity.

8. If Tesla is planning to increase production at its Fremont, California, factory (News Wire “Production and Investment Decisions”), what must be the relationship between marginal cost and price? LO3

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Answer: For Tesla to be able to increase its production, the price that Tesla is expecting to receive must be at a minimum, covering the marginal cost of increasing production. However, this is a minimum condition for supplying additional output; Tesla must be able to receive a price high enough to be able to cover its fixed costs too—that is, its average total costs—to sustain the increased production.

9. How many cars will Tesla want to produce at its new Texas factory (News Wire “Production and Investment Decisions”)? LO4 Answer: Tesla’s factory in Austin, Texas, will have the capacity to produce 840,000 to 1 million cars per year plus enough lithium-ion batteries to power the cars. Tesla will want to produce the number of cars that will allow it to cover, at a minimum, its marginal cost, but it will need to cover its fixed costs, too, to sustain the increased production.

10. POLICY PERSPECTIVES If capital investment ceased, what would happen over time to worker productivity and living standards? LO6 Answer: The U.S. labor force continues to grow by more than a million workers each year.

Capital investment stimulates each and every worker’s productivity. If capital investments don’t keep pace or, even worse, they cease, these added workers would strain production facilities. The law of diminishing marginal product (decreased worker productivity) would push wages lower and reduce living standards.

PROBLEMS 1. a. What is the marginal physical product of each successive worker in Figure 5.1? LO2 b. For which worker is marginal physical product: (i) first diminishing? (ii) zero?

Answer: a. Marginal physical product (MPP) is the change in total output associated with one additional unit of input. In our example, marginal physical product is the extra output obtained by hiring one more worker. It is calculated as the change in total output (quantity) divided by the change in the number of workers.

• MPP of the first worker = (total output with the first worker − total output of no workers) ÷ (one more worker) = (15 − 0) ÷ 1 = 15.

• MPP of the second worker = (total output with the second worker − total output of first worker) ÷ (one more worker) = (34 − 15) ÷ 1 = 19.

• MPP of the third worker = (total output with the third worker − total output of second worker) ÷ (one more worker) = (44 − 34) ÷ 1 = 10.

• MPP of the fourth worker = (total output with the fourth worker − total output of third worker) ÷ (one more worker) = (48 − 44) ÷ 1 = 4.

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• MPP of the fifth worker = (total output with the fifth worker − total output of fourth worker) ÷ (one more worker) = (50 − 48) ÷ 1 = 2.

• MPP of the sixth worker = (total output with the sixth worker − total output of fifth worker) ÷ (one more worker) = (51 − 50) ÷ 1 = 1.

• MPP of the seventh worker = (total output with the seventh worker − total output of sixth worker) ÷ (one more worker) = (51 − 51) ÷ 1 = 0.

• MPP of the eighth worker = (total output with the eighth worker − total output of seventh worker) ÷ (one more worker) = (47 − 51) ÷ 1 = −4 b. (i) The relative scarcity of other inputs (capital and land) constrains the marginal physical product of labor and eventually causes it to diminish. The law of diminishing returns states that the MPP of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs. In this case, the MPP first diminished with worker number 3. (ii) According to the table, the MPP of worker number 7 is zero.

2. a. Compute average fixed costs and average variable costs in Figure 5.3 for all rates of output. LO3 b. At what rate of output is: (i) average fixed cost the lowest? (ii) average variable cost the lowest? (iii) average total cost the lowest?

Answer: a. Average fixed cost is fixed cost divided by total output [= fixed cost ÷ total output]. When the rate of output is 10, average fixed cost is $12 (= $120 ÷ 10 units). When the rate of output is 15, average fixed cost is $8 (= $120 ÷ 15 units), and so on.

Average variable cost is variable cost divided by total output [= variable cost ÷ total output].

When the rate of output is 10, average variable cost is $8.50 (= $85 ÷ 10 units). When the rate of output is 15, average variable cost is $8.33 (= $125 ÷ 15 units), and so on. b. (i) According to the table, average fixed cost is lowest where the rate of output is 51 units and average fixed cost is $2.35. Note that average fixed cost always falls with increased output. (ii) Average variable cost is lowest where the rate of output is 20 units and average variable cost is $7.50. (iii) Average total cost is lowest where the rate of output is 40 units and average total cost is $11.75.

3. a. Complete the following table; LO3 b. then plot the marginal cost and average total cost curves on a graph. c. What output has the lowest per-unit cost? d. What is the value of fixed costs?

Rate of Output

Total Cost

Marginal Cost

Average Total Cost

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0 1 2 3 4 5

$80 90 100 120 160 250

___ ___ ___ ___ ___ ___

___ ___ ___ ___ ___ ___

Answer: a. Marginal cost is the increase in total cost associated with a one-unit increase in production. It is calculated as the change in total cost divided by the change in output [= (TC 2 − TC1) ÷ (Q2 − Q1)]. For example, the first unit of output has a marginal cost of $10 *= ($90 − $80) ÷ (1 − 0)+, the second unit has a marginal cost of $10 *= ($100 − $90) ÷ (2 − 1)+, and so on. Average total cost (ATC) is total cost divided by the quantity produced. In this case, ATC for the first unit is $90 (= $90 ÷ 1), ATC for the second unit is $50 (= $100 ÷ 2), and so on. b. The two curves (marginal cost and average total cost) are plotted on the graph. Examples of points on the marginal cost curve are Q = 1; MC = $10 and Q = 2; MC = $10, and so on. The average total cost curve is plotted in a similar way.

See the graph on the next page for an illustration of these two curves.

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c. ATC is at a minimum at 4 units of output and a per-unit cost of $40. d. Fixed costs are the costs of production that do not change when the rate of output is altered, e.g., the cost of basic plant and equipment. Recall that total cost equals fixed costs plus variable costs. If there is no output produced (output = 0), variable cost = $0. Fixed costs are the costs that exist when output is zero—in this instance, $80.

4. Suppose the mythical Tight Jeans Corporation leased a second sewing machine, giving it the following production function: LO1 Number of workers Quantity of output

0 0

1 10

2 36

3 56

4 68

5 74

6 76

7 76

8 74

a. Graph the production function. b. On a separate graph, illustrate marginal physical product (MPP).

At what level of employment does: c. The law of diminishing returns become apparent? d. MPP hit zero? e. MPP become negative?

Answer: a. The production function is plotted with the quantity of output on the vertical axis and the number of workers on the horizontal axis. One point along the production function is 10 pairs of jeans and 1 worker (10, 1). A second point along the production function is 36 pairs of jeans and 2 workers (36, 2). The rest of the production function is plotted in the same manner.

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b. The marginal physical product is the change in output when one more worker is hired. It is calculated as the change in output divided by the change in the number of workers [= (Q2 − Q1) ÷ (L2 − L1)]. For example, when one worker is hired the marginal physical product is 10 [= (10 − 0) ÷ (1 − 0)+, when a second worker is hired the marginal physical product is 26 *= (36 − 10) ÷ (2 − 1)], and so on.

The marginal physical product curve is plotted with marginal physical product on the vertical axis and the number of workers on the horizontal axis. One point along the MPP curve is 10 pairs of jeans and 1 worker (10, 1). A second point along this curve is 26 pairs of jeans and 2 workers (26, 2). See the graph on the next page for an illustration of marginal physical product (MPP).

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c. The law of diminishing returns states that the marginal physical product (MPP) of a variable input declines as more of it is employed with a given quantity of other (fixed) inputs. According to the table, the MPP declines with the third worker. An MPP of 20 for the third worker is less than an MPP of 26 for the second worker. d. According to the table provided, MPP is zero for the seventh worker. e. The MPP for the eighth worker is −2.

5. Using the data in problem 4 and a price of $30 per pair of jeans, calculate the marginal physical product and the value of the marginal physical product. Note the value of the marginal physical product is the price of the product multiplied by the marginal physical product. LO3 Answer: The marginal physical product (MPP) is the change in output when one more worker is hired. It is calculated as the change in output divided by the change in the number of workers [= (Q2 − Q1) ÷ (L2 − L1)]. For example, when hiring the third worker, the MPP is 20 *= (56 − 36) ÷ (3 − 2) = 20 ÷ 1+.

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The value of the MPP is price times the MPP (= price × MPP). For example, the MPP for the third worker is 20 and the price per pair of jeans is $30, yielding a value of $600 (= 20 × $30).

The MPP for the seventh worker is zero, which yields a value of $0 (= 0 × $30).

6. Using Figure 5.3 as a guide, compute total profits at a price of $15 per pair of jeans and output of: LO3 a. 40 pairs and b. 50 pairs.

Answer: You can calculate profit using two different methods depending on the information available to you. Total profit is equal to total revenue minus total cost (Profit = TR − TC). Total revenue is price multiplied by quantity (TR = p × q). Total cost is given in the table or total profit is equal to the quantity sold multiplied by the difference between price and average total cost (Profit = q × (p − ATC)). All of this information is given in the table. a. Total profit is $130 when price is equal to $15 and output is equal to 40.

Profit = TR − TC = (p × q) − TC = ($15 × 40) − $470 = $600 − $470 = $130 Profit = q × (p − ATC) = 40 × ($15.00 − $11.75) = $130 b. Total profit is $80 when price is equal to $15 and output is equal to 50.

Profit = TR − TC = (p × q) − TC = ($15 × 50) − $670 = $750 − $670 = $80 Profit = q × (p − ATC) = 50 × ($15.00 − $13.40) = $80 7. Suppose a company incurs the following costs: Labor Equipment Materials

$800 $400 $300

The company owns the building, so it doesn’t have to pay the usual $900 in rent. LO5 a. What is the total accounting cost? b. What is the total economic cost? c. How would accounting and economic costs change if the company sold the building and then leased it back?

Answer: a. Accounting costs include dollar costs only (those explicit costs) and ignore any resource use that doesn’t result in an explicit dollar cost. These explicit costs include the checks written for the labor, equipment, and materials, which total to $1,500 (= $800 + $400 + $300). b. Economic costs include the value of all resources used to produce a good or service. This includes all explicit costs plus implicit costs, which total to $2,400 (= $1,500 explicit costs totaled in part a + $900 implicit cost in rent). c. Accounting costs would increase by the amount of the lease because the lease payment is now an explicit dollar outlay. Accounting costs now total to $2,400 (= $800 + $400 + $300 +

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$900). Economic costs already include the true costs of the building use and would therefore not change.

8. POLICY PERSPECTIVES If investment in new machinery doubles the productivity of every worker, what will be the marginal physical product (MPP) of the fifth worker in Figure 5.1?

LO6 Answer: The marginal physical product (MPP) of the fifth worker is 2 pairs of jeans. MPP of the fifth worker = (total output with the fifth worker − total output of fourth worker) ÷ (one more worker) = (50 − 48) ÷ 1 = 2. If productivity for this worker doubled, productivity would increase to 4 pairs of jeans (= 2 × 2).

9. POLICY PERSPECTIVES If the world’s population is growing by 1 percent a year, LO6 a. How fast does production have to increase to keep living standards constant? b. Will living standards rise, fall, or stay the same if the workforce and productivity (marginal physical product, MPP) also increase by 1 percent each year?

Answer: a. Living standards will be maintained if the economy's production keeps up with its population growth. In this example, since population is growing at 1 percent a year, living standards will be maintained if the increase in production is also equal to 1 percent a year.

• Living standards will fall if the increase in production is less than the growth in population.

• Living standards will rise if the increase in production is greater than the growth in population. b. Marginal physical product (MPP) is the change in total output that occurs when workers are added.

• If population, workforce, and MPP are all rising at the same rate, living standards would be maintained.

• If the population rises faster than the workforce and MPP, then living standards will fall.

• If the population rises slower than the workforce and MPP, then living standards will rise.

CHAPTER 6: COMPETITION ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Identify the unique characteristics of perfectly competitive firms and markets.

2 Illustrate how total profits change as output expands.

3 Describe how the profit-maximizing rate of output is found.

4 Recite the determinants of competitive market supply.

5 POLICY PERSPECTIVES Explain why profits get eliminated in competitive markets.

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QUESTIONS FOR DISCUSSION 1. What industries do you regard as being highly competitive? Can you identify any barriers to entry in those industries? LO1 Answer: Examples of highly competitive industries include: • Farming and farm supplies: Barriers are the cost of land and machinery, or in the case of chemical applications, licensing.

• Consumer electronics: Barriers are brand loyalty or control of essential factors of production.

• Dry cleaners: Barriers are the availability of suitable locations (near residential areas and properly zoned) and the availability of equipment, in addition to high start-up costs.

• Internet service providers: Barriers are the knowledge of running a server, the cost of purchasing the computer server, and the cost of a dedicated trunk line for access to the telephone network.

• Taxi service: Barriers include the need for taxi medallions, which must be purchased from existing companies or acquired through an expensive legal proceeding.

2. If there were more bookstores around your campus, would textbook prices rise or fall? Why aren’t there more bookstores? LO5 Answer: Prices would fall as supply increased. There may not be more bookstores for a variety of reasons. First, there might be high barriers to entry. For small schools, the college might refuse to allow competition for their book orders. It might also be the case that profits are not high enough to attract new firms into the market, i.e., only normal profits are being earned.

3. Why doesn’t The Coca-Cola Company lose all its customers when it raises its price? Why would a catfish farmer lose all her customers if she raised her price? LO1 Answer: Because many customers are loyal to the Coke brand name, The Coca-Cola Company can raise its price without losing all its customers, many of whom consider it to be a unique product, i.e., one with no close substitutes, not even Pepsi. A catfish farmer will, however, lose all her customers at a higher price because customers are not loyal to a specific farmer’s catfish, which are not usually “branded.” As a result, if one farmer raises the price, customers will switch to another farmer’s catfish.

4. Why doesn’t a corn farmer have to make a pricing decision? LO1

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Answer: A corn farmer does not have to make a pricing decision because the corn produced is identical to the corn produced by other similar farmers. The farmer faces a perfectly competitive market without product differentiation, and as a result, is a price taker—the price the farmer faces is the market price. The farmer’s output is small relative to market supply such that the farmer’s output has no significant effect on the total quantity or price in the market.

5. If the price of a catfish is 95 cents a pound and the market price of the fish is $1 a pound, should an existing farmer stop producing? LO3 Answer: A catfish farmer should only stop producing if the price of catfish falls below average total costs. In this case, if the farmer’s price is 95 cents a pound, this will not make a difference, since the market price is $1 per pound. The farmer will still wind up receiving the market price for the fish, since the farmer’s output is small relative to market supply such that the farmer’s output has no significant effect on the total quantity or price in the market. If the market price is below the farmer’s average total cost, then the farmer should stop producing.

6. POLICY PERSPECTIVES What is making life so difficult for the catfish farmers in Belzoni, Mississippi (see the News Wire “Entry and Exit”)? What can they do to make their lives better? LO5 Answer: Catfish farmers in Belzoni, Mississippi, face increasing feed and electricity costs, as well as increased competition from both domestic and foreign producers. Market prices for catfish have decreased since more firms have entered the market. Farmers have been exiting this market due to the challenge of covering average total costs. Farmers can improve their lives by finding ways to decrease costs to stay in business, accounting for the lower market price, or by exiting and moving into another industry where prices and profits are high enough to cover costs.

7. Why would anyone want to enter a profitable industry knowing that profits would eventually be eliminated by competition? LO5 Answer: Even though the economic profits are expected to be temporary and returns to resources in this industry will equal their next-best alternative, the adjustment process may take a number of years. During the adjustment process, firms that enter the industry may earn substantial profits.

8. In the News Wire “Competitive Pressure,” what types of costs are cited? Which are not mentioned? If the shop owner wanted to increase production and sales, what additional costs would he incur? Should he do so? LO3

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Answer: The owner is tabulating only the marginal costs of a T-shirt. He is saying nothing about the fixed costs of production (e.g., the store rent), which will also determine his profits.

To increase production (sales), he would need not only more material, but also more labor, electricity, and other variable costs. He should do so only if price exceeds marginal cost (which appears to be the case here).

9. POLICY PERSPECTIVES If Apple had no competitors, would it be improving iPhone features as fast? LO5 Answer: Yes, Apple would continue to improve its products even without competitors since this creates higher barriers to entry for new firms trying to enter this market. In this case, a higher technology barrier has been created for firms trying to compete with Apple.

10. POLICY PERSPECTIVES Adam Smith in The Wealth of Nations asserted that the pursuit of self-interest by competitive firms promoted the interests of society. What did he mean by this? LO5

Answer: In attempting to obtain the highest return on resources, businesses will seek out markets with the greatest profit potential. Entering these industries shifts the supply curve to the right, lowering prices to the minimum point on the average total cost curve. Thus, the drive of profits results in consumers receiving products at the lowest possible cost, and producers are driven to make the most efficient use of available resources.

PROBLEMS 1. If feed prices were to rise, LO3 a. which curve in Figure 6.5 would be affected? b. how would it change? c. how would the profit-maximizing rate of output change?

Answer: a. If feed prices were to rise, marginal cost would rise. b. Graphically, the marginal cost curve would shift up, representing this rise in feed prices. c. Recall that the profit-maximizing rate of output for a perfectly competitive firm is where marginal cost equals price. If marginal cost rises, the intersection of the marginal cost curve with the price curve would be to the left of the original equilibrium. In other words, this increase in marginal cost would cause a decrease in the profit-maximizing rate of output.

2. Use Figure 6.5 to determine the following: LO3 a. How many baskets of fish should be harvested at market prices of (i) $9? (ii) $13? (iii) $17? b. How much total revenue is collected at each price? c. How much profit does the farmer make at each of these prices?

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Answer: a. At a market price of $9, a competitive firm maximizes total profits at the output rate where MC = p. (i) When p = $9, the output rate where MC ($9) = p ($9) is 3 baskets of fish. (ii) When p = $13, the output rate where MC ($13) = p ($13) is 4 baskets of fish. (iii) When p = $17, the output rate where MC ($17) = p ($17) is 5 baskets of fish. b. At a market price of $13, total revenue is equal to p × q. (i) When price is $9 and quantity is 3, total revenue is $27 (= $9 × 3). (ii) When price is $13 and quantity is 4, total revenue is $52 (= $13 × 4). (iii) When price is $17 and quantity is 5, total revenue is $85 (= $17 × 5). c. At a market price of $17, profit is equal to total revenue minus total cost. (i) When price is $9, total revenue is $27, and total cost (to produce 3 baskets as given in the cost table) is $31. Therefore, profit is –$4 (= $27 − $31). (ii) When price is $13, total revenue is $52 and total cost (to produce 4 baskets as given in the cost table) is $44. Profit is $8 (= $52 − $44). (iii) When price is $17, total revenue is $85 and total cost (to produce 5 baskets as given in the cost table) is $61. Thus, profit is $24 (= $85 − $61).

3. In Figure 6.5, what rate of output: LO2 a. maximizes total revenue? b. maximizes profit per unit? c. maximizes total profit? (Choose the higher level of output.)

Answer: a. Total revenue is equal to price times quantity (Total revenue = price × quantity). According to the table, total revenue is maximized at 5 baskets of fish and a total revenue of $65. b. Profit per unit is total profit divided by output (Profit per unit = total profit ÷ output). Profit per unit is maximized at 3 baskets of fish or a profit per basket of $2.67 (= $8 ÷ 3 baskets). c. Total profit is total revenue minus total cost (Total profit = total revenue − total cost).

Profit is maximized at both 3 and 4 baskets of fish, where total profit is $8. In this case, you were asked to choose the higher level of output.

4. Graph a situation where the typical catfish farmer is incurring a loss at the prevailing market price. Label this market price as p1. LO3, LO4 a. What is MC equal to at the best possible rate of output? b. Is ATC above or below p1? c. Identify if the following would raise or lower the market price. (i) A reduction in all firms’ output. (ii) An increase in input costs for all firms. (iii) Exit of firms from the industry. (iv) An improvement in technology to grow catfish. d. What price would prevail in long-term equilibrium?

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a. A competitive firm maximizes total profits at the output rate where MC = p. If MC is less than price, the firm can increase profits (or reduce losses) by producing more. If MC exceeds price, the firm should reduce output. In this case, profit maximization occurs at an output of 650 pounds of fish per day. Even when a firm is operating at a loss, this is the best possible rate of output. In this example of a typical catfish farmer, the profit-maximizing rate of output is where MC = p. Since price is $4, MC = $4. b. ATC is above price, so the firm is therefore operating at a loss. Specifically, ATC is about $5, and price is equal to $4. c. (i) A reduction in all firms' output would decrease the market supply (shifting it to the left), leading to an increase in the market price. (ii) An increase in input costs for all firms would decrease the market supply (shifting it to the left), leading to an increase in the market price. (iii) Exit of firms from the industry would decrease the market supply (shifting it to the left), leading to an increase in the market price. (iv) An improvement in technology to grow catfish would increase the market supply (shifting it to the right), leading to a decrease in the market price. d. In the long-run competitive market equilibrium, price equals minimum average total cost and economic profit is eliminated. In this case, a price of $5 would prevail in the long run.

5. Suppose a firm has the following costs: LO3

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Output (units): Total cost:

10

11

12

13

14

15

16

$50

$52

$56

$62

$70

$80

$92

17

18

19

$106 $122 $140

a. If the prevailing market price is $14 per unit, how much should the firm produce? b. How much profit will it earn at that output rate? c. If it increases output by 2 units, will it make more profit or less?

Answer: Remember from a previous chapter that marginal cost is the change in total cost when output is increased by one more unit [MC = (TC2 − TC1) ÷ (q2 − q1)].

For example: Marginal cost from increasing output from 10 to 11 units is $2 [= (TC 2 − TC1) ÷ (q2 − q1) = ($52 − $50) ÷ (11 − 10) = $2 ÷ 1]. Marginal cost from increasing output from 11 to 12 units is $4 [= (TC2 − TC1) ÷ (q2 − q1) = ($56 − $52) ÷ (12 − 11) = $4 ÷ 1+. Marginal cost from increasing output from 12 to 13 units is $6 [= (TC2 − TC1) ÷ (q2 − q1) = ($62 − $56) ÷ (13 − 12) = $6 ÷ 1]. a. A competitive firm maximizes total profits at the output rate where MC = p. According to the table, this is at an output level of 17 units, where MC equals p (MC = $14 and p = $14). b. Profit is equal to total revenue minus total cost (Profit = TR − TC). Total revenue is price multiplied by quantity (TR = p × q). At the profit-maximizing output level of 17 units, total revenue is $238 (= $14 × 17 units) and total costs are $106 (as given by the table). Thus, profit is $132 (= $238 − $106). c. The firm maximizes profits where marginal revenue equals price. If the firm increases output beyond the profit-maximizing output, profits will fall.

6. What curve is shifting to alter the market equilibrium in the News Wire “Entry and Exit”? LO5 Answer: According to the article, at the market level there has been increased domestic production and increased imports. This represents an increase in the number of suppliers, causing the market supply to increase, driving the market price down. Individual catfish farmers in Belzoni have faced rising feed and electricity prices, causing their costs of production at the firm level to rise.

7. Graphically show the market outcome for a typical catfish farmer in Mississippi today as described by James Avery in the News Wire “Entry and Exit.” LO3 Answer: According to the article, the individual catfish farmers in Belzoni have faced rising feed and electricity prices, causing their costs of production at the firm level to rise. At the same time, the market price for fish has been falling due to higher overall production and increasing imports. The result is that the market price is less than the average total costs, causing the individual catfish farmer in Belzoni to earn economic losses. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

8. Consider the case of a T-shirt shop for which the following data apply: Rent = $200 per day; Labor cost = $4 per T-shirt; and Output (sales) = 40 T-shirts per day. Using these data and the information contained in the News Wire “Competitive Pressure,” compute: LO3 a. total revenue per day. b. average total cost. c. per unit profit. d. total profit per day.

