Solution Manual For Essentials of Economics 5e Stanley Brue, Campbell McConnell and Sean Flynn

Solution Manual For Essentials of Economics 5e Stanley Brue, Campbell McConnell and Sean Flynn Chapter 1-18

Chapter 1 Limits, Alternatives, and Choices QUESTIONS Question 1 Ralph Waldo Emerson once wrote: ―Want is a growing giant whom the coat of have was never large enough to cover.‖ How does this statement relate to the definition of economics? LO1 Answer Emerson’s statement reflects the fundamental economic problem of attempting to satisfy unlimited wants with finite (scarce) economic resources.

Question 2 ―Buy 2, get 1 free.‖ Explain why the ―1 free‖ is free to the buyer but not to society. LO1 Answer Because an expenditure is not required for the buyer to obtain the ―1 free‖ once she has already purchased the first two, it is free to the buyer. It is not free to society, however, because resources were used in producing the third unit that could have been directed to alternate uses.

Question 3 What is an opportunity cost? How does the idea relate to the definition of economics? Which of the following decisions would entail the greater opportunity cost: Allocating a square block in the heart of New York City for a surface parking lot or allocating a square block at the edge of a typical suburb for such a lot? Explain. LO1 Answer An opportunity cost is what was sacrificed to do or acquire something else. The condition of scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one thing to acquire another. The opportunity cost would be much higher in New York City as the alternative uses for that square block are much more valuable than for a typical suburban city block.

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What is ―utility‖ and how does the idea relate to purposeful behavior? LO1 Answer ―Utility‖ refers to the pleasure, happiness, or satisfaction gained from engaging in an activity (eating a meal, attending a ball game, etc.). It is an important component of purposeful behavior because people will allocate their scarce time, energy, and money in an attempt to gain the most utility possible.

Question 5 Cite three examples of recent decisions that you made in which you, at least implicitly, weighed marginal cost and marginal benefit. LO1 Answer Student answers will vary but may include the decision to come to class, to skip breakfast to get a few extra minutes of sleep, to attend college, or to make a purchase. Marginal benefits of attending class may include the acquisition of knowledge, participation in discussion, and better preparation for an upcoming examination. Marginal costs may include lost opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for marginal decisions.

Question 6 What are the key elements of the scientific method, and how does this method relate to economic principles and laws? LO2 Answer The key elements include the gathering of data (observation), the formulation of possible explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and repeated testing of hypotheses that have appeared to be valid in prior tests.

The scientific method is the technique used by economists to determine economic laws or principles. These laws or principles are formulated to explain and/or predict behavior of individuals or institutions.

Question 7 Indicate whether each of the following statements applies to microeconomics or macroeconomics: LO3 a. The unemployment rate in the United States was 3.7 percent in December 2018. b. A U.S. software firm laid off 15 workers last month and transferred the work to India. c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise. d. U.S. output, adjusted for inflation, grew by 3 percent in 2017. e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1 percentage point. f. The consumer price index rose by 2.2 percent from November 2017 to November 2018.

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Answer Microeconomics examines the decision making of specific economic units or institutions.

Macroeconomics looks at the economy as a whole or its major aggregates. a. The unemployment rate in the United States was 5.1 percent in September 2015.

Macroeconomics looks at the economy as a whole or its major aggregates (unemployment). b. A U.S. software firm discharged 15 workers last month and transferred the work to India.

Microeconomics examines the decision making of specific economic units or institutions (a software firm). c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of oranges to rise. Microeconomics examines the decision making of specific economic units or institutions (citrus market). d. U.S. output, adjusted for inflation, decreased by 2.4 percent in 2014. Macroeconomics looks at the economy as a whole or its major aggregates (U.S. output). e. Last week Wells Fargo Bank lowered its interest rate on business loans by one-half of 1 percentage point. Microeconomics examines the decision making of specific economic units or institutions (one bank). f. The consumer price index rose by 0.2 percent from August 2014 to August 2015.