Answer: a. Total revenue is price times quantity (TR = p × q). Price is given as $15 per T-shirt in the article and quantity (sales or output) is given as 40 T-shirts per day. Therefore, total revenue is equal to $600 per day (= $15 per T-shirt × 40 T-shirts per day). b. Average total cost can be calculated two different ways. Either method yields the same result. The costs given in the News Wire and table include blank T-shirts, stock transfers, labor cost per T-shirt, and rent per day. (i) Average total cost is total cost divided by the quantity produced in a given time period (ATC = TC ÷ output). Total costs include rent (per day) and total spending on blank T-shirts, stock transfers, and labor for the 40 T-shirts sold per day. Total cost = $200 + [($1.60 + $1.50 + $4.00) × 40] = $200 + $284 = $484. Average total cost = $12.10 (= total cost ÷ output = $484 ÷ 40).

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(ii) Average total cost is the summation of all per unit costs (ATC = cost 1 ÷ output + cost2 ÷ output + ...). Costs per unit include rent (per T-shirt = $200 ÷ 40 T-shirts = $5 per T-shirt) and spending on blank T-shirts, stock transfers, and labor cost per T-shirt. Average total cost = $12.10 (= $5.00 + $1.60 + $1.50 + $4.00). c. Profit per unit is price minus average total cost (Profit per unit = p − ATC). Therefore, profit per unit is $2.90. d. Total profit can be calculated two different ways. Either method yields the same result. (i) Total profit is the difference between total revenue and total cost (Total profit = TR − TC).

Total revenue was calculated in part a as $600 and total cost was calculated in part b as $484. Therefore, total profit is $116 (= $600 − $484). (ii) Total profit is average profit times quantity sold (Total profit = average profit × quantity sold). Average profit is the same as profit per unit. Profit per unit was calculated in part c as $2.90 per T-shirt and quantity sold was given as 40 T-shirts per day. Therefore, total profit is $116 (= $2.90 per T-shirt × 40 T-shirts).

9. POLICY PERSPECTIVES a. What are expected profits for a perfectly competitive firm in the long run? b. Create a graph that shows the firm’s long-run outcome. LO5 Answer: a. In long-run competitive market equilibrium, price equals minimum average total cost and economic profit is eliminated (economic profit = $0). b. Zero economic profit is shown graphically when the price line is equal to the minimum of the average total cost curve.

See the graph on the next page for an illustration of the firm’s long-run outcome.

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10. POLICY PERSPECTIVES Suppose that the monthly market demand schedule for Frisbees is: Price Quantity demanded

$8

$7

$6

$5

$4

$3

1,000

2,000

4,000

8,000

16,000

32,000

$2

$1

64,000 150,000

Suppose further that the marginal and average costs of Frisbee production for every competitive firm are: Rate of output Marginal cost Average total cost

100 $2.00 $2.00

200 $3.00 $2.50

300 $4.00 $3.00

400 $5.00 $3.50

500 $6.00 $4.00

600 $7.00 $4.50

Finally assume that the equilibrium market price is $6 per Frisbee. LO5 a. Draw the cost curves of the typical firm. b. Draw the market demand curve and identify market equilibrium. c. How many Frisbees are being sold in equilibrium? d. How many (identical) firms are initially producing Frisbees? e. How much profit is the typical firm making? f. In view of the profits being made, more firms will want to get into Frisbee production. In the long run, these new firms will shift the market supply curve to the right and push the price down to minimum average total cost, thereby eliminating profits. At what equilibrium price are all profits eliminated? g. How many firms will be producing Frisbees at this price?

Answer:

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a. Market demand is provided in the table above. It is plotted with price on the vertical axis and quantity demanded on the horizontal axis. According to the problem, the equilibrium market price for a Frisbee is $6. Hence, market equilibrium is 4,000 Frisbees at a price of $6. b. Marginal cost is provided in the table above. It is plotted with marginal cost on the vertical axis and rate of output on the horizontal axis. Average total cost is plotted in the same manner with average total costs on the vertical axis and rate of output on the horizontal axis. c. At the equilibrium market price of $6 per Frisbee, 4,000 Frisbees are being sold. d. In a competitive market, each individual, profit-maximizing firm will produce the quantity where MC = p. According to the table related to firm costs, when MC = $6, the typical firm produces 500 units. Thus, there are 8 identical firms selling Frisbees (= equilibrium market quantity ÷ quantity per firm = 4,000 ÷ 500 units). e. Total profit is average profit times quantity sold. Average profit is the same as profit per unit, which is equal to the difference between price and average total cost (profit per unit = p − ATC). Market price is given ($6) and average total costs are given in the table related to firm costs ($4). Profit per unit is $2 (= $6 − $4). Quantity sold by the typical firm was calculated in part d as 500 Frisbees per month. Therefore, total profit for a typical firm is $1,000 (= $2 per Frisbee × 500 Frisbees). f. Profits will be eliminated when the long-run price equals the minimum ATC. ATC is at its minimum at $2 as shown by the table related to firm costs. g. At this low price (= $2), 64,000 units are demanded as shown by the market demand. In a competitive market, each individual, profit-maximizing firm will produce the quantity where MC = p. According to the table related to firm costs, when MC = $2, the typical firm produces 100 units. Thus, there are 640 identical firms selling Frisbees in this industry in the long run (= equilibrium market quantity ÷ quantity per firm = 64,000 ÷ 100 units).

CHAPTER 7: MONOPOLY ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Define what a monopoly is.

2 Explain why price exceeds marginal revenue in monopoly.

3 Describe how a monopoly sets output and price.

4 Illustrate how monopoly and competitive outcomes differ.

5 POLICY PERSPECTIVES Discuss the pros and cons of monopoly structures.

QUESTIONS FOR DISCUSSION 1. If you owned the only bookstore on or near campus, what would you charge for this textbook? How much would you pay students for their used books? LO3

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Answer: If you wanted to maximize profits, you would charge the highest price you could at the quantity where MC = MR. You would want to pay students the minimum price they will accept but still sell you the used books.

2. Why don’t competitive industries produce at the rate of output that maximizes industry profits, as a monopolist does? LO4 Answer: In a competitive industry, each firm acts independently to maximize its own profits.

It would require some type of group action to behave like a monopolist, and since there are so many firms in the industry, this is impossible. Comparing a perfectly competitive industry to a monopoly, we see that the industry quantity in the former is where demand intersects marginal cost (supply) while in the latter it is where marginal revenue intersects marginal cost. Furthermore, it should be noted that while a monopolist may make excess profits in the long run and a perfectly competitive firm makes only normal profits, the industry total revenue under perfect competition is greater than it is under monopoly.

3. Is single ownership of a whole industry necessary to exercise monopoly power? How might an industry with several firms achieve the same result? Can you think of any examples? LO1 Answer: No, single ownership is not necessary. In an industry with many firms, some firms might achieve market power through their ability to segment the market for their product through advertising that creates brand loyalty. Examples of such industries are airlines and over-the-counter pain medication. Finally, if firms act in concert, via collusion, they can exercise monopoly power. Examples are oil and coffee cartels as well as professional sports.

4. Despite its reaffirmed monopoly position, Polaroid went bankrupt in 2001 and stopped making instant development cameras in 2007. What happened? LO4 Answer: Polaroid indeed had a patent protecting its instant development cameras, yet Eastman Kodak entered this market despite the barrier. Moreover, Polaroid won the 14-year legal patent protection battle. In fact, the judge determined that Polaroid’s profits would have been twice as much ($909.5 million higher) had Kodak never entered the market. The judge forced Kodak to repay these lost profits to Polaroid.

Yet, during the ensuing years, computer technologies and digital capabilities developed quickly and steadily. Digital cameras replaced instant development cameras and in-home picture printing became the norm. Digital cameras (including those contained within phones!) have replaced instant development cameras.

5. Why don't monopolists try to establish the highest price possible, as many people allege?

What would happen to sales? To profits? LO3

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Answer: The monopolist's goal is to maximize profits, not revenue. To maximize profits, the monopolist needs to produce the quantity at which MC = MR and then see what the price is from the demand curve. Monopolists have the ability to charge higher prices, but if MC is greater than MR, that would lower their profits.

6. What circumstances might cause a monopolist to charge less than the profit-maximizing price? LO3 Answer: The monopolist might be trying to build future consumer loyalty and/or drive a producer of a similar product out of business. Also, it might be trying to deter potential competition or avert government intervention. It could accomplish any of these by charging less than its monopoly power allowed.

7. How could free Internet-search software (on Android phones) possibly harm consumers? LO4 Answer: Free Internet-search software included with Android phones, or Internet-search software available for free, makes it difficult for competitors to sell their products profitably.

Consumers might enjoy better products if the market for Internet-search software was more competitive.

8. What entry barriers exist in (a) the coffee-bar business, (b) cable TV, (c) the taxicab industry, (d) the illegal drug trade? LO1 Answer: a. Coffee-bar business: For existing brands, the primary barrier is acquiring a franchise license for the individual restaurant. On the other hand, there are few barriers to entering the industry on your own, as exemplified by the number of independent coffee bars. b. Cable TV: The primary barrier is obtaining a local franchise license. However, once established, new firms wanting to enter the market must also face very high start-up costs. c. Taxicab industry: There are higher start-up costs to entering this industry, including the cost of cars and local licensing. Taxicab services also face competition from similar services, such as Lyft and Uber, that have fewer costs since these companies do not own any of the vehicles and choose to bring on contractors on demand instead of employees. In addition, new companies must establish relationships with local businesses to service their cars. d. Illegal drug trade: New entrants are often kept out of this industry by threats from current suppliers in the market. Also, the illegality of the drug trade causes the government, through the possibility of legal sanctions, to be a barrier to entry.

9. In the COVID pandemic of 2020, the world’s largest pharmaceutical companies were quick to develop vaccines. Would a market composed of many smaller companies have been able to respond as fast? LO5

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Answer: Monopolists have the resources (monopoly profits) with which to carry out expensive R&D functions. The manager of a perfectly competitive firm, by contrast, has to worry about day-to-day production decisions and profit margins. As a result, the manager is unable to take the longer view necessary for significant research and development and could not afford to pursue such a view even if he/she could see it.

10. POLICY PERSPECTIVES What advantages would consumers get from breaking up Big Tech?

LO5 Answer: Consumers may have more variety in the products that they can consume, from the type of phone to the apps that run on that phone. Prices may fall because there would be increasing competition. Finally, more consumer-focused features, such as increased privacy, may be more strongly developed.

PROBLEMS 1. In Figure 7.1, LO2 a. what is the highest price the monopolist could charge and still sell fish? b. what is total revenue at that highest price? c. what happens to total revenue as price is reduced from A to F? d. what is the value of marginal revenue as price is reduced from F to G? Answer: a. According to the demand curve in the figure and the demand schedule, consumers will purchase 1 pound of fish at a price of $13. No demand exists for prices above $13. b. Total revenue is price multiplied by quantity (TR = p × q). At a price of $13, the firm could sell 1 pound of fish for total revenue of $13 (= $13 × 1 pound of fish). c. As price is reduced from $13 to $8, total revenue increases from $13 to $48 (= $8 × 6 pounds of fish). d. Marginal revenue is the additional revenue a firm receives from selling one more unit of output [MR = (change in total revenue) ÷ (change in quantity)]. As price is reduced from $8 to $7, total revenue increases from $48 (= $8 × 6 pounds of fish) to $49 (= $7 × 7 pounds of fish), yielding a marginal revenue of $1 *= ($49 − $48) ÷ (7 pounds of fish − 6 pounds of fish) = $1 ÷ 1 = $1).

2. Use the graph in Figure 7.1 to answer the following: LO3 a. At what output rate (from A to G) is total revenue maximized? b. What is marginal revenue at that output rate? c. If the firm is currently producing at the rate of output identified in part a, should the firm increase, decrease, or not change the rate of production?

Answer: a. Total revenue is at its highest level (= $49) when output is equal to 7 pounds of fish. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. When output is equal to 7 pounds of fish, marginal revenue is equal to $1. c. This question cannot be answered unless marginal cost information is provided. A firm will produce the profit-maximizing quantity by choosing the output level where marginal revenue equals marginal cost (MR = MC). A firm will increase the output level if MR > MC. A firm will decrease the output level if MR < MC. 3. Use Figure 7.2 to answer the following questions: LO2 a. What rate of output maximizes total profit? b. What is the marginal revenue at that rate of output? c. What is the price at that rate of output? d. If output is increased by 1 pound beyond that point, is marginal cost greater than or less than marginal revenue? e. What happens to total profits if output is increased like in d?

Answer: a. The most profitable rate of output is indicated by the intersection of marginal revenue and marginal cost (MR = MC). In this case, marginal revenue and marginal cost intersect at an output of 4 pounds per hour. b. At an output of 4 pounds per hour, marginal revenue is shown by the marginal revenue curve and is equal to $7. c. Price is shown by the demand curve. For 4 pounds of fish, consumers are willing to pay $10; therefore, the price is $10 per pound of fish. d. If output is increased to 5 pounds, marginal cost (= $9) is greater than marginal revenue (= $5). e. A firm maximizes profits if it produces the profit-maximizing quantity where output is determined, where marginal revenue equals marginal cost (MR = MC). If the firm produces more or less than this profit-maximizing quantity, profits will fall.

4. Compute marginal revenue from the following data on market demand: LO2 Price per unit Units demanded Marginal revenue

$38 10 __

36 11 __

34 12 __

32 13 __

30 14 __

28 15 __

26 16 __

36 11 396 $16

34 12 408 12

32 13 416 8

30 14 420 4

28 15 420 0

26 16 416 −4

a. At what price does MR = 0? b. At what price is MR < 0? c. At what price is MR < price?

Answer: Price per unit Units demanded Total revenue Marginal revenue

$38 10 $380 ꟷ

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Total revenue is price multiplied by quantity (TR = p × q). Total revenue for 10 units is $380 (= $38 × 10 units). Total revenue for 11 units is $396 (= $36 × 11 units), and so on.

Marginal revenue is the change in total revenue given a one-unit increase in quantity, or [Marginal revenue = (TR2 − TR1) ÷ (q2 − q1)]. Marginal revenue from the 11th unit is $16 [= ($396 − $380) ÷ (11 − 10) = $16 ÷ 1+. Marginal revenue from the 12th unit is $12 *= ($408 − $396) ÷ (12 − 11) = $12 ÷ 1+, and so on. a. MR = 0 when the price is $28. b. When the price falls below $28, MR < 0. c. Since the demand curve facing a monopolist is always downward sloping, marginal revenue is always less than price for a monopolist.

5. Suppose the following data represent the market demand for catfish: LO2 Price (per unit) Quantity demanded (units per day) Total revenue Marginal revenue (MR)

$20

19

18

17

16

15

14

13

12

11

12 __ __

13 __ __

14 __ __

15 __ __

16 __ __

17 __ __

18 __ __

19 __ __

20 __ __

21 __ __

a. Compute total and marginal revenue to complete the table above. b. At what rate of output is total revenue maximized? c. At what rate of output is MR less than price? d. At what rate of output does MR first become negative? e. Graph the demand and MR curves.

Answer: Table: Price $20 $19 $18 $17 $16 $15 $14 $13 $12 $11

Quantity 12 13 14 15 16 17 18 19 20 21

Total Revenue $240 $247 $252 $255 $256 $255 $252 $247 $240 $231

Marginal Revenue — $7 $5 $3 $1 –$1 –$3 –$5 –$7 –$9

a. Total revenue is price multiplied by quantity (TR = p × q). Total revenue for 12 units is $240 (= $20 × 12 units). Total revenue for 13 units is $247 (= $19 × 13 units), and so on. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

Marginal revenue is the change in total revenue given a one-unit increase in quantity [Marginal revenue = (TR2 − TR1) ÷ (q2 − q1)]. Marginal revenue from the 13th unit is $7 [= ($247 − $240) ÷ (13 − 12) = $7 ÷ 1+. Marginal revenue from the 14th unit is $5 *= ($252 − $247) ÷ (14 − 13) = $5 ÷ 1+, and so on. b. Total revenue is maximized at 16 units of output (= $256). c. Since the demand curve facing a monopolist is always downward sloping, marginal revenue is always less than price at all output levels for a monopolist. d. Marginal revenue first becomes negative at output greater than 16 units. e. Demand and marginal revenue are graphed with price on the vertical axis and quantity on the horizontal axis. One point on the demand curve is $20 and 12 units. One point on the marginal revenue curve is $7 and 13 units.

See the graph on the next page for an illustration of the demand and MR curves.

6. Assume that the following marginal costs exist in catfish production: LO4

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Quantity produced (units per day) Marginal cost (MC) (per unit)

10 $4

11 6

12 8

13 10

14 12

15 14

16 16

17 18

a. Graph the MC curve. b. Use the data on market demand below and graph the demand and marginal revenue (MR) curves on the same graph.

Price (per unit) Quantity demanded (units per day)

$25 10

24 11

23 12

22 13

21 14

20 15

19 16

18 17

c. At what rate of output is MR = MC? d. What price will a monopolist charge for that much output? e. If the market were perfectly competitive, what price would prevail? f. How much output would be produced in perfect competition?

Answer: a, b. See the graph and the table on the next page.

Price $25 $24

Quantity 10 11

Marginal Cost $4 $6

Total Revenue Marginal Revenue $250 — $264 $14

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$23 $22 $21 $20 $19 $18

12 13 14 15 16 17

$8 $10 $12 $14 $16 $18

$276 $286 $294 $300 $304 $306

$12 $10 $8 $6 $4 $2

Total revenue is price multiplied by quantity (TR = p × q). Total revenue for 10 units is $250 (= $25 × 10 units). Total revenue for 11 units is $264 (= $24 × 11 units), and so on.

Marginal revenue is the change in total revenue given a one-unit increase in quantity [Marginal revenue = (TR2 − TR1) ÷ (q2 − q1)]. Marginal revenue from the 11th unit is $14 [= ($264 − $250) ÷ (11 − 10) = $14 ÷ 1+. Marginal revenue from the 12th unit is $12 *= ($276 − $264) ÷ (12 − 11) = $12 ÷ 1+, and so on. a, b. Marginal cost, demand, and marginal revenue are graphed with price or cost on the vertical axis and quantity on the horizontal axis. One point on the marginal cost curve is $4 and 10 units. One point on the demand curve is $25 and 10 units. One point on the marginal revenue curve is $14 and 11 units. c. Marginal revenue is equal to marginal cost at 13 units per day. This is the monopolist's profit-maximizing quantity per day. d. A monopolist will produce its profit-maximizing quantity of 13 units per day (where MR = MC) and charge a price equal to $22. To determine the price charged for the quantity produced, look at the demand information. Consumers are willing to pay $22 per unit when only 13 units are available each day. e. If the market were perfectly competitive, the price charged would be where MC = p. The demand curve shows price; therefore, the profit-maximizing price would be where MC intersects the demand curve. Looking at the graph, the MC curve intersects the demand curve (and therefore MC = p) at $18. f. If the market were perfectly competitive, the profit-maximizing quantity would be where MC = p. Looking at the graph, MC = p at 17 units per day.

7. If a can of tuna sells for $2.40, how much did the price per ounce go up when the tuna companies reduced can size (see the News Wire “Price-Fixing”)? LO4 Answer: If the price per can of tuna is $2.40, then the reduction in can size increased the price per ounce by 20 percent.

6-ounce can price per ounce = $2.40 ÷ 6 ounces = $0.40 per ounce 5-ounce can price per ounce = $2.40 ÷ 5 ounces = $0.48 per ounce Percentage change in price = (new price per ounce − old price per ounce) ÷ old price per ounce × 100 = ($0.48 − $0.40) ÷ $0.40 × 100 = 20%.

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8. If generic producers were able to produce a substitute for Revlimid that reduced Revlimid’s sales by 50 percent, how much less revenue would Celegne take in per year? (See the News Wire “R&D Barriers.”) LO4 Answer: According to the article, Celegne earns $8 billion in revenue from sales of the drug Revlimid. If a product came to market that was a substitute for Revlimid and reduced sales of Revlimid by 50 percent, then Celegne would earn approximately $4 billion per year from sales of Revlimid *= $8 billion − (0.50 × $8 billion) = $8 billion − $4 billion+.

This means that Celegne would earn $4 billion less in revenue than before a generic was available (= $8 billion − $4 billion).

9. Assume the on-campus demand for soda is as follows: LO4

Price ($ per can) 2.00 1.75 1.50 1.25 Quantity demanded (per day) 30 40 50 60

1.00 70

0.75 80

0.50 90

0.25 100

If the marginal cost of supplying a soda is 50 cents, what price will students end up paying in: a. a perfectly competitive market? b. a monopolized market?

Answer: The table below shows the total and marginal revenue for the on-campus soda market. Total revenue is price multiplied by quantity (TR = p × q). Marginal revenue is the change in total revenue given a one-unit increase in output [MR = (TR2 − TR1) ÷ (q2 − q1)].

Calculating marginal revenue is a little bit more complicated in this example because the quantity changes by 10-unit increments (not just a one-unit increment as you have seen in many of the examples).

For example, the marginal revenue from increasing sales from 30 to 40 cans per day is $1.00 per can [= (TR2 − TR1) ÷ (q2 − q1) = ($70 − $60) ÷ (40 − 30) = $10 ÷ 10+. The marginal revenue from increasing sales from 40 to 50 cans per day is $0.50 per can [= (TR2 − TR1) ÷ (q2 − q1) = ($75 − $70) ÷ (50 − 40) = $5 ÷ 10+, and so on.

Price $2.00 $1.75 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25

Quantity 30 40 50 60 70 80 90 100

TR $60 $70 $75 $75 $70 $60 $45 $25

MR $1.00 $0.50 $0.00 −$0.50 −$1.00 −$1.50 −$2.00

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a. In a perfectly competitive market, firms maximize profit where the price of the product is equal to marginal cost. (Remember that for a perfectly competitive firm, market price = the firm's marginal revenue = the firm's demand). To maximize profit, the firm will produce the quantity where price is equal to marginal cost (p = MC). Graphically, the profit-maximizing quantity is where demand and supply intersect (recall this is where p = MC for an individual firm in a competitive market), at a price of $0.50 and a quantity of 90 cans.

Since the marginal cost is $0.50, there will be 90 cans of soda sold at a price equal to $0.50. b. In a monopolized market, the firm will maximize profit by producing a quantity where marginal revenue is equal to marginal cost (MR = MC). Graphically, the profit-maximizing quantity is where marginal revenue and marginal cost intersect. The price consumers are willing to pay for this quantity is given by the demand curve.

MR ($0.50) = MC ($0.50) occurs at a quantity of 50 cans. The monopolist will charge a price of $1.50 per can.

10. Titleist sells about 15 million golf balls a year. If it has to sell them at Costco’s price rather than the ProV1 price, how much less revenue would Titleist take in? (See the News Wire “Legal Barriers.”) LO3 Answer: If Titleist sold its ProV1 balls at $4 each, it would earn $60 million in revenue (= 15 million balls × $4). If Titleist sold its ProV1 balls at the Costco price of $1.25 each, it would earn $18.75 million in revenue (= 15 million balls × $1.25).

The difference in revenue is $41.25 million (= $60 million − $18.75 million).

11. POLICY PERSPECTIVES Suppose the fixed costs of Facebook are $5 million. LO5 a. Calculate Facebook’s average fixed cost for its 2 billion active daily users. b. If Facebook were broken up into four companies with the users spread equally among the companies, what would the average fixed cost be for these “Little Techs”? c. Has average fixed cost risen or stayed the same when “Big Tech” was broken up?

Answer: a. Average fixed cost is fixed cost divided by output. For this single Facebook, average fixed cost is $0.0025 per user (= $5 million ÷ 2 billion = $5 million ÷ 2,000 million = $0.0025 per user). b. Each company now has only 500 million customers (= 2 billion ÷ 4 = 0.5 billion or 500 million). Average fixed cost is fixed cost divided by output. For these "Little Techs," average fixed cost is $0.01 per user (= $5 million ÷ 500 million = $0.01 per user). c. Average fixed cost has risen when this company is broken into four smaller companies.

This is because each company faces the same fixed cost (= $5 million), but each now has fewer customers. Fixed cost is spread less among the customers than with a single company.

CHAPTER 8: THE LABOR MARKET ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Cite the forces that influence the supply of labor.

2 Explain why the labor demand curve slopes downward.

3 Describe how the equilibrium wage and employment levels are determined.

4 Depict how a legal minimum wage alters market outcomes.

5 POLICY PERSPECTIVES Explain why wages are so unequal.

QUESTIONS FOR DISCUSSION 1. Why are you doing this homework? What are you giving up? What do you expect to gain? If homework performance determined course grades, would you spend more time doing it?

LO1 Answer: You could say that this homework is being done in exchange for a payoff in the form of a good grade for the course and, eventually, a degree. The opportunity cost of doing this homework is a forgone income-earning opportunity or leisure of some sort. The utility expected is the satisfaction of a good grade.

If homework performance determined your course grades, the opportunity cost of not doing the homework would be larger and you would probably spend more time doing it.

2. Why does the opportunity cost of doing homework increase as you spend more time doing it? LO1 Answer: As you spend more time doing homework, your marginal productivity falls. In other words, your first few hours doing homework is generally very productive. However, as more time is spent, your marginal productivity falls as you get tired, or you have already answered most of the questions. For example, let's say that you are able to answer five questions in the first hour, four questions in the second hour, and only one question in the third hour. Since your productivity is falling, i.e., less homework is produced in the last hour than in the first, what you are giving up per question completed increases.

3. How do “supply and demand” explain the wage gap between chemical engineering and English majors (News Wire “Unequal Wages”)? LO3 Answer: There are fewer chemical engineering majors graduating than English majors.

Therefore, the supply of chemical engineers is lower, and since the demand for chemical engineers is higher than for English majors, employers are forced to "bid higher" or pay more for chemical engineers since other employers are also seeking to hire them. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

4. Explain why marginal physical product would diminish as: LO2 a. more administrative assistants are hired in an office. b. more professors are hired in the economics department. c. more construction workers are hired to build a school.

Answer: Each of these examples can be illustrated with the basic point that more and more people create problems of overworked machines, facilities, schedules, etc. Some students might also comment on the increasing difficulty of finding equally qualified individuals, although the text assumes equal quality for units of labor and relies on the use of equipment as the primary explanation for diminishing returns.

5. Under what conditions might an increase in the minimum wage not reduce the number of low-wage jobs? How much of a job loss is acceptable? LO4 Answer: The impact on jobs due to an increase in the minimum wage is controversial. While competitive market theory says that a minimum wage results in a surplus of labor and therefore an increase in that wage will result in a larger surplus, some empirical studies have found the opposite to be true. Finally, an increase in the minimum wage will not reduce the number of low-wage jobs when the equilibrium wage is above the minimum wage. In such a case, the minimum wage is ineffective.

From the viewpoint of minimum-wage workers, no job losses are acceptable if it is their job that is eliminated. A higher minimum wage might be acceptable if you are not the worker losing your job. If a higher minimum wage reduces profits or raises prices, then it might not be acceptable to businesses or consumers, respectively.

6. The United Farm Workers want strawberry pickers to join its union. It hopes then to convince consumers to buy only union-picked strawberries. Will such activities raise picker wages?

Increase employment? LO3 Answer: Unions generally seek to raise wage rates above equilibrium. To do so, they bargain collectively with employers. Yet, in order to get and maintain an above-equilibrium wage, a union must exclude some workers from the market, in effect, decreasing the number of workers employed.

Recall that the demand for strawberry pickers depends on the demand for strawberries. In this situation, if the United Farm Workers Union actually convinces consumers to buy more of these union strawberries, the demand for strawberry pickers should increase as well. Thus, there is at least the potential for strawberry picker wages to increase and the number of employed to increase as well (due to an increase in demand for pickers).

7. Why did American Airlines eliminate so many jobs (News Wire “Derived Demand”)? LO1

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Answer: Domestic airline passenger counts were 60 percent lower than in 2019 due to government restrictions and people’s concerns about contracting COVID-19. This means that the demand for flights had fallen significantly. Reducing labor is the way that the company chose to respond to the market and to cut costs in response to the loss.

8. How might you measure the marginal revenue product of (a) a quarterback, (b) the team’s coach, and (c) the team’s owner? LO5 Answer: It is easy to measure marginal revenue product of a strawberry picker or even a salesclerk because we are able to measure each employee’s productivity directly (or nearly directly). Measuring the MRP of a quarterback, coach, and team owner is another story altogether. The MRP of a quarterback might be measured based on passing yardage, running yardage, number of fumbles, or number of scores generated. The MRP of a coach might be based on the number of team wins, the number of playoff game wins, or the number of players in newspaper headlines (both positive and negative publicity). The MRP of a team owner might be based on the amount of team apparel sold, the percentage of the stadium filled with fans, the number of advertising dollars generated, or the number (and value of) media contracts.

9. The Congressional Budget Office estimated that a minimum-wage hike to $15 an hour would increase wages for 17 million workers but also eliminate 1.4 million jobs. Whose jobs would be lost? Is the trade-off worthwhile? LO4 Answer: The minimum wage acts as a price floor in the market for labor. At a minimum wage of $15 per hour, more people would be willing and able to supply their labor, so there would have been an increase in the quantity of labor supplied. However, labor represents a cost to companies. These companies would have needed to absorb the higher labor costs and would have been less willing and able to hire workers at the higher minimum wage.

The workers whose jobs would be lost are those that were working before the rise in the minimum wage but are now no longer working because the quantity demanded fell. Is this trade-off worthwhile? It depends. Some workers gain because they are now earning a higher wage while some workers lose because they are now out of a job.

10. POLICY PERSPECTIVES Why do people want to cap CEOs’ salary but not Beyonce’s? LO5 Answer: There is a general sense that "corporate America" doesn't deserve more money, but individual entertainers do. The achievements of an entertainer are more visible and understandable than the work of a corporate CEO, whose contributions are hard to quantify and less visible to the public. Entertainers’ work is something that the public experiences directly when they attend a performance, but the public generally does not see the day-today management of most companies.

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Furthermore, CEO pay is frequently compared by critics to the pay of company employees.

While opportunity wages–the wages that CEOs could earn elsewhere with in-demand managerial skills, and the fact that CEOs are highly skilled and can work at many jobs– partially explain CEO pay, and this work isn’t always visible to the public.

PROBLEMS 1. a. According to the News Wire “Labor Supply,” what was the apparent market surplus at the Amazon Career Day? LO3 b. If Amazon increased wages to $20 per hour, what would happen to that market surplus?

Answer: a. According to the article, at the end of the day, there were 384,000 people looking for a job and only 33,000 positions available. This means the apparent market surplus was 351,000 people (= 384,000 − 33,000). b. If the minimum hourly wage were to increase from $15 to $20 an hour, the number of people seeking jobs would increase. This increase in the quantity supplied would increase the surplus of workers.

2. According to Figure 8.4, how many workers would be hired if the prevailing wage were: LO3 a. $10 an hour? b. $2 an hour?

Answer: The marginal revenue product (MRP) curve is the firm’s labor demand curve, and an employer is willing to pay a worker no more than his or her marginal revenue product. As long as the MRP is greater than or equal to the wage rate, the firm will hire the next worker. a. According to the figure, if the prevailing wage were $10 an hour, the firm would hire 2 workers. b. If the prevailing wage were $2 an hour, the firm would hire 6 workers.

3. The following table depicts the number of grapes that can be picked in an hour with varying amounts of labor: LO2

Number of pickers (per hour) Output of grapes (in flats)

1

2

3

4

5

6

7

8

10

28

43

54

61

64

65

61

a. Calculate marginal physical product (MPP) and b. graph the total product (output) and MPP curves.

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Answer: a. The marginal physical product of labor is the increase in total production (also called total product or output) that results when one additional worker is hired [MPP = (TP 2 − TP1) ÷ (qworkers2 − qworkers1)].

For example, when the first worker is hired, the MPP is 10 *= (10 − 0) ÷ (1 − 0) = 10 ÷ 1+.

When the second worker is hired, the MPP is 18 *= (28 − 10) ÷ (2 − 1) = 18 ÷ 1+. When the third worker is hired, the MPP is 15 *= (43 − 28) ÷ (3 − 2) = 15 ÷ 1+, and so on. b. When graphing the total product (or total output) curve, the number of workers is along the horizontal axis and output (in flats of grapes) is along the vertical axis. One point on the total product curve is 0 workers and 0 flats of grapes. Another point is 1 worker and 10 flats of grapes.

When graphing the marginal physical product curve, the number of workers is along the horizontal axis and output (in flats of grapes) is along the vertical axis. One point on the marginal physical product curve is the first worker and 10 flats of grapes. Another point is 2 workers and 18 flats of grapes.

4. a. Assuming that the price of grapes is $3 per flat, use the data in problem 3 to calculate total revenue and marginal revenue product (MRP). b. Graph the MRP curve. LO2 c. How many pickers will be hired if the going wage rate is $9 per hour?

Answer: Number of Pickers

Output of Grapes

Price

Total Revenue

Marginal Revenue Product

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(per hour) 0 1 2 3 4 5 6 7 8

(in flats) 0 10 28 43 54 61 64 65 61

($) 3 3 3 3 3 3 3 3 3

($ per hour) 0 30 84 129 162 183 192 195 183

($) — 30 54 45 33 21 9 3 –12

a. Total revenue is the price of the product multiplied by the quantity of output in a given time period (TR = p × q). The marginal revenue product is the change in total revenue that results when one additional worker is hired [MRP = (TR2 − TR1) ÷ (qworkers2 − qworkers1)].

For example, when the first worker is hired, the MRP is $30 *= ($30 − $0) ÷ (1 − 0) = $30 ÷ 1+.

When the second worker is hired, the MRP is $54 [= ($84 − $30) ÷ (2 − 1) = $54 ÷ 1+. When the third worker is hired, the MRP is $45 *= ($129 − $84) ÷ (3 − 2) = $45 ÷ 1+, and so on. b. When graphing the marginal revenue product curve, the number of workers is along the horizontal axis and the marginal revenue product (in dollars) is along the vertical axis. One point on the marginal revenue product curve is 1 worker and $30. Another point is 2 workers and $54.

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c. Remember that the marginal revenue product curve is the firm's labor demand curve, and the firm will hire until the wage rate equals the MRP. In this example, if the wage rate is $9 per hour, 6 pickers will be hired.

5. Using the production information contained in Table 8.1 and assuming that the price of strawberries is $3 per box, how many workers would be hired at a wage of (a) $12 per hour and (b) $6 per hour? LO3 Answer:

Number of Pickers (per hour) 0 1 2 3 4

Output of Strawberries (boxes per hour) 0 5 10 14 17

Marginal Revenue Price Total Revenue Product ($ per box) ($ per hour) ($) 3 0 — 3 15 15 3 30 15 3 42 12 3 51 9

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5 6 7 8 9

19 20 20 18 15

3 3 3 3 3

57 60 60 54 45

6 3 0 –6 –9

The marginal revenue product (MRP) is the change in total revenue that results when one additional worker is hired [MRP = (TR2 − TR1) ÷ (qworkers2 − qworkers1)].

For example, when the first worker is hired, the MRP is $15 *= ($15 − $0) ÷ (1 − 0) = $15 ÷ 1+.

When the second worker is hired, the MRP is $15 *= ($30 − $15) ÷ (2 − 1) = $15 ÷ 1+. When the third worker is hired, the MRP is $12 *= ($42 − $30) ÷ (3 − 2) = $12 ÷ 1+, and so on.

The marginal revenue product is the firm's labor demand, and the firm will hire until the wage rate equals the MRP. a. If the wage rate was $12 per hour, 3 pickers would be hired. b. If the wage rate was $6 per hour, 5 pickers would be hired.

6. The University of Alabama increased the capacity of its Bryant-Denny Stadium by 10,000 seats when it hired Nick Saban as its football coach. LO3 a. If the average price of a season ticket is $1,000, how much additional revenue is the university getting from those added seats per year? b. Does that exceed Coach Saban's 2021 pay (see the News Wire "Marginal Revenue Product")?

Answer: a. If the average price of a season ticket is $1,000 and 10,000 more seats were created, there will be $10,000,000 (= $10 million) in additional revenue per year (= $1,000 per seat × 10,000 seats). b. According to the article, Coach Saban earned $9.5 million in 2021. This means that, yes, the $10 million in additional revenue per year exceeds the coach's pay in 2021.

7. In Figure 8.7, LO4 a. how many workers lose their jobs when the minimum wage is enacted? b. how many workers are unemployed at the minimum wage?

Answer: At the equilibrium, qe workers are hired at the wage rate we . a. If a minimum wage is enacted and equal to wm , qd workers will be hired at this higher wage rate. This means that qe workers minus qd workers lose their jobs. b. If a minimum wage is enacted and equal to wm , qd workers will be hired and qs workers are looking for jobs at this higher wage rate. This means that qs workers minus qd workers are unemployed.

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Keep in mind that the number of people who lose their jobs is different from the total number unemployed because an increase in the minimum wage has two effects. It decreases the quantity demanded from the initial equilibrium, and this results in a job loss. At the same time, the increase in the minimum wage results in an increase in the number of workers looking for employment. Since these additional workers are new entrants to the labor force, the result is an increase in unemployment.

8. If the price elasticity of demand of labor is 0.1 and the wage increased from $10 to $15 an hour, what is the predicted decrease in the level of employment in percentage terms? LO4 Answer: Calculate elasticity using the price elasticity of demand formula (E = percentage change in quantity demanded ÷ percentage change in price, in absolute value). Given is the elasticity (= 0.1).

You can calculate the percentage change in price = (new p − old p) ÷ (old p) × 100 = ($15 − $10) ÷ ($10) × 100 = $5 ÷ $10 × 100 = 50%.

Together, you can calculate the percentage change in employment.

E = percentage change in quantity demanded ÷ percentage change in price 0.1 = percentage change in quantity demanded ÷ 50% 5% = percentage change in quantity demanded 9. In July 2020 the Kansas City Chiefs football team signed a 10-year contract with quarterback Patrick Mahomes that will pay him about $40 million a year. If the Chiefs were going to cover that salary with additional ticket revenues, by how much would the team have to increase the average ticket price for the eight home games in its 76,000-seat Arrowhead Stadium?

LO2 Answer: To cover the $40 million per year salary through additional ticket revenue, the Chiefs will need to increase ticket prices by $65.79 for each home game. This is calculated as: $40 million ÷ 8 home games ÷ 76,000 tickets per home game = $65.79 more per ticket for each home game.

The Chiefs will also generate other sources of revenue such as parking fees, concessions, stadium advertising, broadcast fees (television and radio), and sports memorabilia that will help pay the cost of Mahomes’s salary. If Mahomes helps them to make the playoffs, there would be even more revenue from the additional games.

10. Assuming that a college graduate on average earns her MRP, what is the MRP for a newly hired Economics major? (See the News Wire “Unequal Wages.”) LO4 Answer: If a worker is paid her marginal revenue product (MRP), then the wage is the MRP. For an Economics major, MRP = $58,200. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

11. POLICY PERSPECTIVES If Nick Saban (see the News Wire "Marginal Revenue Product") were offered a CEO position at a sporting goods company, what would his opportunity cost be?

LO5 Answer: Nick Saban's opportunity cost to take a CEO position at a sporting goods company is the salary from the job he currently has (= $9.5 million in 2021 according to the News Wire).

CHAPTER 9: GOVERNMENT INTERVENTION ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Define what market failure means.

2 Explain why the market underproduces public goods.

3 Tell how externalities distort market outcomes.

4 Describe how market power prevents optimal outcomes.

5 POLICY PERSPECTIVES Define what government failure is.

QUESTIONS FOR DISCUSSION 1. Why should taxpayers subsidize public colleges and universities? What external benefits are generated by higher education? LO3 Answer: The market provides a sub-optimal amount of goods or services with positive externalities. Taxpayer subsidization is one way to increase the amount closer to the optimal level. All citizens in a state or in a country benefit from the positive externalities of education.

Better education breeds better citizenship and strengthens democracy. We are able to maintain a higher standard of living because those who benefit directly from the public colleges and universities become the engineers, inventors, and entrepreneurs who make our economy grow. These social benefits justify subsidies to education.

2. If everyone seeks a free ride, what mix of output will be produced in Figure 9.2? Why would anyone voluntarily contribute to the purchase of public goods like flood control or snow removal? LO2

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Answer: If everyone seeks a free ride, then no public goods will be produced, and the output mix will consist entirely of private goods. People might voluntarily contribute to flood control if their house is in a flood plain because there is some private benefit associated with the public good. Also, they might voluntarily contribute out of a strong sense of community (to “help out” their neighbor), which in fact people across the world do in the form of charitable donations.

3. Could local fire departments be privately operated, with services sold directly to customers?

What problems would be involved in such a system? LO3 Answer: Yes. Many rural fire departments charge an annual fee. Should a house for which no annual fee has been paid catch fire, it is allowed to burn. Neighboring houses that have paid for fire protection are protected from the fire spreading. There is, of course, the problem that not enough homeowners will pay the annual fee to pay for the total cost of the fire department.

4. Identify a specific government activity that is justified by each source of market failure. LO1 Answer: Exhaust emission regulations for automobiles - Externalities Antitrust division of the Department of Justice - Market power Aid for families with children - Inequity National defense - Public goods 5. Given the effectiveness of Israel’s Iron Dome (News Wire “Public Goods”), why wouldn't individuals want to pay for its protective services? Could this be a profitable venture in the private market? LO2 Answer: This is a classic "public goods" problem. An individual who pays for the Iron Dome isn't any better protected than a neighbor who gets a "free ride.” Therefore, a private company would have a difficult time selling individual subscriptions to a missile-protection system.

6. Environmentalists and Native Americans oppose the Keystone Pipeline because it causes external costs (News Wire “External Costs”). Should any activity that generates external costs be prohibited? LO3 Answer: Answers may vary. External costs are costs not borne by those in the market and constitute a market failure, in that the social demand for a product is less than the market demand. The market will produce more of the product and overstate the social benefits of it.

The external costs are substituted for private costs. There are external costs involved in many everyday activities, such as driving a car (air pollution/carbon emissions). However, whether or not these activities should be prohibited is a political question that can be answered in a variety of ways. Any situation in which there are external costs, though, is a situation in which the government could decide to intervene to reduce the external costs since the market only reflects private benefits. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

7. Does anyone have an incentive to maintain auto exhaust control devices in good working order? How can we ensure that they will be maintained? LO3 Answer: Auto exhaust controls reduce pollution, an external cost. But they reduce the efficiency of the car and don't improve the air the driver is breathing, so few people would voluntarily purchase exhaust controls. In such a case, the government may have to require controls.

8. POLICY PERSPECTIVES What are the costs of New York City’s recycling program (see the News Wire “Opportunity Costs”)? Are these costs justified? LO5 Answer: There are costs to collect, sort, clean, and process the recycled items. There is also air pollution, emissions, traffic, and wear on streets from the second set of trucks. In order to decide if the costs can be justified, they must be compared to the benefits of recycling. Like all economic activities, recycling should be done up to the point where the marginal cost equals the marginal benefit.

9. Most cities are served by only one cable company. How might this monopoly power affect prices and service? What should the government do, if anything? LO4 Answer: As a monopolist, the one cable company would have complete market power and the resulting incentives to increase prices and limit services. Thus, we would expect higher prices and reduced quantity when one cable company rather than many companies serves a city.

One goal of government intervention in cases such as the one described above is to prevent or dismantle concentrations of market power. Allowing or even encouraging competition decreases price while increasing output. Government regulation may have the result of forcing monopolies to decrease price and increase services as well.

10. POLICY PERSPECTIVES Why might the market underproduce and the government overproduce flood-control dams? LO5 Answer: Flood control is an example of a public good. When a flood-control dam is built, the benefits of less flooding in an area are reaped by anyone in the area, not just those who pay for the construction of the dam. In this case, the market would tend to underproduce floodcontrol dams since nonpayers can’t be excluded. As with other similar public goods, if left to the market, it is likely that many people would not pay for the dam’s construction since they would have an incentive to be “free riders;” that is, people would wait for others to pay, since they will receive the benefits whether they pay for the construction or not. Nobody would demand flood control from the market since nobody would be willing to pay and underproduction would result.

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PROBLEMS 1. In Figure 9.3, by how much is the market overproducing cars? LO3

Answer: Whenever external costs exist market demand overstates social demand. At p1, the market would demand qM cars. Because of external costs, however, society wants only qS cars. Hence, the market overproduces qM minus qS cars.

2. How much global output is lost annually as a result of adult deaths from secondhand smoke if the average adult produces (a) $15,000 of output per year, (b) $20,000 of output per year?

(See the News Wire “Externalities.”) LO3

Answer: Secondhand smoke globally kills 602,300 people each year, of which 437,300 are adults (= 602,300 total deaths − 165,000 child deaths). a. If the average adult produces $15,000 of output per year, the annual global loss is equal to $6.560 billion (= 437,300 adults × $15,000 per adult). b. If the average adult produces $20,000 of output per year, the annual global loss is equal to $8.746 billion (= 437,300 adults × $20,000 per adult).

3. a. Draw a production possibilities curve (PPC) with cars on the horizontal axis and other goods on the vertical axis. b. Illustrate on your PPC the market failure that occurs in Figure 9.3. LO3

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Answer: a. See the graph on the next page.

b. See the graph.

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In this example, external costs exist in the market for cars, causing market demand to overstate social demand. At p1, the market would demand qM cars. Because of external costs, however, society wants only qS cars at that price. Hence, the market overproduces cars because they create external costs.

The production possibilities curve shows the possible combinations of production of cars and other goods society can make. To illustrate this overproduction on the curve, we first identify the market production mix (M) of output. This is the output combination with the highest production of cars as measured by the horizontal axis. Since the market outcome is an overproduction of cars, the optimal mix (X) of output is the mix of private and public goods that maximizes society’s welfare, with fewer cars and more other goods being produced.

4. a. Draw market demand and social demand curves for COVID-19 shots. b. What is the source of market failure? LO3 Answer: a. See the graph.

Whenever external benefits exist, the social demand exceeds the market demand. In the figure, the social demand will lie above the market demand if external benefits are present.

Society wants more of those goods and services generating external benefits than the market itself will demand. That is why governments subsidize goods and services that generate external benefits such as education and COVID-19 shots.

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b. The source of this market failure is the existence of externalities (i.e., external benefits) that arise from the consumption of COVID-19 shots.

5. In Figure 9.2, identify the market and optimal outcomes. Does the market under- or overproduce (a) public goods? (b) private goods? LO2 Answer: See the graph.