Macroeconomics looks at the economy as a whole or its major aggregates (inflation).

Question 8 What are economic resources? What categories do economists use to classify them? Why are resources also called factors of production? Why are they called inputs? LO5 Answer Economic resources are the natural, human, and manufactured inputs used to produce goods and services. Economic resources fall into four main categories: labor, land (natural resources), real capital (machines, factories, buildings, etc.), and entrepreneurs. Economic resources are also called factors of production because they are used to produce goods and services. They are called inputs because they go into a production process (like ingredients go into a bowl to make a cake), with the resulting goods and services also being referred to as output.

Question 9 Why is money not considered to be a capital resource in economics? Why is entrepreneurial ability considered a category of economic resource, distinct from labor? What roles do entrepreneurs play in the economy? LO5

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Answer Money is not considered a capital resource because money is not productive – it provides access to resources but itself does not directly contribute to the production of goods and services.

Additionally, the quantity of money in circulation does not determine an economy’s productive capacity, while the amount of capital and other resources does.Doubling the amount of money in circulation does not change the economy’s physical capacity to produce goods and services.Money is, however, referred as a financial resource and financial capital, reflecting its ability to acquire real economic resources.

Entrepreneurial ability and labor are both human resources, but they perform different functions in the productive process.Entrepreneurial ability does not directly produce goods and services; it organizes the resources that do.Labor refers to the human inputs that directly engage in production.

Entrepreneurs are risk-takers:They coordinate the activities of the other three inputs for profit— or loss, which is why they are called risk-takers.Entrepreneurs sometimes manage companies that they own, but a manager who is not an owner is not necessarily an entrepreneur but may be performing some of the entrepreneurial functions for the company.Entrepreneurs are also innovators, or perhaps inventors, and profits help to motivate such activities.

Question 10 Explain the typical shapes of marginal-benefit and marginal-cost curves. How are these curves used to determine the optimal allocation of resources to a particular product? If current output is such that marginal cost exceeds marginal benefit, should more or fewer resources be allocated to this product? Explain.

Answer The marginal benefit curve is downward sloping, MB falls as more of a product is consumed because additional units of a good yield less satisfaction than previous units.The marginal cost curve is upward sloping, MC increases as more of a product is produced since additional units require the use of increasingly unsuitable resource. The optimal amount of a particular product occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this use The resources are more valuable in some alternative use (as reflected in the higher MC) than in this use (as reflected in the lower MB).

Question 11 Explain how (if at all) each of the following events affects the location of a country’s production possibilities curve: a. The quality of education increases. b. The number of unemployed workers increases. c. A new technique improves the efficiency of extracting copper from ore.d. A devastating earthquake destroys numerous production facilities. LO6

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Answer a. Assuming better education translates into better work skills, then productivity should rise and this would shift the curve outward. b. An increase in unemployment should not affect the location of the curve. Production moves inward, away from the curve. c. The curve should shift outward as more production is possible with existing resources. d. The curve should shift inward with the destruction of resources (capital).

PROBLEMS Problem 1 Potatoes cost Janice $1 per pound, and she has $5.00 that she could possibly spend on potatoes or other items. If she feels that the first pound of potatoes is worth $1.50, the second pound is worth $1.14, the third pound is worth $1.05, and all subsequent pounds are worth $0.30 per pound, how many pounds of potatoes will she purchase? What if she only had $2 to spend? LO1 Answer Janice will purchase potatoes until the value of potatoes is less than the cost of potatoes or until her income has been exhausted. For example, assume Janice has $5.00 to spend on potatoes or other items and the cost of a pound of potatoes is $1. Now assume the first pound of potatoes is worth $1.50 to Janice. She will purchase this pound of potatoes since the value of the pound of potatoes ($1.50) is greater than the cost ($1). If the second pound is worth $1.14 and the third pound is worth a $1.05, then Janice will purchase these as well since the value exceeds the cost of $1. If all remaining pounds are worth $0.30, then Janice will not purchase these because the value is less than the cost. So, Janice will purchase 3 pounds of potatoes at total cost of $3.00.