The production possibilities curve shows the possible combinations of production of private goods and public goods society can make. Because consumers will not demand enough purely public goods in the marketplace, the price mechanism will not allocate enough resources to the production of public goods.

To illustrate this on the curve, we first identify the market production mix (M) of output, which is the output combination with the most private goods produced as measured by the vertical axis. Since the market outcome is an underproduction of public goods, the optimal mix (X) of output is the mix of private goods and public goods that maximizes society’s welfare, with fewer private goods and more public goods being produced.

6. Suppose the annual cost of the Iron Dome is $500 million. What is the opportunity cost of this defense spending in terms of private housing assuming a new home can be constructed for $100,000? (See the News Wire "Public Goods.") LO2

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Answer: The opportunity cost of the Iron Dome (a public good) is 5,000 houses per year (= $500,000,000 ÷ $100,000 per house).

7. The market demand for cigarettes is given in the following table. LO3

Price ($ per pack) Quantity (packs per day)

6.50 40

6.00 50

5.50 60

5.00 70

4.50 80

4.00 90

3.50 100

Suppose that smoking creates external costs valued at 50 cents per pack. a. Draw the social and market demand curves.

Given a market price of $5.00: b. What quantity is demanded in the market? c. What is the socially optimal quantity?

Answer: a. The social demand curve lies below the market demand curve because external costs of $0.50 per pack exist.

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b. At $5 per pack, 70 packs will be demanded per day. This is shown graphically where the market demand curve (DM) intersects the price of $5. c. At $5 per pack, the socially optimal number of packs demanded is 60 packs per day. This is shown graphically where the socially optimal demand curve (DS) intersects the price of $5.

8. a. Graph the following data on social and market demand: LO3

Price

Market Quantity Demanded

Social Quantity Demanded

($) 20 18 16 14 12 10

(units per month) 10 20 30 40 50 60

(units per month) 20 30 40 50 60 70

b. Does this product have external benefits or external costs? c. How large ($) is that externality?

Answer: a. See the graph.

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b. The social demand curve lies above the market demand curve, thus displaying external benefits. c. The social demand curve lies $2 above the market demand curve, so the external benefit is equal to $2.

9. According to Table 9.1 (Income Transfers), calculate the average benefit a Medicaid recipient receives. LO1 Answer: The average Medicaid recipient receives $8,442 in transfer benefits (= $650 billion in benefits transferred ÷ 77 million people).

10. POLICY PERSPECTIVES The production possibilities curve shows the trade-off between housing and all other goods. LO5

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a. If the market mix of output is at point A and the optimal mix of output is at point C, does a market failure exist? b. If the government has a laissez-faire approach, will it intervene? c. If the government intervenes and the economy moves to point D, is this a government failure?

Answer: a. The optimal mix of output is the most desirable combination of output attainable with existing resources, technology, and social values. If the market mix is at point A and the optimal mix is at point C, there is a market failure (an imperfection in the market mechanism that prevents market outcomes). b. Laissez faire is the doctrine of “leave it alone,” of nonintervention by government in the market mechanism. If the government adopts a laissez-faire approach, it will not intervene in the market. c. Government failure refers to any intervention that fails to improve market outcomes. In this example, if government intervention moves the economy to point D, the intervention moved the economy beyond the optimal mix, which is a government failure.

Neither market failure nor government failure is inevitable. The challenge for public policy is to decide when any government intervention is justified and, when deemed necessary, to intervene in a way that improves outcomes in the least costly way.

CHAPTER 10: THE BUSINESS CYCLE ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

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LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Explain how growth of the economy is measured.

2 Tell how unemployment is measured and affects us.

3 Discuss why inflation is a problem and how it is measured.

4 Define full employment and price stability.

5 POLICY PERSPECTIVES Recite the U.S. track record on growth, unemployment, and inflation.

QUESTIONS FOR DISCUSSION 1. If auto sales are increasing but home construction is falling, is the economy growing or shrinking? LO1 Answer: The economy produces millions of different products. Sales of some are increasing, while sales of others are declining. So, one can't assess changes in GDP based on the sales of any single industry.

2. If the price level is rising faster than nominal GDP, what is happening to real GDP? LO1 Answer: If the price level is rising faster than nominal GDP, then the economy would be experiencing inflation and real GDP would be declining.

3. Why isn’t a full-time college student who is not working not counted as “unemployed”? LO2 Answer: The labor force includes those over age 16 who are working or looking for work.

While a full-time student isn’t working, the student also isn’t actively seeking employment, so the student is not in the labor force.

4. Why might inflation accelerate as the unemployment rate declines? LO4 Answer: As the unemployment rate declines, qualified workers become harder to find. As a result, employers often must pay premiums to workers to attract them into the labor force or away from current employers. The result is higher wages, which is a major source for inflation.

5. During the time period shown in Table 10.4, what happened to the wealth of people holding hordes of gold? LO3

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Answer: According to the information provided in the table, the nominal price of gold fell by 29 percent. Since the price of gold decreased by 29 percent, it is now only 71 percent of its original value. At the same time, because the average price of goods, i.e., the inflation rate, rose by 32 percent, these goods are 132 percent of their original values. The real price of gold is 0.71 ÷ 1.32 = 0.54. Thus, the price of gold is approximately 54 percent of its original value, or a real decline of 46 percent.

6. According to Table 10.2, what happened to the average price of fruit in 2020? LO3 Answer: We don't know. It depends on the relative importance (size, value) of the various fruits in the average consumer's shopping cart. The price changes listed only give the changes for oranges (whose price rose), not for all fruits.

7. How might the inflation numbers in Table 10.2 have affected people’s choice of flying or driving? LO3 Answer: The inflation numbers may have influenced people to travel less by car and to travel more by air. The price of air travel declined while the price of gasoline, which fuels cars and adds to the cost of travel by car, increased.

8. Which of the following people would we expect to be hurt by an increase in the rate of inflation from 3 percent to 6 percent? LO3 a. A homeowner b. A retired person c. An automobile worker d. A bond investor Answer: a. Whatever this person’s nominal mortgage (interest) rate was, the real interest rate will decline by 3 percentage points. Ceteris paribus, borrowers benefit from inflation. b. This person’s purchasing power of fixed income will decline; thus, this person is hurt by inflation. c. The automobile worker may or may not be hurt by inflation. If the worker’s wages increase at the same rate as the inflation rate, then his or her purchasing power will not change, and the worker will neither benefit nor be hurt by the inflation. If the worker’s wages stay the same or decline, his or her purchasing power will decrease, and the worker will be hurt by the inflation. d. Interest rates generally move in the same direction as inflation because nominal interest rates include an inflation component. The values of bonds move in the opposite direction of the movement in interest rates. As a result, the value of the bond declines as inflation increases, and this person is harmed by inflation. In addition, this individual receives a fixed income from this bond. The purchasing power of this fixed income is diminished by inflation.

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9. According to Table 10.4, what happened to (a) the nominal value of silver? (b) the real value of silver? LO3 Answer: a. The nominal value of silver increased by 22 percent from 1991–2001. b. The increase in the nominal value (price) of silver was less than the 32 percent increase in the average price (value) of goods. Holders of silver over this time period were left with an asset whose value did not keep pace with inflation and were left with a decline in real value.

10. POLICY PERSPECTIVES During the coronavirus pandemic of 2020, more than 20 million Americans lost their jobs. Why? LO5 Answer: There are reasons impacting both supply and demand. On the supply side, local and state governments shut down businesses to slow the spread of the highly contagious disease.

Also, some workers were fearful of going to work so this made it difficult for some businesses to stay open. On the demand side, consumers were fearful of catching the disease, so they reduced their spending on travel, routine doctor visits, massage therapy, movies, restaurants, and other goods and services.

PROBLEMS 1. How much more output will the average American have next year if the $22 trillion U.S. economy grows by: LO1 a. 1 percent? b. 3 percent? c. −1 percent?

Assume a population of 340 million.

Answer: Given the information, the average GDP per capita in the United States is currently $64,706 (= $22 trillion ÷ 340 million). Keep in mind that $22 trillion is equal to $22,000 billion or $22,000,000 million or $22,000,000,000,000. a. If GDP grows by 1 percent over the next year, U.S. GDP will increase to $22.22 trillion (= $22 trillion × 1.01). The average GDP per capita in the United States will be $65,353 if GDP grows 1 percent over the next year (= $22.22 trillion ÷ 340 million). Hence, the average GDP per capita in the United States will be $647 more next year with a 1 percent growth rate of GDP (= $65,353 – $64,706). b. If GDP grows by 3 percent over the next year, U.S. GDP will increase to $22.66 trillion (= $22 trillion × 1.03). The average GDP per capita in the United States will be $66,647 if GDP grows 3 percent over the next year (= $22.66 trillion ÷ 340 million). Hence, the average GDP per capita in the United States will be $1,941 more next year with a 3 percent growth rate of GDP (= $66,647 − $64,706).

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c. If GDP contracts by 1 percent (a –1 percent growth rate) over the next year, U.S. GDP will decrease to $21.78 trillion (= $22 trillion × 0.99). The average GDP per capita in the United States will be $64,059 if GDP grows –1 percent over the next year (= $21.78 trillion ÷ 340 million). Hence, the average GDP per capita in the United States will be $647 less next year (– $647) with a –1 percent growth rate of GDP (= 64,059 − $64,706).

2. Suppose the following data describe a nation’s population: LO2

Population Labor force Unemployed

Year 1 330 million 160 million 6.5 million

Year 2 340 million 164 million 6.9 million

a. What is the unemployment rate in each year? b. Has the economy experienced an increase or a decrease in: (i) the number of unemployed persons? (ii) the unemployment rate?

Answer: a. The unemployment rate is calculated as the number of unemployed people divided by the size of the labor force. Using this formula: Unemployment rate in Year 1 = 6.5 million ÷ 160 million = 0.0406, or 4.06 percent.

Unemployment rate in Year 2 is 6.9 million ÷ 164 million = 0.0421, or 4.21 percent. b. (i) The number of unemployed persons from Year 1 to Year 2 increased by 0.4 million, or 400,000 workers (= Year 2 unemployed − Year 1 unemployed = 6.9 million − 6.5 million). (ii) The unemployment rate increased from 4.06 percent in Year 1 to 4.21 percent in Year 2.

3. If the average worker produces $100,000 of GDP, by how much will GDP increase if there are 160 million labor force participants and the unemployment rate drops from 5.0 to 4.5 percent? LO1, LO2 Answer: Recall that the unemployment rate is the number of unemployed people divided by the size of the labor force. In other words, the unemployment rate describes the percentage of the labor force that is currently unemployed. To calculate the number of unemployed, substitute the available data in the equation and solve for the number of unemployed.

If the labor force consists of 160 million labor force participants and the unemployment rate is 5.0 percent, the current number of unemployed is 8 million.

Unemployment rate = number of unemployed people ÷ size of the labor force 5.0% = number of unemployed people ÷ 160 million Number of unemployed people = 5.0% × 160 million = 0.05 × 160 million = 8 million. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

If the unemployment rate changes to 4.5 percent, the number of unemployed is 7.2 million.

Unemployment rate = number of unemployed people ÷ size of the labor force 4.5% = number of unemployed people ÷ 160 million Number of unemployed people = 4.5% × 160 million = 0.045 × 160 million = 7.2 million.

This means that after this change, there will be 0.8 million more people employed (= 8 million − 7.2 million). If the average worker produces $100,000 of GDP, then these 800,000 workers will contribute an additional $80 billion to GDP (= $100,000 × 800,000 = $80,000,000,000).

4. During the past 10 years, by what percentage did (a) the nominal price and (b) the real price of college tuition increase per year (see the News Wire “Price Effects”)? LO3 Answer: a. Nominal prices do not take inflation into account. It is the amount of money paid in current dollars. According to the News Wire, the nominal price of tuition increased by 4.5 percent. b. Real prices do take inflation into account. It is the nominal price adjusted for inflation. To calculate how the real price of tuition has changed, you take the percentage change in the nominal price of tuition and subtract the inflation rate (which is the percentage increase in overall prices). According to the article, inflation was 1.3 percent, so the real price increase of tuition is 3.2 percent (= 4.5 percent − 1.3 percent).

Calculating real price changes for different goods and services is useful because we can compare how much more expensive some goods and services have become compared to the average. In this case, we can say that the price of tuition is rising faster than inflation, so tuition has become relatively more expensive as compared to goods and services overall.

5. Nominal GDP increased from roughly $10 trillion in 2000 to $20 trillion in 2020. In the same period, prices rose on average by roughly 50 percent. By how much did real GDP increase?

LO3 Answer: Real GDP is nominal GDP adjusted for changes in price. The percentage change in real GDP is calculated as the percentage change in nominal GDP minus the percentage increase in prices.

Percentage change in nominal GDP = [(GDP2 − GDP1) ÷ GDP1+ × 100 = *($20 trillion − $10 trillion) ÷ $10 trillion] × 100 = 100%.

Percentage change in real GDP = percentage change in nominal GDP − percentage change in the price level = 100% − 50% = 50%.

6. What will the real value of $100 be in 10 years if you hide the money under your mattress and the inflation rate is: LO3 a. 0%. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. 2%. c. 6%.

(Hint: Table 10.3 provides clues.)

Answer: The equation to calculate future value is: Future value of $100 = $100 ÷ (1 + inflation rate)t, where t is the number of years in the future. The higher the inflation rate, the more rapidly the real value of money decreases. a. The future value of $100 after 10 years of 0 percent inflation is $100.

Future value of $100 = $100 ÷ (1 + 0.00)10 = $100 ÷ 1.0010 = $100 ÷ 1 = $100 If there is no inflation, the real value of money does not decrease. b. The future value of $100 after 10 years of 2 percent inflation is approximately $82.03.

Future value of $100 = $100 ÷ (1 + 0.02)10 = $100 ÷ 1.0210 = $100 ÷ 1.219 = $82.03 c. The future value of $100 after 10 years of 6 percent inflation is approximately $55.83.

Future value of $100 = $100 ÷ (1 + 0.06)10 = $100 ÷ 1.0610 = $100 ÷ 1.791 = $55.83 The great thing about this question is the table that is provided completes the calculation for a real value of $1,000 for different inflation rates (2 percent, 4 percent, 6 percent, 8 percent, and 10 percent). Since the table uses $1,000 as the base value and this question uses $100 as its base value, you simply have to divide all numbers in the table by 10 to scale appropriately.

Related to the second example, you can see in the row 2032 (10 years in the future), at a 2 percent inflation rate, $1,000 will be worth $820. This means that $100 will be worth about $82 ($1,000 ÷ 10 = $820 ÷ 10). Related to the third example, you can see in the row 2032 (10 years in the future), at a 6 percent inflation rate, $1,000 will be worth $558. This means that $100 will be worth about $55.80 ($1,000 ÷ 10 = $558 ÷ 10).

7. According to the following data, between 2000 and 2021, by what percentage did: LO3

Average hourly wage CPI

2000 $ 14 170

2021 $ 30 262

a. nominal wages increase? b. consumer prices increase? c. real wages increase?

Answer: a. Nominal wages are the amount of money you receive in a particular time period; nominal wages are measured in current dollars. Nominal wages increased by 114 percent between 2000 and 2021 *= ($30 − $14) ÷ $14 × 100+. b. Consumer prices, as measured as the change in the consumer price index (CPI), increased by 54 percent between 2000 and 2021 *= (262 − 170) ÷ 170 × 100+.

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c. Since nominal wages are rising more quickly than consumer prices, real wages have increased between 2000 and 2021. Real wages are the purchasing power of that money as measured by the quantity of goods and services your dollars will buy. It is your wages measured in constant dollars (i.e., adjusted for inflation).

8. In Zimbabwe the rate of inflation hit 90 sextillion percent in 2009, with prices increasing tenfold every day. At that rate, how much would a $100 textbook cost one week later? LO3 Answer: The answer is $1 billion. A tenfold increase will cause the price to increase by a factor of 10. This means in one day that the price of a textbook increased from $100 to $1,000 (= $100 × 10). If this continued for one week, the increase would be 107, or a factor of 10,000,000. Therefore, after one week, the price of the textbook increased from $100 to $1,000,000,000 (or $1,000 million or $1 billion).

At the height of Zimbabwe’s inflation, prices were rising by a factor of 10 per day. That means that a Starbucks latte that costs $4 today would cost $40 tomorrow. Such runaway inflation caused an economic and political crisis that shrank Zimbabwe’s output by 30 percent. To avoid that kind of economic disruption, every American president since Franklin Roosevelt has expressed a determination to keep prices from rising.

9. The following table lists the prices of a small market basket purchased in both 2012 and 2022. Assuming that this basket of goods is representative of all goods and services: LO3 a. Compute the cost of the market basket in 2012. b. Compute the cost of the market basket in 2022. c. By how much has the average price level risen between 2012 and 2022? d. The average household’s nominal income increased from $50,000 to $80,000 between 2012 and 2022. What happened to its real income?

Answer: a, b. The cost of the market basket is equal to quantity multiplied by price for each year for all products listed (= quantity × price).

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c. The average price level rose by 48.46 percent between 2012 and 2022. The percentage change in prices is calculated as [(Price2022 − Price2012) ÷ Price2012+ × 100 = *($11,550 − $7,780) ÷ $7,780] × 100 = 48.46 percent. d. Nominal income rose by 60 percent between 2012 and 2022. The percentage change in wages is calculated as [(Wage2022 − Wage2012) ÷ Wage2012+ × 100 = *($80,000 − $50,000) ÷ $50,000] × 100 = 60 percent.

Real income is the purchasing power of that money, as measured by the quantity of goods and services your dollars will buy. If the number of dollars you receive every year is always the same, your nominal income doesn’t change. But your real income will fall if prices increase. If nominal incomes grew more slowly than prices, then real incomes would fall.

Since nominal incomes grew faster than prices (60 percent > 48.46 percent), real incomes rose.

10. According to the information in Table 10.2, which product had (a) the largest price increase in 2020? (b) the biggest price decline? LO3 Answer: a. Of the products included in the table, the price of used cars rose the most (= 10.0 percent). b. Of the products included in the table, the price of airfares fell the most (= –21.3 percent).

11. POLICY PERSPECTIVES Since 1940, LO5 a. when did the longest recession begin? b. when did the shortest recession begin? c. when did the recession with the highest unemployment rate begin? d. when did the recession with the biggest decline in output begin? e. when did the recession with the smallest decline in output begin?

(See Table 10.1.)

Answer: a. Since 1940, the recession that began in 2007 had the longest duration (18 months). b. Since 1940, the recession that began in 2020 had the shortest duration (5 months). c. Since 1940, the recession that began in 2020 had the highest unemployment rate with a peak of 14.8 percent. d. Since 1940, the recession that began in 2020 had the biggest decline in output (GDP fell by 37.0 percent). e. Since 1940, the recession that began in 2001 had the smallest decline in output (GDP fell by 0.3 percent).

CHAPTER 11: AGGREGATE SUPPLY AND DEMAND ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

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LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Cite the major macro outcomes and their determinants.

2 Explain how classical and Keynesian macro views differ.

3 Interpret the shapes of the aggregate demand and supply curves.

4 Tell how macro failure occurs.

5 POLICY PERSPECTIVES Outline the major policy options for macro government intervention.

QUESTIONS FOR DISCUSSION 1. If the price level were below PE in Figure 11.5, what macro problems would we observe? Why is PE considered an equilibrium? LO4 Answer: If the price level were below PE, a macroeconomic shortage of goods and services would exist in the economy. In general, consumers want to purchase more goods and services than producers are willing to supply. As a result, there will be a tendency for the general price level to rise accompanied by an increase in real output.

When the price level reaches PE, aggregate quantity supplied equals aggregate quantity demanded and macroeconomic equilibrium will be achieved.

2. What factors might cause a rightward shift of the aggregate demand curve? What might induce a rightward shift of aggregate supply? LO3 Answer: Changes in the shift parameters will cause either AS or AD to shift position. Factors that would cause an increase in AD, a rightward shift, would include decreases in the interest rate, an increase in the population, increased consumer confidence, increases in government spending, lower consumer taxes, and increases in exports.

Factors that would cause an increase in AS, a rightward shift, are improvements in productivity, resulting from increased investment in plant and equipment; increases in the size of the labor force that reduce wages; improved business confidence; and changes in tax policies and government regulation that favorably impact businesses.

3. What kind of external shock would benefit an economy? LO1 Answer: Any external shock that resulted in a macro equilibrium at, or at least closer to, the desired price level and rate of unemployment would be beneficial. For example, if both the price level and unemployment were too high, the discovery of a readily accessible supply of oil would increase aggregate supply, thereby lowering the price level and the unemployment rate.

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4. What would a horizontal aggregate supply curve imply about producer behavior? How about a vertical AS curve? LO3 Answer: A horizontal aggregate supply curve would imply the economy has the ability to increase output while incurring no limitations on input availability, cost, or quality. In other words, output could increase with no inflationary pressure. This might occur in an economy that is producing well below capacity, i.e., one that is below the production possibilities curve.

A vertical AS curve would indicate the economy was at the limits of its production possibilities curve and could not change its output at all. Any attempt to increase output of one commodity without reducing the output of some other commodity would cause inflation.

5. If equilibrium is compatible with both buyers' and sellers' intentions, how can it be undesirable? LO4 Answer: Equilibrium simply means there is no tendency for the economy to move away from its current income and price level. In the Keynesian view, there is no necessary connection between equilibrium and full employment or a satisfactory distribution of income or goods and services. Equilibrium depends only on well-functioning markets. If economic agents are pessimistic or overly optimistic about the economy, the economy can reach an equilibrium state that is undesirable, i.e., unemployment, prices, or both are too high, but stable.

6. The U.S. stock market increased in value by 25 percent in 2017. How might this have affected aggregate demand? What happens to aggregate demand when the stock market plunges?

LO3 Answer: An increase in the value of the stock market, such as the one that occurred in 2017, is due to wealth effects.

7. Why would job losses in the restaurant industry cause a loss of recreation jobs, as in the News Wire “Undesirable Outcomes” suggests? LO4 Answer: The workers who lose their jobs in the restaurant industry will have less income, which will curtail their retail spending, including spending on recreational activities.

8. POLICY PERSPECTIVES Why did President Biden believe that government intervention was needed to get the economy out of the 2020 recession? Could the economy have recovered on its own? LO4, LO5

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Answer: When President Biden took office, the economy was in a recession due to the effects of the coronavirus pandemic. The Fed had already cut interest rates to the point where it could no longer make further cuts. To continue to combat the recession, using fiscal policy to shift the AD curve and move the economy toward full employment was the option recommended by President Biden. President Biden encouraged increased government spending and tax cuts, including direct payments to households and spending to support business. This spending was designed to shift aggregate demand.

For the second part of the question, answers will vary since this is part of the debate among the various schools of economic thought. Correct student answers should be well-supported by appropriate applications of the classical, Keynesian, monetarist, supply-side, and eclectic explanations as noted in the chapter.

9. POLICY PERSPECTIVES President Trump directed his 2017 tax cuts more to businesses than to consumers. Does it matter? How different would have been the impact of consumer tax cuts? LO5 Answer: The fact that the 2017 tax cuts were directed more at businesses than at consumers indicates that these tax cuts were oriented toward a policy aimed at increasing production and reducing costs to businesses to encourage growth via business investment. This growth encourages growth in aggregate demand as well as aggregate supply, since under this type of policy, businesses have an incentive to increase production capacity.

Consumer-oriented tax cuts instead encourage consumer spending. While this would also elicit growth in aggregate demand, the effect would have been based on increasing consumer spending on goods and services instead of encouraging businesses to purchase capital equipment and to increase their activity. The effect on aggregate supply would not occur.

10. POLICY PERSPECTIVES What is the condition of the U.S. economy now? Should the government intervene more? What policy levers should be pulled, if any? LO5 Answer: Answers will vary. At the time of this writing (2022), the U.S. economy was in the later phases of the coronavirus pandemic. During this time, there was low unemployment, high inflation, and continued concerns about income inequality.

Possible answers for policy levers at this time include anything from continuing the policies of the Biden administration and the Federal Reserve to a hands-off policy (not pulling any policy levers) to greater government intervention designed to alleviate inequality through government spending on related programs. Correct answers will apply any one of the competing theories of economic policy correctly.

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PROBLEMS 1. In Figure 11.8, a. what is the level of output at full employment?

How much is the rate of output reduced when b. AD shifts leftward? c. AS shifts leftward? d. both AD and AS shift leftward? LO4

Answer:

a. Equilibrium occurs at the intersection of AD0 and AS0 at Q4. b. If AD shifts leftward (decreases), the new equilibrium will be at the intersection of AD 1 and AS0 at Q3. c. If AS shifts leftward (decreases), the new equilibrium will be at the intersection of AD 0 and AS1 at Q2. d. If both AD and AS shift leftward (decrease), the new equilibrium will be at the intersection of AD1 and AS1 at Q1.

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2. In Figure 11.6, when AD shifts rightward, does (a) the price level increase or decrease and (b) output increase or decrease? LO3

Answer: If AD shifts rightward (e.g., increases from AD1 to AD0), the new equilibrium will result in (a) a higher price level and (b) higher output.

3. Illustrate these events with AS or AD shifts: LO3 a. government cuts defense spending. b. interest rates rise. c. imported oil gets cheaper. d. taxes on the rich are increased.

Answer: Remember that AD will shift if there are changes in government spending, changes in consumer wealth, changes in taxes on consumers, changes in interest rates or credit conditions, and changes in expectations about the health of the economy (consumer confidence). AS will shift if there are higher costs of essential inputs (like oil), natural disasters impacting production processes, changes in taxes on businesses, and changes in regulations on production. A leftward shift is a decrease, and a rightward shift is an increase.

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a. A decrease in government spending (a cut in defense spending) would shift AD leftward.

b. An increase in interest rates makes both investment and consumer borrowing more expensive and would shift AD leftward.

c. If imported oil becomes cheaper, the cost of producing goods will decrease and AS would shift rightward.

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d. An increase in taxes on the rich would shift AD leftward.

4. Based on the News Wire “Shifting Aggregate Supply”: LO4 a. Illustrate the AS shift that occurs. b. Identify the old (E0) and new (E1) macro equilibriums. c. What are the macro results? d. How can the economy stay healthy in this case?

Answer: a, b. The decrease in available resources causes a leftward shift in the aggregate supply (AS) curve.

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c. Because of the leftward shift in aggregate supply, output decreases and the price level increases. d. The economy can return to the original real output level if government enacts policies that increase aggregate demand and/or increase aggregate supply.

5. Graph the following aggregate supply and demand curves (be sure to draw to scale). LO3

Price Level 100 110 140 200

Real GDP (in $ Trillions) Supplied Demanded 4 16 10 15 14 12 15 6

a. What is the equilibrium price level? b. What is the equilibrium output? c. If the quantity of output demanded at every price level increases by $2 trillion, what happens to equilibrium output and prices? d. Graph your answer to part (c).

Answer: a. The equilibrium price level is where aggregate supply equals aggregate demand (AS = AD) at about 130. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. The equilibrium output level is where aggregate supply equals aggregate demand (AS = AD) at about $13 trillion in real GDP. c. If the quantity of output demanded at every price level increases by $2 trillion, the AD curve would shift to the right. The new equilibrium output increases to $14 trillion in real GDP and the price level increases to 140. d. The aggregate supply curve will shift to the right by $2 trillion at each price level.

See the graph on the next page for an illustration of this situation.

6. Draw a conventional aggregate demand curve on a graph. Then add three different aggregate supply curves, labeled LO1, LO3 S1 : horizontal curve S2 : upward-sloping curve S3 : vertical curve all intersecting the AD curve at the same point. If AD were to increase (shift to the right), which AS curve would lead to: a. the biggest increase in output? b. the largest jump in prices? c. the least inflation?

Answer: If AD were to shift to the right, a. the horizontal curve (S1) will provide a new equilibrium with the highest gain in real output. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

b. the vertical curve (S3) will provide a new equilibrium with the highest increase in prices. c. the horizontal curve (S1) will provide a new equilibrium with the lowest increase in prices because prices will not increase.

7. The following schedule provides information with which to draw both an aggregate demand curve and an aggregate supply curve. Both curves are assumed to be straight lines. LO4 Average Price (Dollars per Unit) $800 $700 $600 $500 $400 $300 $200

Quantity Demanded (Units per Year) 100 200 300 400 500 600 700

Quantity Supplied (Units per Year) 700 600 500 400 300 200 100

a. At what price level does equilibrium occur? b. What curve would have shifted if a new equilibrium were to occur at an output level of 700 and a price level of $800? c. What curve would have shifted if a new equilibrium were to occur at an output level of 700 and a price level of $500? d. What curve would have shifted if a new equilibrium were to occur at an output level of 700 and a price level of $200?

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e. Compared to the initial equilibrium (a), how have the outcomes in (b), (c), and (d) changed price levels or output?

Answer:

a. Equilibrium occurs where AD equals AS at the output level of 400 and the price level of $500. b. To reach the point where output is 700 and the price level is $800, something must have happened to cause AD to shift to the right, raising both prices and output. c. To reach the point where output is 700 and the price level remains at $500, something must have happened to cause both AD and AS to shift to the right for this to occur. Prices stay the same and output increases. d. To reach the point where output is 700 and the price level is $200, something must have happened to cause AS to shift to the right, raising output and lowering prices. e. Compared to the initial equilibrium in part a: (i) In the case of b, the price level increased and output increased. (ii) In the case of c, the price level did not change and output increased. (iii) In the case of d, the price level decreased and output increased. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

8. Suppose AD shifts by $60 for every $1,000 change in consumer wealth. By how much will AD increase when the stock market rises in value by $400 billion? LO3

Answer: A $400 billion increase in consumer wealth from the stock market will cause a $24 billion increase in AD. Total impact on AD = ($400 billion ÷ $1,000) × $60 = $24 billion.

9. Suppose AS increases by $40 billion for every 1 percentage point decrease in business tax rates. By how much will AS shift to the right when the tax rate is reduced from 35 percent to 21 percent? LO3

Answer: AS will shift to the right (increase) by $560 billion if there is a decrease in the tax rate from 35 percent to 21 percent.

Total impact on AS = impact on aggregate supply per 1 percent change in taxes × percentage change in taxes = $40 billion × (35 percent − 21 percent) = $40 billion × 14 = $560 billion.

10. POLICY PERSPECTIVES Suppose a nation’s maximum GDP (with 0 percent unemployment) is $25 trillion. LO5 a. Assuming that full employment occurs when there is 4 percent unemployment, how much is full employment GDP? b. If equilibrium GDP is $20 trillion, how far from full employment GDP is this economy? c. Which of the following shifts will move this economy closer to full employment? (i) AD shifts to the right. (ii) AD shifts to the left. (iii) AS shifts to the right. (iv) AS shifts to the left.

Answer: a. Full employment GDP is the rate of real output (GDP) produced at full employment. In this economy, full employment occurs when unemployment is equal to 4 percent. In other words, the economy is at full employment if 96 percent of workers are employed. If workers contribute equally to GDP, then the full employment GDP is 96 percent of maximum GDP and is equal to $24 trillion (= $25 trillion × 96 percent = $25 trillion × 0.96). b. An equilibrium GDP of $20 trillion is $4 trillion less than our full employment GDP (= $24 trillion − $20 trillion). c. Both an increase (shift to the right) in AD and AS will move this economy toward full employment. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

CHAPTER 12: FISCAL POLICY ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Define what fiscal policy is.

2 Explain why fiscal policy might be needed.

3 Illustrate what the multiplier is and how it works.

4 Tell how fiscal stimulus or restraint is achieved.

5 POLICY PERSPECTIVES Specify how fiscal policy affects the federal budget.

QUESTIONS FOR DISCUSSION 1. Why was the Merrill Lynch economist (see the News Wire “Shifts in Aggregate Demand”) so confident that a recession was coming in 2007? LO2 Answer: In 2007, wealth and income trends indicated that a recession was coming due to indications of a decline in aggregate demand. These indications included the value of housing and the stock market falling, which left consumers with less purchasing power, and the increasing price of gasoline, which increased transportation costs, as well as energy costs.

Major retailers Walmart and Target reported a slowdown in sales, and wage and job growth slowed substantially. All of these point to a decrease in consumption–consumer spending–the largest component of aggregate demand–and a reduction in economic growth.

2. What can people do with an income transfer? What do we want them to do with it? LO4 Answer: Answers will vary. Expect most students to answer that they spend their money almost as soon as they get it. You may want to ask them if they use all of their income for consumption or if they save any. Try to get them to think and talk about the multiplier effect—that their expenditure turns into someone else’s income, which that person then uses for consumption, etc., and the effect the combined spending has on the community in which the college is located. If the income transfer is intended to stimulate the economy, we want them to spend it (and not save it). This will give the highest stimulus effect.

3. What is your MPC? Would a welfare recipient and a millionaire have the same MPC? What determines a person's MPC? LO3

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Answer: Remember that the MPC is the tendency to consume out of additional income, not the tendency to consume out of total income. The average student is likely to have a very high MPC, especially if he or she is the traditional 18- to 22-year-old student. Lower-income people always will be expected to have higher MPCs, since they need all their income just to pay for basic necessities. If a student or a welfare recipient were to earn an extra $10,000, he or she would probably spend most of it. If a millionaire were to earn an extra $10,000, he or she may only spend a small fraction of the extra income. The level of income and tastes are primary determinants of MPC. 4. Why was Walmart worried about the 2013 payroll tax hike (News Wire “Fiscal Restraint”)?

LO4 Answer: The 2013 payroll tax reinstatement left Americans with less money to spend.

Walmart Stores Inc., Burger King Worldwide Inc., and Kraft Foods Group Inc., all were lowering forecasts and expectations in the belief that consumers with smaller paychecks would dine out less and trade down to less expensive purchases. A household with a $65,000 annual income lost $1,300 this year and consumers overall lost $110 billion, leaving Walmart with a great deal to worry about.

5. If the guidelines for fiscal policy (Table 12.2) are so simple, why does the economy ever suffer from unemployment or inflation? LO2 Answer: First, there are unanticipated shocks to the economy that can throw it out of the fullemployment, stable-price equilibrium. Second, there are lags between the time when unemployment or inflation occurs and when discretionary policy actually makes an impact on the economy. Third, fiscal policy cannot necessarily fine-tune the economy, but can, at best, dampen the business cycle. Two other key elements to this problem are politics and human behavior. Often, politicians may have political agendas that differ from the needs of the economy. Legislation that serves the political needs of constituents may act counter to recommended fiscal policy guidelines. Finally, not all economists agree with the foundations on which those guidelines are based on. Different economic models have been developed that recommend differing policies for the same circumstances.

6. In early 2018 businesses bought more inventory, increasing GDP. What would happen if consumers didn’t buy those goods? LO2 Answer: If consumers fail to purchase inventory, businesses will need to decrease the pace of increasing inventory and will eventually decrease their inventory investment, which can lead to a decline in GDP. 7. Was Biden’s American Rescue Plan too big, too small, or just right? LO2

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Answer: Congress uses increased spending to shift the AD curve to the right, increasing GDP and employment. If this spending, combined with the multiplier effect, created the correct boost to the economy, then the American Rescue Plan was “just right.”

But if the plan was too small or too large when combined with the multiplier effect, then the American Rescue Plan’s mix of stimulus to businesses and individuals was not right.

8. Which is likely to give the economy a greater boost, household tax cuts or business tax cuts?

LO3 Answer: Tax cuts for households do give the economy a boost through consumer spending– the largest component of AD–and have a wide impact. However, business tax cuts also stimulate spending through investment as well as through increased production, which can stimulate aggregate supply just as much as aggregate demand. Correct answers account for this as well as for the multiplier effect and the size of the tax cuts.

9. POLICY PERSPECTIVES Would a constitutional amendment that would require the federal government to balance its budget (incur no deficits) be desirable? Explain. LO5 Answer: A constitutional amendment requiring a balanced budget would restrict the ability of the government to manage aggregate demand using fiscal policy, especially from the Keynesian perspective. For example, during a recession, the government has cause to cut taxes and increase its spending, which together would easily throw the budget out of balance. A balanced budget would force the government to pay for increased spending in one area with increased taxes or decreased spending elsewhere to offset the increased cost. This would mean that the government would not be able to influence AD effectively to move the economy out of recession, since it would not be able to increase its spending without increasing taxes, which limits the disposable income of consumers (restricting the “C” component of AD) or taxing businesses (restricting the “I” component of AD).

10. What government programs would you cut in the pursuit of fiscal restraint? LO4 Answer: Answers to this question will vary, depending on the prioritization that students give to different spending categories, from suggesting cuts to defense and foreign aid to suggesting cuts to programs providing various services. All cuts to programs and efforts to create fiscal restraint do decrease the government spending component of AD and have an impact of reducing aggregate demand, since they not only have an impact on the government itself but also on the economy as a whole due to the multiplier effect.

PROBLEMS 1. In Figure 12.2, LO2 a. identify the GDP gap when the demand curve is at AD1. b. is the economy in a recession or expansion? © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

Answer:

The full employment equilibrium occurs where AD2 equals AS. The economy will produce $11 billion in output at the full employment level. If the economy is currently where AD1 equals AS, the current output is $8 billion. a. The GDP gap is the difference between the current equilibrium and full employment equilibrium. According to the figure, the GDP gap is $3 billion (= $11 billion − $8 billion). b. If the current equilibrium output is less than the full employment output, then the economy is in a recession.

2. If the marginal propensity to save is 0.20, LO3 a. what is the MPC? b. how large is the multiplier?

Answer: a. The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption: MPS = (1 − MPC). The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption: MPC = (1 − MPS).

If MPS equals 0.20, then MPC equals 0.80 (= 1 − 0.20). b. The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: Multiplier = 1 ÷ (1 − MPC) or Multiplier = 1 ÷ MPS.

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Given MPC equals 0.80, the multiplier is 5 *= 1 ÷ (1 − MPC) = 1 ÷ 0.20+.

3. In 2019 consumers' disposable income increased by $580 billion and their spending increased by $550 billion. What was the MPC? LO3 Answer: The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption. MPC = additional consumption ÷ additional income = $550 billion ÷ $580 billion = 0.95.

4. According to the News Wire “Fiscal Stimulus: Tax Cuts,” LO3 a. how much did the weekly disposable income of the average household increase as a result of the Trump tax cut? b. how much did the weekly disposable income of all households increase? c. if the MPC was 0.6, by how much did total consumer spending increase (i) after a oneweek boost to incomes and (ii) after all the spending cycles were completed after a oneweek boost to incomes?

Answer: a. According to the News Wire, households received, on average, $40 more per week in after-tax income, also known as disposable income. b. Aggregating all households together, the annual increase in disposable income is equal to $5.2 billion (= $40 per week × 130 million households = $5,200,000,000 = $5.2 billion). c. If the MPC was 0.6: (i) The initial change in consumer spending is $3.1 billion (= MPC × change in disposable income = 0.6 × $5.2 billion). (ii) The cumulative change in consumer spending is $7.8 billion (= multiplier × initial change in consumer spending = *1 ÷ (1 − MPC)+ × initial change in consumer spending = *1 ÷ (1 − 0.6)+ × $3.1 billion = 2.5 × $3.1 billion).

5. If the MPC were 0.8, LO3 a. how much spending would occur in the third cycle of Figure 12.6? b. how many spending cycles would occur before consumer spending increased by $200 billion?

Answer: Keep in mind that each cycle is originated by a change in spending in the product market.

Cycle 1: Government spends $100 billion in the product market.

Cycle 2: This $100 billion will flow to households, and these households would receive $100 billion in new income. Because the marginal propensity to consume is 0.8, households will spend $80 billion (= $100 billion × 0.8) and save $20 billion (= $100 billion × 0.2). As a result, households will spend $80 billion in the product market. The cumulative consumer spending after this cycle is $80 billion.

Cycle 3: This $80 billion will flow to households, and these households would receive $80 billion in new income. Because the marginal propensity to consume is 0.8, households will spend $64 billion (= $80 billion × 0.8) and save $16 billion (= $80 billion × 0.2). As a result, © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

households will spend $64 billion in the product market. The cumulative consumer spending after this cycle is $144 billion (= $80 billion + $64 billion).

Cycle 4: This $64 billion will flow to households, and these households would receive $64 billion in new income. Because the marginal propensity to consume is 0.8, households will spend $51.2 billion (= $64 billion × 0.8) and save $12.8 billion (= $64 billion × 0.2). As a result, households will spend $51.2 billion in the product market. The cumulative consumer spending after this cycle is $195.2 billion (= $80 billion + $64 billion + $51.2 billion).

Cycle 5: This $51.2 billion will flow to households, and these households would receive $51.2 billion in new income. Because the marginal propensity to consume is 0.8, households will spend $40.96 billion (= $51.2 billion × 0.8) and save $10.24 billion (= $51.2 billion × 0.2). As a result, households will spend $40.96 billion in the product market. The cumulative consumer spending after this cycle is $236.16 billion (= $80 billion + $64 billion + $51.2 billion + $40.96 billion), and so on. a. In the third cycle, $64 billion in spending would occur. b. If focusing only on changes in consumer spending, you must exclude the initial government spending from your calculations. Consumer spending will have increased by $195.2 billion after 4 cycles of spending and by $236.16 billion after 5 cycles. Therefore, 5 cycles will have to occur to reach $200 billion in increased consumer spending.

6. The multiplier process depicted in Table 12.1 is based on an MPC of 0.75. LO3 a. Recompute the first four cycles using an MPC of 0.80. b. How much more consumption occurs in the first four cycles? c. What is the value of the multiplier in this case?

Answer: See the table on the next page.

a. The change in spending during a cycle is equal to the previous cycle's spending multiplied by the marginal propensity to consume. The cumulative increase in spending is the total spending in the current cycle plus all previous cycles. For example:

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Cycle 2: Change in spending during the cycle equals $80 billion (= $100 billion × 0.80). The cumulative increase in spending equals $180 billion (= $100 billion + $80 billion).

Cycle 3: Change in spending during the cycle equals $64 billion (= $80 billion × 0.80). The cumulative increase in spending equals $244 billion (= $100 billion + $80 billion + $64 billion).

Cycle 4: Change in spending during the cycle equals $51.2 billion (= $64 billion × 0.80). The cumulative increase in spending equals $295.2 billion (= $100 billion + $80 billion + $64 billion + $51.2 billion). b. Because the MPC is higher, cumulative spending will increase. In this case, the increase in cumulative spending after four cycles is $21.76 billion ($295.2 billion − $273.44 billion). c. The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles: Multiplier = 1 ÷ (1 − MPC). (i) When the MPC = 0.75, the multiplier is 4 *= 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.75)+. (ii) When the MPC = 0.80, the multiplier is 5 *= 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.80)+.

7. Suppose the government increases education spending by $40 billion. If the marginal propensity to consume is 0.75, how much will total spending increase? LO4 Answer: The increased government spending of $40 billion will generate a $160 billion increase in spending after the multiplier effect is complete.

Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.75) = 1 ÷ 0.25 = 4.

Total change in spending = multiplier × initial change in government spending = 4 × $40 billion = $160 billion.

8. If taxes were cut by $1 trillion and the MPC was 0.75, by how much would total spending: LO3 a. increase in the first year with two spending cycles per year? b. increase over three years, with two spending cycles per year? c. increase over an infinite time period per year?

Answer: A tax cut of $1 trillion will generate a $1.31 trillion increase in spending after the first year (with two spending cycles per year), $2.47 trillion after the third year (with two spending cycles per year), and $3.00 trillion after the multiplier effects are complete. A tax cut that increases disposable income will initially increase consumer spending by the amount of the tax cut multiplied by the marginal propensity to consume (MPC). a. In the first year, the first cycle would increase spending by $0.75 trillion (= $1 trillion × 0.75). The second cycle would increase spending by $0.5625 trillion (= $0.75 trillion × 0.75).

Total spending would increase by $1.3125 trillion in the first year (= $0.75 trillion + $0.5625 trillion). b. Over three years, total spending would increase by approximately $2.47 trillion. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

First year: Cycle 1 = $0.75 trillion (= $1 trillion × 0.75) First year: Cycle 2 = $0.56 trillion (= $0.75 trillion × 0.75) Second year: Cycle 1 = $0.42 trillion (= $0.56 trillion × 0.75) Second year: Cycle 2 = $0.32 trillion (= $0.42 trillion × 0.75) Third year: Cycle 1 = $0.24 trillion (= $0.32 trillion × 0.75) Third year: Cycle 2 = $0.18 trillion (= $0.24 trillion × 0.75) c. The total (or cumulative) change in spending will equal the multiplier multiplied by the initial increase in consumption.

Recall: Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.75) = 1 ÷ 0.25 = 4.

Total change in spending = multiplier × initial increase in consumption = 4 × $0.75 trillion = $3.00 trillion.

9. The CARES Act of 2020 increased disposable income by $600 billion. If consumers spent $400 billion of those income transfers immediately, LO4 a. what was the MPC? b. how much stimulus would those income transfers ultimately provide?

Answer: a. The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.

MPC = additional consumption ÷ additional income = $400 billion ÷ $600 billion = 0.67.

b. The increased consumption spending of $400 billion will generate a $1,200 billion increase in spending after the multiplier effect is complete.

Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.67) = 1 ÷ 0.33 = 3.

Total change in spending = multiplier × initial change in government spending = 3 × $400 billion = $1,200 billion.

10. If the MPC was 0.90, and using the Citigroup estimate, LO3 a. how much did consumer spending decline initially in response to the 2013 payroll tax hike (News Wire “Fiscal Restraint”)? b. what was the ultimate decline in aggregate demand after all multiplier effects?

Answer: Recall: Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.90) = 1 ÷ 0.10 = 10.

According to the News Wire, consumers will have $110 billion less in disposable income. a. A tax hike that decreases disposable income will initially reduce consumer spending by the amount of the tax increase multiplied by the marginal propensity to consume (MPC). Initial decrease in consumption = MPC × tax hike = 0.90 × $110 billion = $99 billion.

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b. The total (or cumulative) change in spending will equal the multiplier multiplied by the initial decrease in consumption. Total change in spending = multiplier × initial decrease in consumption = 10 × $99 billion = $990 billion.

11. Assume MPC = 0.75. If an initial fiscal restraint of $100 billion is desired, by how much must: LO4 a. government spending be reduced? b. taxes be raised?

Answer: If an initial change in spending (fiscal restraint) of $100 billion is desired: a. Government spending should be reduced by $100 billion because the initial change in spending equals the government decrease in spending. b. Taxes should be increased by $133.33 billion.

Initial change in spending = MPC × tax hike $100 billion = 0.75 × tax hike $133.33 billion = tax hike 12. POLICY PERSPECTIVES Suppose the government receives $4 billion in tax revenue and spends $5 billion. a. Calculate the federal deficit or surplus. b. According to Keynes, which macro condition is this budget balance appropriate for? LO5

Answer: A budget surplus occurs when government spending is less than tax revenues. A budget deficit occurs when government spending is greater than tax revenues. a. If the government receives $4 billion in tax revenue and spends $5 billion, then the federal government has a deficit equal to $1 billion (= tax revenues – government spending = $4 billion – $5 billion = –$1 billion). b. From a Keynesian perspective, the desirability of a budget deficit or surplus depends on the health of the economy. If the economy is in a recession, an injection of government spending or a tax cut is appropriate. On the other hand, if the economy is expanding, some fiscal restraint (spending cuts, tax hikes) would be called for. Therefore, a federal deficit is appropriate for recessions and a federal surplus is appropriate for expansions.

CHAPTER 13: MONEY AND BANKS ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Detail what the features of money are.

2 POLICY PERSPECTIVES Specify what is included in the money supply.

3 Describe how a bank creates money. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

4 Explain how the money multiplier works.

5 Discuss why the money supply is important.

QUESTIONS FOR DISCUSSION 1. Do bananas satisfy the three conditions for money? Did barter make it easier or more difficult to get a haircut in Venezuela? (See the News Wire “Barter.”) LO1 Answer: Money is anything that serves as a medium of exchange, a store of value, and a standard of value. In the barter economy that developed in Venezuela, bananas served as a medium of exchange and a standard of value, but not as a store of value (they spoil and have a limited shelf life). While barter enabled the people of Venezuela to get a haircut, barter makes exchanging goods and services more difficult, since it creates a problem of making sure that both parties have the right goods available for the exchange–what each party wants. This limits market activity.

2. POLICY PERSPECTIVES Why aren’t mobile payments counted as money? LO2 Answer: Mobile payments are the latest craze in alternative means of payment for shoppers.

In order to make a mobile payment, customers must download an app, then link a credit or debit card to the account. Mobile payments are software programs that permit direct payment to the seller from a smartphone or tablet. The entire transaction occurs in the cloud.

For brick-and-mortar purchases, when it comes time to pay at the register, a customer opens the app and waves his/her phone or tablet in front of the scanner.

Mobile payments may be convenient, but they are not money. Our money supply includes currency held by the public plus balances in transactions accounts. One actually pays for mobile transactions; purchases are debited to a bank or credit account. Mobile payments are a service, not a new form of money.

3. POLICY PERSPECTIVES What percentage of your monthly spending do you pay with (a) cash, (b) check, (c) credit card, (d) debit card, or (e) automatic transfers? How does your behavior compare to others? (See the News Wire "Media of Exchange.") LO2 Answer: Each student will have a different answer based on his/her personal finances. Use the News Wire “Media of Exchange” to inform student comparisons.

4. POLICY PERSPECTIVES If a friend asked you how much money you had to spend, what items would you include in your response? LO2 Answer: Most people would include only their coins, currency, and checking accounts. Some might also include any deposits they have in their savings accounts. Others might try to include the available balance on their credit card(s), but that is incorrect because credit cards are not money. © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

5. Does money have any intrinsic value? If not, why are people willing to accept money in exchange for goods and services? LO1 Answer: Some money, coins for example, have intrinsic value, but it is less than the exchange value. What is important is the role of money as an acceptable medium of exchange, i.e., it has value because market participants are willing to accept it or because the government says that it must be accepted.

6. Have you ever borrowed money to buy a car, to pay tuition, or for any other purpose? In what form did you receive the money? How did your loan affect the money supply?

Aggregate demand? LO3 Answer: When loans are received, they are generally made as deposits to a transactions account. This transaction results in an increase in the money supply. These loans result in aggregate demand increasing because consumption would have been less if the loan were not available.

7. Does the fact that your bank keeps only a fraction of your account balance in reserve worry you? Why don't people rush off to the bank and retrieve their money? What would happen if they did? LO3 Answer: Here, the answer should center on the issues of confidence in money and the fact that there are not conveniently usable alternative kinds of money available. Due to problems in the past, we now have mechanisms to deal with a run on the banks. Bank deposits are insured, and banks could get funds from other banks or the Federal Reserve if needed. The fact that these mechanisms are in place provides assurance to depositors that they will have access to their funds.

8. If all banks heeded Shakespeare's admonition "Neither a borrower nor a lender be," what would happen to the supply of money? LO3 Answer: Banks act as intermediaries between lenders and borrowers. If banks did not serve this function, there would be a significant decrease in the nation’s money supply. If banks were not able to make loans that are deposited in checking accounts, then the largest source of money creation would no longer exist.

9. Why would a bank ever hold excess reserves rather than make new loans? LO3 Answer: At times banks conclude that making loans is too risky due to economic conditions such as high unemployment or uncertain economic conditions. They would rather take a “wait and see” approach to making loans so that they will feel more confident when they eventually do make loans.

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10. If banks stopped making new loans, how would aggregate demand be affected? LO5 Answer: Aggregate demand would decrease since loans finance aggregate demand. Much investment and consumption would fall if firms and consumers could not borrow money.

11. If people want more anonymity in their market transactions, why don’t they simply use cash instead of bitcoins? LO1 Answer: While cash and bitcoins both offer anonymity for market transactions, bitcoins provide people with the ability to conduct those transactions electronically. As a medium of exchange, bitcoins, like transactions account balances, function as a substitute for cash in a convenient form.

PROBLEMS 1. What percent of the money supply depicted in Figure 13.1 is cash? LO2 Answer: The percentage of the basic money supply (M1) that is held in cash is equal to 11 percent. Percentage held in cash = (currency in circulation ÷ total money supply) × 100 = ($1,996 billion ÷ $18,105 billion) × 100 = 0.11 × 100 = 11%.

2. If a bank has $100 million in deposits and $18 million in reserves with a reserve requirement of 0.15, LO3 a. how much are its required reserves? b. how much excess reserves does it have? c. how much can it lend?

Answer: a. Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; required reserves are equal to the required reserve ratio times total transactions deposits.

Required reserves = required reserve ratio × total deposits Required reserves = 0.15 × $100 million Required reserves = $15 million. b. Excess reserves are bank reserves in excess of required reserves.

Excess reserves = total reserves − required reserves Excess reserves = $18 million − $15 million Excess reserves = $3 million. c. A bank can make loans equal to its excess reserves. In this example, excess reserves are $3 million, so the bank can lend $3 million.

3. If a bank has $10 million in deposits, excess reserves of $300,000, and required reserves of $500,000, LO3 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

a. what are its total reserves? b. what is the required reserve ratio?

Answer: a. Excess reserves = total reserves − required reserves Rearranged, Total reserves = required reserves + excess reserves Total reserves = $500,000 + $300,000 = $800,000 or $0.8 million. b. Required reserves = required reserve ratio × total deposits Rearranged, Required reserve ratio = required reserves ÷ total deposits Required reserve ratio = $500,000 ÷ $10 million = 5%.

4. How large is the money multiplier when the required reserve ratio is 0.25? If the required reserve ratio decreases to 0.20, what happens to the money multiplier? LO4 Answer: The money multiplier is the number of additional deposit dollars—or loan dollars— that the banking system can create from $1 of excess reserves. a. Money multiplier = 1 ÷ required reserve ratio Money multiplier = 1 ÷ 0.25 Money multiplier = 4.00. b. Money multiplier = 1 ÷ required reserve ratio Money multiplier = 1 ÷ 0.20 Money multiplier = 5.00.

5. If a bank has total reserves of $200,000 and $1 million in deposits, how much money can it lend if the required reserve ratio is: LO3 a. 4 percent? b. 6 percent?

Answer: Required reserves are the minimum amount of reserves a bank is required to hold by government regulation; required reserves are equal to the required reserve ratio times total transactions deposits. Required reserves = required reserve ratio × total deposits.

Excess reserves are bank reserves in excess of required reserves. A bank can make loans equal to its excess reserves. Excess reserves = total reserves − (required reserve ratio × total deposits). a. A bank can make loans equal to its excess reserves.

Excess reserves = $200,000 − (0.04 × $1 million) = $200,000 − $40,000 = $160,000. b. A bank can make loans equal to its excess reserves.

Excess reserves = $200,000 − (0.06 × $1 million) = $200,000 − $60,000 = $140,000.

6. How large a loan can Bank #2 in Figure 13.2 make? LO3

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Answer: Each bank is able to loan an amount up to its excess reserves. Bank #2 can lend $6.25.

7. What volume of loans can the banking system in Figure 13.2 support? If the reserve requirement were 50 percent rather than 75 percent, what would the system’s lending capacity be? LO3, LO4

Answer: The money multiplier process is illustrated in the figure. When a new deposit enters the banking system, it creates both excess and required reserves. Excess reserves are bank reserves in excess of required reserves. A bank can make loans equal to its excess reserves.

Remember that the money multiplier is the number of additional deposit dollars—or loan dollars—that the banking system can create from $1 of excess reserves: Money multiplier = 1 ÷ required reserve ratio. The potential deposit creation is equal to the excess reserves from the new deposit multiplied by the money multiplier. a. In this example, the required reserve ratio is 0.75, so University Bank is required to hold $75 of the $100 deposit as required reserves. This means the bank is able to lend its excess reserves equal to $25.

Potential deposit creation = excess reserves at University Bank × money multiplier Potential deposit creation = $25 × (1 ÷ 0.75) = $25 × 1.33 = $33.25. b. In this example, the required reserve ratio is 0.50, so University Bank is required to hold $50 of the $100 deposit as required reserves. This means the bank is able to lend its excess reserves equal to $50.

Potential deposit creation = excess reserves at University Bank × money multiplier Potential deposit creation = $50 × (1 ÷ 0.50) = $50 × 2 = $100.00.

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8. Suppose that a lottery winner deposits $5 million in cash into her transactions account at the Bank of America. Assume a reserve requirement of 20 percent and no excess reserves in the banking system prior to this deposit. Show the changes on the Bank of America balance sheet when the $5 million is initially deposited. LO3 BANK OF AMERICA Assets Change in required reserves Change in excess reserves Change in total reserves

$__ million

Change in deposits

Liabilities $__ million

$__ million $__ million

Answer: Assets Change in required reserves Change in excess reserves Change in total reserves

$1.0 million

Change in deposits

Liabilities $ 5.0 million

$4.0 million $5.0 million

The bank's liabilities and assets increase by $5 million because of the new deposit. The bank's liabilities are the increased demand deposits equaling $5 million. The bank's assets are the increased reserves equaling $5 million.

Due to this new deposit, the bank is required to increase its required reserves by $1 million (= required reserve ratio × deposit = 0.20 × $5 million). The bank's excess reserves have increased by $4 million (= total reserves − required reserves = $5 million − $1 million). The bank could make loans with these excess reserves.

9. In December 1994, a man in Ohio decided to deposit all of the 8 million pennies he had been saving for nearly 65 years. (His deposit weighed over 48,000 pounds!) With a reserve requirement of 10 percent, how did his deposit change the lending capacity of: LO3, LO4 a. his bank b. the banking system?

Answer: a. The man deposited 8 million pennies, which is equal to $80,000. Since the reserve requirement is 10 percent, the bank will hold $8,000 in required reserves (= required reserve ratio × new deposits = 0.10 × $80,000). Thus, the bank's excess reserves will increase by

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$72,000 (= total reserves − required reserves = $80,000 − $8,000). A bank can make loans equal to its excess reserves, so the bank's lending capacity will increase by $72,000. b. The potential deposit creation (= lending capacity) for the banking system is equal to the excess reserves from the new deposit multiplied by the money multiplier.

Potential deposit creation = excess reserves × money multiplier Potential deposit creation = $72,000 × (1 ÷ 0.10) = $72,000 × 10 = $720,000.

10. POLICY PERSPECTIVES If the value of bitcoins increases from $50,000 to $60,000 this year, by how much will M1 increase? LO2 Answer: The money supply (M1) includes all cash held by the public plus balances people hold in transactions accounts (e.g., checking accounts, credit union share draft accounts, savings deposits). Bitcoins are not a new form of money; thus, their changing value does not cause M1 to change.

CHAPTER 14: MONETARY POLICY ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Describe how the Federal Reserve is organized.

2 Identify the Fed’s three primary policy tools.

3 Explain how open market operations work.

4 Tell how monetary stimulus or restraint is achieved.

5 POLICY PERSPECTIVES Discuss how monetary policy affects macro outcomes.

QUESTIONS FOR DISCUSSION 1. Why do banks want to maintain as little excess reserves as possible? Under what circumstances might banks desire to hold excess reserves? (Hint: See Figure 14.3.) LO4 Answer: Excess reserves represent unused lending power. The opportunity cost of excess reserves can be high. Banks are in the business of making profits. They need to put their reserves to work by loaning them out and earning interest. In some cases, banks may be hesitant to make loans and therefore might want to hold excess reserves if they expect a relatively high withdrawal rate from the bank.

2. Why do people hold bonds rather than larger savings account or checking account balances?

Under what circumstances might they change their portfolios, moving their funds out of bonds and into bank accounts? LO3

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Answer: Bonds have the advantage of offering possible capital appreciation as well as interest payments. Neither savings nor checking accounts do that. A significant depreciation in the selling price of bonds—occasioned by an increase in interest rates—might cause bondholders to sell them and move their funds into bank accounts.

3. If the Federal Reserve banks mailed everyone a brand-new $100 bill, what would happen to prices, output, and income? Illustrate with aggregate demand and supply curves. LO5 Answer: The initial impact would be to increase aggregate demand. This could increase prices or output or both, depending on the shape of the aggregate supply curve. The possibilities are illustrated in Figure 14.7. This increase in aggregate demand will eventually, in the long run, cease.

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4. If economic growth accelerates this year, what should the Fed do? LO4 Answer: The Federal Reserve is concerned with both unemployment and inflation targeting.

Typically, when economic growth accelerates, unemployment falls and inflation increases. If inflation is increasing too rapidly, the Fed should conduct restrictive policy to keep inflation in check.

5. How does an increase in the money supply get into the hands of consumers? What do they do with it? LO4 Answer: An increase in the money supply gets into the hands of consumers via the banking system. As the money supply increases, banks increase their holdings of money—reserves— and therefore, their capacity to lend to consumers, who then are able to borrow and spend.

6. Is a reduction in interest rates likely to affect spending on pizza? What kinds of spending are sensitive to interest rate fluctuations? LO5 Answer: Since consumers usually pay cash for pizza, a change in interest rates would not directly affect spending on pizza. For the most part, interest rate changes only directly affect spending on items that are purchased with borrowed money such as houses, cars, etc.

A reduction in interest rates isn’t likely to have an impact on spending on pizza or similar goods, but it will likely have an impact on spending for which people borrow money. Spending on items like houses and cars will be impacted by this because when the Fed reduces interest rates, it provides banks with an incentive to lend and therefore encourages consumers to take out loans and to spend these funds out in the economy.

7. Which aggregate supply curve in Figure 14.7 does the Fed chair fear the most? Why? LO5

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Answer: The AS curve in Figure 14.7 (b) is the curve that causes the Fed chair concern since the AS curve is vertical. The quantity of goods in this case depends on structural factors such as production capacity and labor market efficiency. In this situation, there is no incentive for producers to change their rate of output when the money supply changes, and any monetary policy by the Fed only has an impact on the price level—it does not shift AD. This renders the Fed’s policy ineffective for intervening in the case of a recession.

8. If the Fed successfully shifted the AD curve to the right and the price level didn’t go up, which AS curve in Figure 14.7 was prevailing? LO5 Answer: In this situation, the horizontal AS curve prevailed as in the simple Keynesian model, since inflation would not occur. In this model, AD is shifting along the horizontal portion of the AS curve and output is expanding toward capacity without inflation. In this situation, inflation is a concern only if AD increases beyond capacity. See Figure 14.7 (a).

9. POLICY PERSPECTIVES Like all human institutions, the Fed makes occasional errors in altering the money supply. Would a constant (fixed) rate of money supply growth eliminate errors?

LO5 Answer: Although some policy analysts call for a constant rate of growth of the money supply, this will not eliminate errors according to the Keynesian perspective. We know that the economy is going to have its ups and downs as it moves through the business cycle. When the economy needs to be stimulated, then the growth rate of the money supply should be increased; when it needs to be slowed down, the growth rate of the money supply should be decreased. Having a constant rate of money supply growth, in no way, guarantees that it will be the right rate all of the time.

Critics of discretionary monetary policy argue that having a fixed rate of money supply growth would be less prone to error, since discretionary policy involves determining the slope of the AS curve. Making the wrong prediction that the AS curve is less vertical than it is in a situation of expansionary monetary policy would lead to the Fed’s policy creating inflation.

However, a fixed rate of money supply growth would not eliminate errors, since keeping a particular fixed rate would limit the Fed’s ability to respond to the economy. Situations in which the chosen fixed rate would not be an appropriate policy response would also be a source of error.

10. POLICY PERSPECTIVES The Fed cut the discount rate multiple times in 2020 (see the News Wire “Discount Rates”), but the economy still fell into a recession. Why didn’t the reduced interest rates end the recession? LO5

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Answer: The Fed attempted to keep interest rates low and to encourage banks to borrow from it, hoping to encourage lending and a multiplier effect in consumer spending. Even though there was money to be borrowed, consumers slowed their spending because the coronavirus pandemic limited their spending opportunities (e.g., limited travel and vacations, going to eat at restaurants). Businesses also slowed borrowing because they paused expansion plans and purchasing because of the pandemic.

PROBLEMS 1. Suppose the following data apply: LO2 Total reserves: Transactions deposits: Cash held by public: Bonds held by public: Stocks held by public: Gross domestic product: Interest rate: Required reserve ratio:

$55 billion $500 billion $400 billion $400 billion $140 billion $8 trillion 6 percent 0.10

a. How large is the money supply (M1)? b. How much excess reserves are there? c. What is the money multiplier? d. What is the available lending capacity of the banking system?

Answer: a. The money supply (M1) includes cash, transactions account balances, and traveler's checks. Given the information in the table, M1 is equal to $900 billion (= $500 billion in transactions deposits + $400 billion in cash). b. If the required reserve ratio is 0.10, then banks are required to keep $50 billion in reserves (= transactions deposits × required reserve ratio = $500 billion × 0.10). Since banks have total reserves of $55 billion, there is $5 billion in excess reserves (excess reserves = total reserves − required reserves = $55 billion − $50 billion). c. The money multiplier is calculated as 1 ÷ required reserve ratio. Thus, the money multiplier is 10 (= 1 ÷ 0.10 = 10). d. The lending capacity is equal to the excess reserves multiplied by the money multiplier (= excess reserves × money multiplier). Since there are $5 billion in excess reserves and the money multiplier is 10, there is $50 billion in available lending capacity (= $5 billion × 10).

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2. Assume that the following data describe the condition of the commercial banking system: LO2 Total reserves: Transactions deposits: Cash held by public: Required reserve ratio:

$200 billion $900 billion $300 billion 0.20

a. How large is the money supply (M1)? b. How large are excess reserves?

Now assume that the public transfers $20 billion in cash into transactions accounts. c. What would happen to the money supply initially (before any lending takes place)? d. How much would the total lending capacity of the banking system be after this portfolio switch? e. How large would the money supply be if the banks fully utilized their lending capacity? f. What three steps could the Fed take to offset this potential growth in M1?

Answer: a. The money supply (M1) includes cash, transactions account balances, and traveler's checks. Given the information in the table, M1 is equal to $1,200 billion (= $900 billion in transactions deposits + $300 billion in cash). b. If the required reserve ratio is 0.20, then banks are required to keep $180 billion in reserves (= transactions deposits × required reserve ratio = $900 billion × 0.20). Since banks have total reserves of $200 billion, there is $20 billion in excess reserves (excess reserves = total reserves − required reserves = $200 billion − $180 billion). c. The money supply (M1) includes cash, transactions account balances, and savings deposits.

There will be no change in M1 if a portion of the cash currently in existence is deposited into transactions accounts. Transactions deposits are now $920 billion, and cash is $280 billion. d. After the additional deposit of $20 billion in cash, transactions deposits are now $920 billion (= $900 billion + $20 billion) and total reserves are $220 billion (= $200 billion + $20 billion). Required reserves have increased to $184 billion (= transactions deposits × required reserve ratio = $920 billion × 0.20). The banking system has excess reserves of $36 billion (= $220 billion − $184 billion). The lending capacity is equal to the excess reserves multiplied by the money multiplier (= excess reserves × money multiplier). Recall that the money multiplier is calculated as 1 ÷ required reserve ratio = 1 ÷ 0.20 = 5. The lending capacity of the banking system is now $180 billion (= excess reserves × money multiplier = $36 billion × 5). e. Assuming the lending capacity of $180 billion is fully used, the money supply will rise to $1,380 billion (= $920 billion in transactions deposits + $280 billion in cash + $180 billion in new money created through the lending process).

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f. The Fed can reduce the money supply by (1) raising reserve requirements, (2) increasing the discount rate, or (3) selling bonds in the open market. All of these actions will reduce bank lending capacity and therefore M1.

3. Suppose the Federal Reserve decided to purchase $50 billion worth of government securities in the open market. LO3 a. By how much will M1 change initially if the entire $50 billion is deposited into transactions accounts? b. How will the lending capacity of the banking system be affected if the reserve requirement is 10 percent? c. How will banks induce investors to utilize this expanded lending capacity?

Answer: a. The money supply (M1) includes cash, transactions account balances, and savings deposits. If the Federal Reserve buys $50 billion in securities, M1 will increase by $50 billion because this entire amount will be deposited into transactions accounts. b. If the required reserve ratio is 0.10, then banks are required to keep $5 billion of these new deposits in reserves (change in required reserves = change in total reserves × required reserve ratio = $50 billion × 0.10). Banks can lend out the remaining $45 billion (change in excess reserves = change in total reserves − change in required reserves = $50 billion − $5 billion).

The lending capacity is equal to the change in excess reserves multiplied by the money multiplier. Recall that the money multiplier is calculated as 1 ÷ required reserve ratio = 1 ÷ 0.10 = 10. The lending capacity of the banking system is now changed by $450 billion (= change in excess reserves × money multiplier = $45 billion × 10). c. If the Fed buys securities, it will increase bank lending capacity. The banks in turn will try to use that expanded capacity and make more loans. By offering lower interest rates or easier approvals, the banks can encourage people to borrow and spend more money.

4. Suppose the economy is initially in equilibrium at an output level of 100 and a price level of 100. The Fed then manages to shift aggregate demand rightward by 20. LO4 a. Illustrate the initial equilibrium (E1) and the shift of AD. b. Show what happens to output and prices if the aggregate supply curve is (i) horizontal, (ii) vertical, and (iii) upward sloping.

Answer: a. The aggregate demand (AD) curve will increase (shift to the right).

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b. Given the shift in aggregate demand, (i) the horizontal AS curve results in the largest increase in output; (ii) the vertical AS curve results in the largest increase in the price level; and (iii) the upward-sloping AS curve results in both an increase in output and the price level.

5. According to the News Wire “Reserve Requirements,” what was the money multiplier in China: LO2 a. before the change in reserve requirements? b. after the change in reserve requirements?

Answer: The money multiplier is calculated as 1 ÷ required reserve ratio. a. Before the change in reserve requirements, the reserve requirement was 12.5 percent, or 0.125, so the money multiplier was 8.0 (= 1 ÷ 0.125 = 8.0). b. After the change in reserve requirements, the reserve requirement was 11.5 percent, or 0.115, so the money multiplier was 8.7 (= 1 ÷ 0.115 = 8.7).

6. According to the News Wire “Reserve Requirements,” LO2 a. by how much did excess reserves in China increase? b. by how much did the lending capacity of Chinese banks increase as a result?

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Answer: a. According to the News Wire, due to the decrease in the reserve requirement, an additional $79 billion was available as excess reserves. b. The lending capacity is equal to the change in excess reserves multiplied by the money multiplier (= excess reserves × money multiplier).

Recall that the money multiplier is calculated as 1 ÷ required reserve ratio = 1 ÷ 0.115 = 8.7.

The lending capacity of the banking system is now changed by $687.3 billion (= change in excess reserves × money multiplier = $79 billion × 8.7).

7. If every one-point change in the federal funds rate alters aggregate demand by $200 billion, how far did AD shift in response to the News Wire “Discount Rates?” LO5

Answer: A lower interest rate increases aggregate demand (AD) by making it "easier" to obtain loans so that consumers buy more things using loans and businesses increase their investments.

In the News Wire, the Fed decreased the interest rate by 2.50 percentage points (from 2.75 percent to 0.25 percent). This means that AD would be stimulated and would shift to the right by $500 billion (= percentage point cut × impact of a 1 percent cut in AD = 2.50 percentage point cut × $200 billion per percentage point cut = $500 billion).

8. POLICY PERSPECTIVES From June 2008 to June 2009, M1 increased from $1,400 billion to $1,656 billion. LO5 a. By what percentage did M1 increase? b. If the Fed had used a fixed rule of 3 percent growth of M1, how large would M1 have been in 2009?

Answer: a. You can find the percentage change by using *(new value − old value) ÷ old value+ × 100 = *($1,656 billion − $1,400 billion) ÷ $1,400 billion+ × 100 = ($256 ÷ $1,400) × 100 = 0.182857 × 100 = 18.3 percent. b. If the money supply was allowed to grow by only 3 percent each year, then M1 could have only grown by $42 billion between 2008 and 2009 (= $1,400 billion × 3 percent = $1,400 billion × 0.03 = $42 billion). This means that if the Fed followed this 3 percent growth rule, the money supply in 2009 would be equal to $1,442 billion (= $1,400 billion + $42 billion).

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9. POLICY PERSPECTIVES If the price level increases by 0.2 percent for every $100 billion increase in the money supply, by how much might prices rise if the Fed increases total reserves by $40 billion and the reserve requirement is 0.05? LO5

Answer: If the required reserve ratio is 0.05, then banks are required to keep $2 billion in reserves (= change in reserves × required reserve ratio = $40 billion × 0.05). Since banks now have additional reserves of $40 billion, there is $38 billion in excess reserves (excess reserves = total reserves − required reserves = $40 billion − $2 billion). The money multiplier is calculated as 1 ÷ required reserve ratio. Thus, the money multiplier is 1 ÷ 0.05 = 20.

The lending capacity (or the potential increase in the money supply) is equal to the excess reserves multiplied by the money multiplier (= excess reserves × money multiplier). Since there are $38 billion in excess reserves and the money multiplier is 20, there is $760 billion in available lending capacity (= $38 billion × 20).

Therefore, the total potential impact on the price level is 1.52 percent [= ($760 billion ÷ $100 billion) × 0.2 percent = 7.6 × 0.002].

CHAPTER 15: ECONOMIC GROWTH ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Specify how economic growth is measured.

2 Describe what GDP per capita and GDP per worker measure.

3 Discuss how productivity increases growth.

4 Explain how government policy affects growth.

5 POLICY PERSPECTIVES Discuss why economic growth is desirable.

QUESTIONS FOR DISCUSSION 1. In what specific ways (if any) does a college education increase a worker's productivity? LO3 Answer: Specific ways depend on the type of job and the student’s major. For example, if you study math and have a job that utilizes math skills, then the education increased your productivity.

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A more general answer is that a college education helps people think better. Much of what is learned in college is how to examine available information and make a decision based on that information. For example, in economics students learn about marginal costs and marginal benefits and how this information can be used to make better decisions.

2. What’s wrong with a negative saving rate, as Portugal had in 2019 (see the News Wire “Saving Rates”)? LO3 Answer: Negative saving means there’s less capital available for investment since income is being used for consumption. This usually results in lower productivity and living standards.

3. Notice in the News Wire “Improved Living Standards” how the time spent working on the job and at home has declined. How are these changes indicative of economic growth? LO5 Answer: Time spent on the job has fallen from 37.1 hours to 34.5 hours while working at home hours declined from 3.9 hours to 3.5 hours. During this same period output increased, consumption increased, and household net worth doubled, indicating significant economic growth. So, we are getting more for less due to increases in productivity.

4. How would the following factors affect a nation’s growth potential? LO4 a. Legal protection of private property. b. High tax rates. c. Judicial corruption. d. Government price controls. e. Free trade.

Answer: a. Legal protection of private property through the establishment of well-defined property rights allows all benefits of ownership to accrue to the owner and all costs associated with ownership to be paid by the owner. As a result, businesses are willing to invest in factories and technology, and consumers are willing to purchase cars and houses, with each knowing their ownership is protected. If this legal protection did not exist, businesses would not build new factories, invest in new technology, or develop new products, fearing their investments would not return a profit as others steal their investments. When this investment stops, economic growth not only stops, but contracts, as is evident in the Russian economy during the 1990s. b. High tax rates reduce the profit potential to work or invest. As a result, only those work or investment projects that are profitable enough to pay the high taxes occur and, as a result, economic growth is slowed. c. When judicial corruption exists, all the issues associated with the lack of legal protection discussed in the answer to part (a) occur. Businesses fear their investments might be stolen. If the judicial system is corrupt, there exists no viable legal recourse and, as a result, the total quantity of investment is reduced and economic growth declines.

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d. Government price controls are generally established to prevent the price levels from rising to the market equilibrium level. This lower price decreases the profits earned in this market and, as a result, less investment occurs and economic growth declines. Government price controls can also establish price floors such as the minimum wage, which some economists believe results in higher unemployment rates, which negatively affect the nation’s economy. e. Free trade allows resources to migrate, over time, to the area of greatest returns (profits).

A nation without free trade has a tendency to use its resources inefficiently when compared to a nation with free trade. Although there is generally a painful adjustment period to free trade, free trade generally results in a nation’s resources being used more efficiently, and this results in increased economic growth.

5. Why do some nations grow so slowly and others so much faster? LO4 Answer: Economic growth rates vary across countries due to variations in productivity. These variations stem from the skills of the labor force, capital investment, improvements in management and the production process, and technological advancement. All of these push production possibilities outward. Additionally, varying government policies related to education, training, immigration, regulation, and incentives for savings and investment play a role in explaining the variation in growth rates among nations.

6. What role do immigrants play in economic growth? In what ways might immigrants accelerate or slow economic growth? LO4 Answer: Immigrants increase a country’s population and bring a different mix of skills and backgrounds into the economy. The additional population from immigration provides both a change in the mix of the labor market and additional consumers who participate in markets.

Increased population from immigration creates the challenge of dividing up the output of GDP and the challenge of using scarce resources, but increases the size of the labor force, leading to an increase in production possibilities. However, the skill level of immigrants can create an economic challenge in the labor market due to differences in educational attainment.

7. How does easier bank lending contribute to economic growth? Are there any risks for growth with easier bank lending? LO4 Answer: Easier bank lending allows businesses to be able to borrow money to fund purchases of capital equipment as well as investment. It also enables consumers to borrow to make purchases such as houses and cars. With easier bank lending, the cost of borrowing decreases and incentives increase for spending that can increase aggregate demand.

8. Would a higher minimum wage accelerate or slow economic growth? LO4

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Answer: While a higher minimum wage does increase the ability of consumers who receive a higher wage to spend and therefore would increase consumer spending (increasing growth via aggregate demand), some economists believe that a higher minimum wage will result in higher unemployment rates since the minimum wage functions as a price floor for the price of labor. Higher rates of unemployment will have a negative effect on the economy. While more people are willing to participate in the labor force (supply of labor) at a higher minimum wage, employers will see the higher minimum wage rates as a cost to their business. They will be willing and able to supply fewer jobs and will have a lower quantity demanded of workers.

This, in turn, will mean fewer people will be employed and will have the ability to spend, which has a negative effect on AD. 9. POLICY PERSPECTIVES Suppose that economic growth could be achieved only by increasing inequality (e.g., via tax incentives for investment). Would economic growth still be desirable?

LO5 Answer: The desirability of such economic growth is open to considerable debate. One position is that the growth resulting from the increased inequality of income distribution would be insufficient to offset the impact of the increased inequality. In other words, although total output might increase, the net effect might be that the rich get richer and the poor get poorer. Another position is that the increased growth would more than offset the initial negative impact of increased inequality. Everyone would benefit, although some would benefit more than others. Whether this outcome is desirable depends on your social views of income inequality.

10. POLICY PERSPECTIVES Is limitless growth really possible? What forces do you think will be most important in slowing or halting economic growth? LO5 Answer: What is most important to consider for this question is whether unlimited growth is possible in a given time period. Although new technologies, production techniques, and population growth will continue to allow for economic growth, there are limits at any point in time to how much growth an economy can experience. If we ever do fall behind in developing new technology and in devising new production techniques, then there is a possibility that the rate of growth will be slowed or even reduced to zero.

PROBLEMS 1. a. Between 1500 and 1820, which areas of the world experienced zero economic growth in per capita GDP (Figure 15.4)? LO1 b. Between 1820 and 1995, which area of the world experienced the fastest growth in per capita GDP? c. Between 1820 and 1995, which area of the world experienced the slowest growth in per capita GDP?

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Answer: a. According to the table, Africa and China experienced zero per capita GDP growth because the per capita GDP remained constant between 1500 and 1820 (= $400 for Africa and $600 for China). b. Japan experienced the fastest growth between 1820 and 1995 *= ($19,720 − $675) ÷ $675 × 100 = 2,821 percent]. c. Africa experienced the slowest growth between 1820 and 1995 *= ($1,221 − $400) ÷ $400 × 100 = 205 percent].

2. According to the rule of 72 (Table 15.1), how many years will it take for GDP to double if GDP growth is: LO1 a. 4 percent? b. 2 percent? c. 1 percent?

Answer: Small differences in annual growth rates cumulate into large differences in GDP. Shown here are the number of years it would take to double GDP at various growth rates.

Doubling times can be approximated by the rule of 72. Seventy-two divided by the growth rate equals the number of years it takes to double. a. Using the rule of 72, it will take 18.0 years (= 72 ÷ 4). b. Using the rule of 72, it will take 36.0 years (= 72 ÷ 2). c. Using the rule of 72, it will take 72.0 years (= 72 ÷ 1).

3. China’s output grew at a rate of 2.3 percent in 2020. LO2 a. At that rate, how long would it take for China’s GDP to double? (See Table 15.1.) b. With its population increasing at 0.4 percent per year, how long will it take for per capita GDP to double?

Growth Rate (Percent) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

Doubling Time (Years) Never 144 72 48 36 29 24 21 18 16 14

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Answer: Small differences in annual growth rates cumulate into large differences in GDP. Shown here are the number of years it would take to double GDP at various growth rates.

Doubling times can be approximated by the rule of 72. Seventy-two divided by the growth rate equals the number of years it takes to double. a. Using the rule of 72, it will take 31.3 years (= 72 ÷ 2.3). b. The growth rate in per capita GDP is equal to the growth rate in GDP minus the growth rate in population. For China, in 2020, the per capita growth rate was 1.9 percent (= 2.3 percent GDP growth − 0.4 percent population growth). Using the rule of 72, it would take 37.9 years for China’s GDP per capita to double (= 72 ÷ 1.9).

4. In 2020, only 57 percent of the adult population (260 million) was employed. If the employment rate increased to a typical nonrecession level of 61 percent, LO2 a. how many more people would be working? b. by how much would output increase if GDP per worker was $100,000?

Answer: a. In 2020, 57 percent of the adult population is equal to 148.2 million people working (= 260 million × 57 percent = 260 million × 0.57). If employment increased to 61 percent, 158.6 million people would be working (= 260 million × 61 percent = 260 million × 0.61). This means that if the employment rate increased from 57 percent to 61 percent, 10.4 million more people would be working (= 158.6 million − 148.2 million). b. If each worker contributed $100,000 to GDP on average, these additional 10.4 million workers would add $1,040 billion to GDP (= 10.4 million workers × $100,000 = $1,040,000 million = $1,040 billion).

5. According to the data in Figure 15.4, by what percentage did world GDP per capita grow from: LO1 a. 1000 to 1500? b. 1500 to 1820? c. 1820 to 1995?

Answer: Percentage growth rate in GDP = *(new GDP − old GDP) ÷ old GDP+ × 100 a. ($545 − $420) ÷ $420 = ($125 ÷ $420) × 100 = 29.8%. b. ($675 − $545) ÷ $545 = ($130 ÷ $545) × 100 = 23.9%. c. ($5,188 − $675) ÷ $675 = ($4,513 ÷ $675) × 100 = 668.6%.

6. According to Figure 15.4, by what percentage did GDP per capita increase between 1820 and 1995 in: LO5 a. North America? b. Latin America? © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

c. Africa?

Answer: Percentage growth rate in GDP = *(new GDP − old GDP) ÷ old GDP+ × 100 a. ($22,933 − $1,233) ÷ $1,233 = ($21,700 ÷ $1,233) × 100 = 1,759.9%. b. ($5,031 − $671) ÷ $671 = ($4,360 ÷ $671) × 100 = 649.8%. c. ($1,221 − $400) ÷ $400 = ($821 ÷ $400) × 100 = 205.3%.

7. a. According to the News Wire “Saving Rates,” if a Swiss and an American both had $10,000, how many more dollars would the Swiss save in 2019? LO5 b. Why are higher saving rates desirable?

Answer: a. If a Swiss and an American both had $10,000, the Swiss would save $1,620 (= $10,000 × 16.2 percent = $10,000 × 0.162) and the American would save $780 (= $10,000 × 7.8 percent = $10,000 × 0.078). The Swiss would save $840 more than the American (= $1,620 − $780). b. Savings are a primary source of investment financing. Higher saving rates imply proportionately less consumption and more investment and growth, leading to higher productivity levels and a higher standard of living in the future.

8. Suppose that every additional 3 percentage points in the investment rate (I ÷ GDP) boosts GDP growth by 1 percentage point. Assume also that all investment must be financed with consumer saving. The economy is now characterized by Consumption: Saving (= Investment): GDP:

$12 trillion $1 trillion $13 trillion

If the goal is to raise the growth rate by 2 percentage points, LO3 a. by how much must investment increase? b. by how much must consumption decline?

Answer: a. Each 3 percent increase in the investment (= saving) rate causes a 1 percent increase in GDP growth. If the goal is to increase GDP growth by 2 percent, then the investment rate has to increase by 6 percent. The investment rate is currently 7.69 percent (= investment ÷ GDP = $1 trillion ÷ $13 trillion), so the investment rate must rise by 6 percentage points to 13.69 percent (= 7.69 percent + 6 percent).

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To achieve this with current GDP, investment must increase to $1.78 trillion (= $13 trillion × 13.69 percent = $1.78 trillion), which requires $780 billion more investment (= desired level of investment − current level of investment = $1.78 trillion − $1 trillion). b. Investment comes from saving and saving comes from decreased consumption.

Consumption must decline by the same $780 billion to provide for the increase in investment financed by saving.

9. POLICY PERSPECTIVES The World Bank projects that the world's population will increase from 7.8 billion in 2020 to 8.6 billion in 2035. World output in 2020 was roughly $88 trillion.

LO5 a. What was the global income per capita in 2020? b. What will per capita income be in 2035 if the world's economy doesn't grow? c. By what percentage must the world economy grow by 2035 to maintain current living standards?

Answer: a. Per capita income is equal to world GDP divided by world population. It is equal to $11,282 in 2020 (= $88 trillion ÷ 7.8 billion = $88,000 billion ÷ 7.8 billion). b. Per capita income is equal to GDP divided by the population. It would be equal to $10,233 if the population grows to 8.6 billion with no increase in world GDP (= $88 trillion ÷ 8.6 billion = $88,000 billion ÷ 8.6 billion). c. The world's population is projected to grow by 10.26 percent *= (new population − old population) ÷ old population × 100 = (8.6 billion − 7.8 billion) ÷ 7.8 billion × 100 = 0.8 billion ÷ 7.8 billion × 100]. This means that to maintain current living standards, or GDP per capita, world GDP must also grow by 10.26 percent.

CHAPTER 16: INTERNATIONAL TRADE ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 Describe U.S. trade patterns.

2 Explain how trade increases total output.

3 Tell how the terms of trade are established.

4 Discuss how trade barriers affect market outcomes.

5 Describe how currency exchange rates affect trade flows.

6 POLICY PERSPECTIVES Explain why trade rules are needed.

QUESTIONS FOR DISCUSSION © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

1. Suppose a lawyer can type faster than any administrative assistant. Should the lawyer do her own typing? LO2 Answer: No, the lawyer should not do her own typing because the administrative assistant has a comparative advantage in typing, i.e., the administrative assistant’s opportunity cost of typing is lower than that of the lawyer. Students can use an example, such as the one in Table 16.3 after appropriate modifications, to demonstrate this.

2. Can you identify three services Americans import? How about three exported services? LO1 Answer: Imports: Travel, insurance, entertainment (among many others).

Exports: Travel, passenger fares, royalties and license fees (among others).

3. If a nation exported much of its output but imported little, would it be better or worse off?

How about the reverse–that is, exporting little but importing a lot? LO1 Answer: Given that AD = C + I + G + (X – M), the larger X is and the smaller M is, the larger AD will be. The larger AD is, the higher the level of employment. If full employment is the goal, then the economy is better off with large exports and small imports. The opposite is true for the reverse situation.

4. Are “Buy American” provisions good for (a) U.S. consumers, (b) U.S. producers? LO4 Answer: a. Probably not since consumer choices are restricted and thus domestic producers can charge higher prices than imports. b. Yes, since consumers are required to buy American goods, this allows American producers to charge higher prices than imported products without suffering the normal market results.

5. Who gained and who lost from President Trump’s 25 percent tariff on French wines? LO4 Answer: The winners are wine producers that are not French that sell wine in the United States. Because French wine is now relatively more expensive in the United States, the competing wine producers in the Unites States, Spain, and elsewhere are now receiving higher prices for their wine. The losers are those consumers in the United States that drink French wine because now they have to pay higher prices for the French wine.

6. How would each of these events affect the supply or demand for Japanese yen? LO5 a. Stronger U.S. economic growth. b. A decline in Japanese interest rates. c. Higher inflation in the United States.

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Answer: a. A stronger U.S. economy will result in U.S. consumers wanting to purchase more Japanese-made products. As a result, the demand for Japanese yen will increase. Although the U.S. consumer does not pay for Japanese-made products directly with yen, importers must settle by paying the Japanese manufacturers with yen. b. A decline in Japanese interest rates will make investment in Japanese financial instruments less attractive and, as a result, there will be less demand for Japanese yen used to purchase Japanese financial instruments. At the same time, Japanese investors will want to move some of their savings into U.S. financial instruments, whose interest rates are assumed to have not changed, resulting in an increase in the supply of Japanese yen in the United States. c. Higher inflation in the United States will result in making U.S. dollar-financial instruments less attractive. U.S. goods will become more expensive in Japan, resulting in some investors investing more in Japanese yen-denominated investments, and the demand for Japanese yen will increase.

7. Is a stronger dollar good or bad for America? Explain. LO5 Answer: A strong dollar is a double-edged sword. When the dollar is strong, it takes fewer dollars to purchase other foreign currencies. As a result, the cost of imports declines, and U.S. consumers of foreign goods and services see an improvement in their purchasing power. At the same time, a stronger U.S. dollar means that it takes more of a foreign currency to purchase one U.S. dollar. Consequently, a strong dollar results in the foreign price of U.S. exports increasing, and U.S. exports decline as a result.

8. Why might China want to keep the price of the yuan low? Who suffers from this policy? LO5 Answer: By keeping the price of the yuan low, China is effectively making its exports cheaper for other nations. This is good for foreign consumers of Chinese exports, but it gives China an unfair advantage in international trade. That hurts import-competing industries in other nations. It also increases the demand for Chinese goods, pushing up prices for Chinese consumers.

9. POLICY PERSPECTIVES If another nation raises tariffs on U.S. products, should the United States retaliate with similar trade barriers? Who would gain? Who would lose? LO6 Answer: When another nation raises tariffs on U.S. goods, it makes U.S. exports more expensive. This reduces the quantity of exports demanded and therefore hurts U.S. exporters.

It also hurts consumers in the tariff nations, who must then pay higher prices. The tariffs give the foreign producers a competitive advantage that increases their sales while putting downward pressure on U.S. domestic prices. Retaliation is dangerous as it can easily lead to an escalating trade war that eliminates the comparative advantages of free trade, thereby reducing consumption possibilities in both nations.

10. POLICY PERSPECTIVES If more jobs are lost in steel-using industries than are saved by tariffs in the steel industry, why are tariffs on steel ever imposed? LO6 © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

Answer: Demands from the steel industry for protection against foreign competition, arguments related to protecting industries vital to national security from related groups, and demands from the steel producers’ employees for job security all play a role in persuading policymakers to adopt tariffs. These demands from beneficiaries of tariffs influence policymakers to impose tariffs. In turn, tariff beneficiaries will support those who support the steel industry in an election.

PROBLEMS 1. Suppose the following table reflects the domestic supply and demand for T-shirts: LO4 Price ($) Quantity supplied Quantity demanded

15 8 2

13 7 4

11 6 6

9 5 8

7 4 10

5 3 12

3 2 14

1 1 16

a. Graph these market conditions and identify when there is an absence of trade: (i) the market price, (ii) domestic consumption, and (iii) domestic production. b. Now suppose that foreigners enter the market, offering to sell an unlimited supply of Tshirts for $7 apiece. Now with free trade, identify (i) the market price, (ii) domestic consumption, and (iii) domestic production. c. If a tariff of $2 per T-shirt is imposed, with this trade barrier, identify (i) the market price, (ii) domestic consumption, and (iii) domestic production.

Answer:

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a. Without trade, the market price is determined where domestic quantity demanded equals domestic quantity supplied. This occurs at a price of $11 where consumers demand and producers supply 6 units. b. With free trade, foreign producers enter the market and are willing to sell an unlimited quantity of T-shirts at a price of $7 each. With free trade, the market price is now $7. At this price, consumers will demand 10 units and producers will supply 4 units. c. Tariffs increase the price of imported goods and services. With a $2 tariff on imports, the market price will increase to $9 each (= free-trade price + tariff = $7 + $2). With this trade barrier, consumers will demand 8 units and producers will supply 5 units.

2. Alpha and Beta, two tiny islands in the Pacific, produce pearls and pineapples. The production possibilities schedules in the table below describe their potential output in tons per year. LO3

Pearls 0 2 4 6 8 10

Alpha Pineapples 30 25 20 15 10 5

Pearls 0 10 20 30 40 45

Beta Pineapples 20 16 12 8 4 2

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12

0

50

0

a. Graph the production possibilities confronting each island. b. What is the opportunity cost of pineapples on each island? c. Which island has a comparative advantage in pineapple production?

Answer: a.

b. The opportunity cost is what you have to give up in order to obtain something else. In this example, Alpha and Beta can produce pineapples or pearls with their resources. This means that the opportunity cost of producing more pineapples is that some pearl production must be given up. Similarly, the opportunity cost of producing more pearls is that some pineapple production must be given up. If all of Alpha’s resources are dedicated to producing pearls, it can produce 12 tons of pearls. If its resources are used to produce pineapples, it can produce 30 tons of pineapples. This is a ratio of 12 ÷ 30 = 0.4 tons of pearls must be given up for each ton of pineapples produced. In Beta, the opportunity cost is 2.5 tons of pearls (50 ÷ 20 = 2.5) for each ton of pineapples produced. c. Comparative advantage is the ability of a country to produce a specific good at a lower opportunity cost than its trading partners. Alpha will have the comparative advantage in pineapples because it can produce pineapples at a lower opportunity cost, as calculated in part b, 0.4 tons of pearls compared to 2.5 tons of pearls for Beta.

3. Suppose the two islands in problem 2 agree that the terms of trade will be 1 ton of pineapples for 1 ton of pearls and that trade soon results in an exchange of 10 tons of pineapples for 10 tons of pearls. LO2 Alpha

Beta

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Pearls 0 2 4 6 8 10 12

Pineapples 30 25 20 15 10 5 0

Pearls 0 10 20 30 40 45 50

Pineapples 20 16 12 8 4 2 0

a. If Alpha produced 6 tons of pearls and 15 tons of pineapples and Beta produced 30 tons of pearls and 8 tons of pineapples before they decided to trade, how much would each be producing after trade became possible? Assume that the two countries specialize just enough to maintain their consumption of the item they export, and make sure each island trades the item for which it has a comparative advantage. b. How much would the combined production of pineapples increase for the two islands due to trade? How much would the combined production of pearls increase? c. How could both islands produce and consume even more?

Answer: a. Comparative advantage is the ability of a country to produce a specific good at a lower opportunity cost than its trading partners. Alpha will have the comparative advantage in pineapples because it can produce 1 ton of pineapples at a lower opportunity cost, 0.4 tons of pearls compared to 2.5 tons of pearls for Beta. Beta will have the comparative advantage in pearls because it can produce 1 ton of pearls at a lower opportunity cost, 0.4 tons of pineapples compared to 2.5 tons of pineapples for Alpha. b. The countries have decided to trade 10 tons of pineapples for 10 tons of pearls. Since Alpha specializes in pineapple production, it will increase its pineapple production by 10 tons of pineapples. Alpha increases production of pineapples from 15 tons to 25 tons while decreasing pearl production from 6 tons to 2 tons. Since Beta specializes in pearl production, it will increase its pearl production by 10 tons of pearls. Beta increases pearl production from 30 tons to 40 tons while decreasing pineapple production from 8 tons to 4 tons. This specialization reflects the opportunity costs facing the two islands. c. Total pearl production would increase by 6 tons (from 36 tons to 42 tons of pearls) while pineapple production would increase by 6 tons (from 23 tons to 29 tons of pineapples). d. World output and thus the potential gains from trade will be maximized when each island produces according to its comparative advantage.

4. What is the equilibrium euro price of the U.S. dollar: LO5 a. in Figure 16.3? b. in Figure 16.4? c. Did the dollar appreciate or depreciate in Figure 16.4?

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Answer: a. In the figure, the U.S. dollar price of one euro is $1.10 (1 euro = 1.10 U.S. dollars).

This means that the price of one euro is $1.10. To determine the euro price of one U.S. dollar, you must calculate the price of one U.S. dollar in terms of euros.

1 euro = 1.10 U.S. dollars (1 euro ÷ 1.10) = (1.10 U.S. dollars ÷ 1.10) 0.91 euro = 1 U.S. dollar.

Therefore, the euro price of one U.S. dollar is 0.91 euro. This means that the price of one U.S. dollar is 0.91 euro. b. In the figure, the U.S. dollar price of one euro is now $1.15 (1 euro = 1.15 U.S. dollars). This means that the price of one euro is $1.15. Since there is an increase in the value of the euro compared to the dollar, the euro has appreciated. To determine the euro price of one U.S. dollar, you must calculate the price of one U.S. dollar in terms of euros.

1 euro = 1.15 U.S. dollars (1 euro ÷ 1.15) = (1.15 U.S. dollars ÷ 1.15) 0.87 euro = 1 U.S. dollar.

Therefore, the euro price of one U.S. dollar is 0.87 euro. This means that the price of one U.S. dollar is 0.87 euro. c. Since there is a decrease in the value of the dollar compared to the euro, the dollar has depreciated. It now takes fewer euros (0.87) to purchase a U.S. dollar than it did previously

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(0.91). When the dollar depreciates (falls in value), the euro simultaneously appreciates (rises in value).

5. In what country was the U.S. dollar price of a Big Mac the highest with the following exchange rates? LO5 a. 13,963 rupiah = $1 b. 0.80 euro = $1 c. 33 baht = $1 d. 6.46 yuan = $1 Answer: a. The U.S. dollar price of a foreign good is equal to the price of the foreign good multiplied by the U.S. dollar price of the foreign currency. To answer this question, you must first convert the price of the Big Mac into U.S. dollars. One important thing to observe is that the exchange rate given in the question is the foreign currency price of the U.S. dollar, so you must convert this exchange rate to the U.S. dollar price of the foreign currency.

U.S. dollar price = foreign price × U.S. dollar price of foreign currency U.S. dollar price = foreign price × (1 ÷ foreign currency price of U.S. dollar) U.S. dollar price = foreign price ÷ foreign currency price of U.S. dollar.

In this example: • The U.S. dollar price of a Big Mac in Indonesia is 2.41 U.S. dollars.

U.S. dollar price = 33,653 rupiah × (1 ÷ 13,963 rupiah) U.S. dollar price = 33,653 rupiah ÷ 13,963 rupiah = 2.41 U.S. dollars • The U.S. dollar price of a Big Mac in Italy is 5.30 U.S. dollars.

U.S. dollar price = 4.24 euros ÷ 0.80 euro = 5.30 U.S. dollars • The U.S. dollar price of a Big Mac in Thailand is 3.91 U.S. dollars.

U.S. dollar price = 129 baht ÷ 33 baht = 3.91 U.S. dollars • The U.S. dollar price of a Big Mac in China is 3.41 U.S. dollars.

U.S. dollar price = 22 yuan ÷ 6.46 yuan = 3.41 U.S. dollars b. The U.S. dollar price of a Big Mac is highest in Italy.

6. If a PlayStation 5 costs 40,000 yen in Japan, how much will it cost in U.S. dollars if the exchange rate is as follows? LO5 a. 120 yen = $1 b. 1 yen = $0.00833 c. 110 yen = $1

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Answer: To answer this question, you must convert the price of the PlayStation 5 into U.S. dollars. The U.S. dollar price of a foreign good is equal to the price of the foreign good multiplied by the U.S. dollar price of the foreign currency.

One important thing to observe is if the exchange rate given in the question is the foreign currency price of the U.S. dollar or the U.S. dollar price of the foreign currency. If it is in the foreign currency price of the U.S. dollar, you must convert this exchange rate to the U.S. dollar price of the foreign currency. a. In this example, the U.S. dollar price of a PlayStation 5 is 333.33 U.S. dollars.

U.S. dollar price = foreign price × U.S. dollar price of foreign currency U.S. dollar price = foreign price × (1 ÷ foreign currency price of U.S. dollar) U.S. dollar price = foreign price ÷ foreign currency price of U.S. dollar U.S. dollar price = 40,000 yen ÷ 120 yen = 333.33 U.S. dollars b. In this example, the U.S. dollar price of a PlayStation 5 is 333.20 U.S. dollars.

U.S. dollar price = foreign price × U.S. dollar price of foreign currency U.S. dollar price = 40,000 yen × 0.00833 = 333.20 U.S. dollars c. In this example, the U.S. dollar price of a PlayStation 5 is 363.64 U.S. dollars.

U.S. dollar price = foreign price × U.S. dollar price of foreign currency U.S. dollar price = foreign price × (1 ÷ foreign currency price of U.S. dollar) U.S. dollar price = foreign price ÷ foreign currency price of U.S. dollar U.S. dollar price = 40,000 yen ÷ 110 yen = 363.64 U.S. dollars 7. By what percent did the dollar price of a euro fall between February and August 2018 (see the News Wire “Currency Appreciation”)? LO5

Answer: In February a dollar bought 0.80 euro; in August, the same dollar is worth about 0.88 euro. This means that the dollar price of the euro fell 10 percent.

Percentage change = (new value − old value) ÷ old value × 100 = (0.88 − 0.80) ÷ 0.80 × 100 = (0.08 ÷ 0.80) × 100 = 0.10 × 100 = 10 percent.

8. If an admission ticket to Disney World in Florida cost $116 (see the News Wire “Currency Appreciation”), what was the euro price of the ticket in: LO5 a. February 2018? b. August 2018?

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Answer: The euro price of an American good is equal to the price of the American good multiplied by the euro price of the U.S. dollar. Euro price = American price × euro price of the U.S. dollar.

The euro had depreciated (and the dollar had appreciated), which means that Europeans vacationing in America were paying higher euro prices. a. The euro price of a ticket to Disney World in February 2018 was 92.80 euros.

Euro price = American price × euro price of the U.S. dollar Euro price = $116 × 0.80 = 92.80 euros b. The euro price of a ticket to Disney World in August 2018 was 102.08 euros.

Euro price = American price × euro price of the U.S. dollar Euro price = $116 × 0.88 = 102.08 euros 9. If the Trump 25 percent tariff on French wine caused imports of French wine to fall by 50 percent, what was the U.S. price elasticity of demand for French wine? LO4

Answer: Calculate elasticity using the price elasticity of demand formula.

E = percentage change in quantity demanded ÷ percentage change in price, in absolute value E = 25% ÷ 50% = 0.50.

10. According to the News Wire “Import Quotas,” how much more are U.S. candy companies paying for sugar as a result of the import quota? LO4 Answer: According to the article, as a result of the import quota, the United States pays $0.28 per pound for sugar, which is higher than the world price of sugar (= $0.12 per pound).

This means that U.S. candy companies are paying $0.16 more per pound for sugar because of the quota (= $0.28 per pound − $0.12 per pound).

11. POLICY PERSPECTIVES Using supply and demand, how would you illustrate the effect of a “Buy American” policy? LO6 Answer: A "Buy American" policy would increase the demand for American-made products and decrease the demand for foreign-made products.

CHAPTER 17: THEORY VERSUS REALITY ANSWERS TO QUESTIONS FOR DISCUSSION AND PROBLEMS

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After reading this chapter, you should be able to: 1 Identify the major tools of macro policy.

2 Explain how macro tools can fix macro problems.

3 Depict the track record of macro outcomes.

4 Describe major impediments to policy success.

5 POLICY PERSPECTIVES Discuss the pros and cons of discretionary policy.

QUESTIONS FOR DISCUSSION 1. What policies would Keynesians, monetarists, and supply-siders advocate for? LO2 a. Restraining inflation. b. Reducing unemployment.

Answer: Keynesians a. To restrain inflation, Keynesians recommend policy tools that decrease (shift to the left) AD. Thus, they would argue for increases in taxes, decreases in government spending, and a decrease in the money supply (caused by buying government bonds in open market operations, increasing the discount rate, or increasing the reserve requirements). b. To reduce unemployment, Keynesians recommend policy tools that increase (shift to the right) AD. Thus, they would argue for decreases in taxes, increases in government spending, and an increase in the money supply (caused by selling government bonds in open market operations, decreasing the discount rate, or decreasing the reserve requirements).

Monetarists a, b. Monetarists see no point in discretionary policies since they believe the AS curve is vertical at the natural rate of unemployment. Thus, their prescription for inflation and unemployment is patience. There should be no attempt to fine-tune the economy. They would also argue for a steady change in the money supply at a rate consistent with the desired longterm growth rate of the economy.

Supply-siders a. To restrain inflation, supply-siders argue policy tools should be used to shift the location and shape of the AS curve. In this case, they would argue for a shift of AS to the right by cutting taxes and regulations and also lowering import barriers to allow cheaper foreign goods into the markets. b. To reduce unemployment, supply-siders argue again that policy tools should be used to shift the location and shape of the AS curve. In this case, they would argue for cuts in marginal tax rates on investment and labor. They would also look for ways to reduce government regulation to reduce the cost of producing goods and services.

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2. Suppose it is an election year and aggregate demand is growing so fast that it threatens to set off an inflationary movement. Why might Congress and the president hesitate to cut back on government spending or raise taxes, as economic theory suggests is appropriate? LO4 Answer: Political considerations, unfortunately, can and do outweigh economic fundamentals on occasion. Tax hikes and reduced government spending are not usually well received by voters. The goal for politicians may be to get reelected and then deal with economic problems. Politicians prefer to encourage growth or stimulate the economy before elections, and then to exercise fiscal restraint afterward, resulting in a political business cycle of short-run instability.

3. Should military spending be subject to macroeconomic constraints? What programs should be expanded or contracted to bring about needed changes in the budget? LO4 Answer: From a strictly economic viewpoint, all federal spending, including military spending, should be subject to macroeconomic constraints. Yet, macroeconomic theory provides no specific guidelines on which spending should be targeted. Political viewpoints and theoretical leanings help guide policymakers when making controversial decisions regarding expanding and contracting individual programs.

4. Why does it take so long to recognize that a recession has begun (see the News Wire “Measurement Problems”)? LO4 Answer: Collecting data takes time, so it takes several months after an economic event has occurred before the data has been captured and analyzed to confirm that the event did occur.

5. Democrats opposed President Trump’s 2017 tax cuts because the cuts favored corporations over middle-class families. If the tax cuts had favored families over corporations, what differences would it have made for macro outcomes? LO2 Answer: Fiscal stimulus involving tax cuts favoring families might have created a different outcome, since families would have spent their additional disposable income on consumer goods. If fiscal stimulus money is spent primarily on consumer goods rather than capital or investment goods, the impact of the fiscal stimulus will have less long-term impact, since it might not have encouraged greater business investment.

6. Outline a macro policy package for attaining full employment and price stability in the next 12 months. What obstacles, if any, will impede attainment of these goals? LO2

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Answer: Answers will depend on the state of the economy when this question is assigned.

The biggest obstacle is going to be the policy lags. It is relatively easy to prescribe a change in government spending or taxes or both, but it is more difficult—and potentially time consuming—for Congress and the president to agree on what government spending or taxes to change and by how much. Even after that is done, it takes time for the policy to actually have an impact on the economy. Attaining these goals in 12 months is rather ambitious.

7. Which nation had the best macro performance in 2000–2017 (see the News Wire “Comparative Performance”)? LO3 Answer: From 2000–2017, China had the best performance of overall real growth (9.7%), while Mexico had the lowest unemployment rate (3.8%). However, China also had one of the fastest rates of inflation, and despite its lower inflation rate, France had the highest unemployment rate. The U.S. economy performed better than the European economies, but still had higher unemployment than did Japan, China, and Mexico. No one nation had overall macro outcomes of the lowest inflation and unemployment rates combined with the fastest real growth rate.

8. According to the News Wire “Comparative Performance,” which country had: LO3 a. the fastest growth and highest inflation? b. the slowest growth and the lowest inflation? c. Why might these performance measures be correlated?

Answer: a. China had the fastest inflation rate and the highest growth rate. b. Japan had the slowest growth rate and the slowest inflation rate. c. These performance measures may be correlated due to the role of aggregate demand.

Faster growth implies increasing demand for goods and services, and if aggregate supply does not also increase, pressure on prices will increase, pushing up the rate of inflation (upward-sloping AS curve). In the case of slow growth, there is little pressure on prices, and a small increase in aggregate demand without increased aggregate supply will not trigger excessive inflation (along the horizontal portion of the upward-sloping AS curve).

9. President Trump said the Fed was making a mistake when it raised interest rates in 2018.

Should the president have more control of the Fed? Should Congress? LO5 Answer: Answers to this question may vary depending on student views, but correct answers should have support based on the text. Forming an understanding of how much oversight the government should have over the Fed has to do with balancing the challenges of policy implementation along with the Fed’s structure as an independent body with its charge to foresee problems in the economy and take action to try to avert them.

10. POLICY PERSPECTIVES Should economic policies respond immediately to any changes in reported unemployment or inflation rates? When should a response be undertaken? LO5

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Answer: Monthly data on the economy are highly variable and contain a margin of error (which is why they are always being adjusted later). It takes time to collect and analyze data to determine the general direction of the economy, and there are also month-to-month and seasonal fluctuations that need to be accounted for in the data. Hence, policymakers are better off waiting to discern clear trends before taking any action.

PROBLEMS 1. The 2021 fiscal policy package included roughly $400 billion in stimulus payments that were sent to taxpayers. Assuming the MPC is 0.80, by how much would aggregate demand shift: LO2 a. initially? b. ultimately as a result of these rebates?

Answer: Recall: Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.80) = 1 ÷ 0.20 = 5 a. A tax rebate (a tax cut) increases consumer spending (which is an increase in aggregate demand) by the amount equal to the marginal propensity to consume (MPC) multiplied by the tax rebate. Initial increase in consumption = MPC × tax rebate = 0.80 × $400 billion = $320 billion. b. The total (or cumulative) change in spending will equal the multiplier multiplied by the initial increase in consumption. Total change in spending = multiplier × initial increase in consumption = 5 × $320 billion = $1,600 billion.

2. The expiration of the payroll tax cut of January 1, 2013, raised taxes by $110 billion per year.

If the marginal propensity to save was 0.20, LO2 a. by how much did consumer spending decrease initially? b. what was the ultimate decline in aggregate demand?

Answer: Recall: Marginal propensity to consume (MPC) = 1 − marginal propensity to save (MPS) MPC = 1 − MPS = 1 − 0.20 = 0.80 Multiplier = 1 ÷ (1 − MPC) = 1 ÷ (1 − 0.80) = 1 ÷ 0.20 = 5 a. A tax increase that decreases disposable income reduces consumer spending by the amount equal to the marginal propensity to consume (MPC) multiplied by the change in taxes. Initial decrease in consumption = MPC × tax increase = 0.80 × $110 billion = $88 billion.

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b. The total (or cumulative) change in spending (aggregate demand) will equal the multiplier multiplied by the initial decrease in consumption. Total change in spending = multiplier × initial decrease in consumption = 5 × $88 billion = $440 billion.

3. If every one-point reduction in the corporate tax rate increases business investment by $30 billion, by how much did the 2017 tax cut increase investment (refer to Table 17.2)? LO2

Answer: The corporate tax rate fell by 14 percentage points (= 35 percent − 21 percent).

If each one-point percent decrease in the corporate tax rate stimulates investment by $30 billion, the total impact of this tax cut is $420 billion (= 14 percentage points × $30 billion).

4. Suppose that for every 1 percentage point increase (decrease) in GDP growth, automatic stabilizers LO4 a. increase (decrease) tax revenues by $70 billion per year and b. decrease (increase) transfer payments by $30 billion per year.

Using this information, complete the table.

Change in GDP Growth Rate −2% +1% +3%

Change in Tax Revenue (billions)

Change In Transfer Payments (billions)

Change In Budget Balance (billions)

Change in Tax Revenue (billions) −$140 billion $70 billion $210 billion

Change In Transfer Payments (billions) $60 billion −$30 billion −$90 billion

Change In Budget Balance (billions) −$200 billion $100 billion $300 billion

Answer:

Change in GDP Growth Rate −2% +1% +3%

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If the change in the GDP growth rate is −2 percent, it will result in a decrease in tax revenue of $140 billion (= −2 × $70 billion = −$140 billion) and an increase in transfer payments of $60 billion (= −2 × −$30 billion = $60 billion). The budget balance will fall by $200 billion because both the decrease in tax revenue and the increase in transfer payments will cause the budget balance to fall (= −$140 billion − $60 billion = −$200 billion). This means that if we currently have a deficit, that deficit would increase by $200 billion. If we currently have a surplus, that surplus would decrease by $200 billion.

If the change in the GDP growth rate is +1 percent, it will result in an increase in tax revenue of $70 billion (= 1 × $70 billion = $70 billion) and a decrease in transfer payments of $30 billion (= 1 × −$30 billion = −$30 billion). The budget balance will rise by $100 billion because both the increase in tax revenue and the decrease in transfer payments will cause the budget balance to rise (= $70 billion − (−$30 billion) = $100 billion). This means that if we currently have a deficit, that deficit would decrease by $100 billion. If we currently have a surplus, that surplus would increase by $100 billion.

If the change in the GDP growth rate is +3 percent, it will result in an increase in tax revenue of $210 billion (= 3 × $70 billion = $210 billion) and a decrease in transfer payments of $90 billion (= 3 × −$30 billion = −$90 billion). The budget balance will rise by $300 billion because both the increase in tax revenue and the decrease in transfer payments will cause the budget balance to rise (= $210 billion − (−$90 billion) = $300 billion). This means that if we currently have a deficit, that deficit would decrease by $300 billion. If we currently have a surplus, that surplus would increase by $300 billion.

5. If automatic stabilizers reduce the federal deficit by $60 billion for every 1 percent increase in real GDP growth, what will happen to the deficit balance if economic growth accelerates from 1 percent to 4 percent? LO4

Answer: The change in the GDP growth rate is 3 percent (= 4 percent − 1 percent). If the change in the GDP growth rate is 3 percent, the deficit balance will fall by $180 billion because of the automatic stabilizers (automatic changes in tax revenue and changes in transfers = 3 percentage points × $60 billion). This means that if we currently have a deficit, that deficit would decrease by $180 billion.

6. The so-called misery index is computed as the sum of the unemployment and inflation rates.

According to the News Wire “Comparative Performance,” what was the most miserable nation from 2000 to 2017 by this measure? LO3 Answer: According to the table, France had the highest misery index (= 1.4 percent inflation + 9.0 percent unemployment = 10.4 percent misery index). © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.

7. POLICY PERSPECTIVES The following table presents hypothetical data on inflation, unemployment, and pollution associated with various levels of government expenditure and taxation. A government decision maker is trying to determine the optimal level of government expenditures and taxation with each of the three columns being a possible option (policy options A, B, or C). LO5

Government expenditure Taxes Inflation (index) Unemployment rate Pollution index

Policy Option A B C $700 $800 $900 $600 $800 $1,000 1.00 1.04 1.15 10% 4% 3.5% 1.00 1.80 2.00

a. Compute the federal budget balance for each policy option. b. What policy option would best accomplish each of the following goals? (i) Lowest taxes. (ii) Lowest pollution. (iii) Lowest inflation rate. (iv) Lowest unemployment rate. (v) A balanced federal budget.

Answer: a. The federal budget balance is equal to government expenditures minus taxes. If the budget balance is positive, there is a surplus. If the budget balance is negative, there is a deficit. If the budget balance is zero, the budget is balanced.

Policy option A: Federal budget balance = $600 billion − $700 billion = −$100 billion = deficit of $100 billion.

Policy option B: Federal budget balance = $800 billion − $800 billion = $0 billion = balanced budget.

Policy option C: Federal budget balance = $1,000 billion − $900 billion = $100 billion = surplus of $100 billion. b. Policy option A is associated with the lowest taxes, lowest pollution, and lowest inflation rate. Policy option C is associated with the lowest unemployment rate. Policy option B has the only balanced federal budget.

8. Monetary stimulus in the form of lower interest rates is an alternative to fiscal stimulus. If a 0.1 percentage point change in interest rates has the stimulus impact of $10 billion in spending, what is the monetary equivalent (in terms of a change in the interest rate) of a $500 billion fiscal stimulus? LO2

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Answer: A 5.0 percentage point change is the monetary equivalent [= ($500 billion ÷ $10 billion) × 0.1 percentage point = 50 × 0.1 percentage point = 5.0 percentage points].

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