Now assume Janice only has $2.00 to spend on potatoes. She will purchase the first pound because it is worth $1.50 to her and it only costs a $1. She will purchase the second pound because it is worth $1.14. She has now spent her entire income on potatoes. She would like to purchase the third pound because the value of this pound of potatoes is $1.05, but she does not have the income to make this purchase. So, Janice will purchase 2 pounds of potatoes at a total cost of $2.00.

Problem 2 Pham can work as many or as few hours as she wants at the college bookstore for $12 per hour.

But due to her hectic schedule, she has just 15 hours per week that she can spend working at either the bookstore or multiple other potential jobs. One potential job, at a café, will pay her $15 per hour for up to 6 hours per week. She has another job offer at a garage that will pay her $13 an hour for up to 5 hours per week. And she has a potential job at a daycare center that will pay her $11.50 per hour for as many hours as she can work. Assume that the travel time between job locations is negligible. If her goal is to maximize the amount of money she can make each week, how many hours will she work at the bookstore? LO1 1-5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer Feedback: Pham will choose to work at the bookstore as long as the wage rate at the bookstore exceeds her other opportunities. However, if another job offers a higher wage rate she will choose employment there.She will work until her total time allotment (for work) is exhausted.

She will choose to work at the café for the full 6 hours because the wage rate at the café is $15 per hour, which is greater than the wage rate at the bookstore of $12. This leaves her with 9 hours of work time remaining. Next, she will choose to work at the garage for the full 5 hours because the wage rate here is $13, which again is greater than the bookstore wage rate $12. After this decision she only has 4 hours of work time remaining. She will choose to work these last 4 hours at the bookstore because the bookstore wage rate of $12 exceeds the daycare center wage rate of $11.50.

Problem 3 Suppose you won $15 on a lotto ticket at the local 7-Eleven and decided to spend all the winnings on candy bars and bags of peanuts.Candy bars cost $0.75 each while bags of peanuts cost $1.50 each. LO4 a. Construct a table showing the alternative combinations of the two products that are available. b. Plot the data in your table as a budget line in a graph. What is the slope of the budget line?

What is the opportunity cost of one more candy bar? Of one more bag of peanuts? Do these opportunity costs rise, fall, or remain constant as additional units are purchased? c. Does the budget line tell you which of the available combinations of candy bars and bags of peanuts to buy? d. Suppose that you had won $30 on your ticket, not $15. Is the slope of a new budget line flatter, steeper, or the same as in the diagram above? .Has the number of available combinations increased or decreased?

Answer Part a: Consumption alternatives Goods

A

B

C

D

E

F

Candy bars

0

4

8

12

16

20

of 10

8

6

4

2

0

Bags peanuts Part b:

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Bags of Peanuts

Slope 

 .75   .5 1.5

10

20

Candy Bars

Feedback: The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (− Pcb /Pbp or − 0.75/1.5). The opportunity cost of one candy bar is 0.5 bags of peanuts. Note that the figure could also be drawn with bags of peanuts on the horizontal axis.The slope of that budget line would be -2. The opportunity cost of one more candy bar is ½ of a bag of peanuts.The opportunity cost of one more bag of peanuts is 2 candy bars.These opportunity costs are constant.They can be found by comparing any two of the consumption alternatives for the two goods.

Part c: No; it only tells you what is possible.

Feedback: The budget line does not tell you which of the available combinations of candy bars and bags of peanuts to buy. You will need to use your preference relationship for candy bars and bags of peanuts to determine which combination to buy. The budget line only tells you which combinations are feasible.

Part d: Increased.

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B ags of P eanuts Incom e = $ 15

20

10

Income = $30

20 40 Candy Bars Feedback: An increase in income will cause a parallel shift outward. The slope is the same. The budget line at $30 includes greater quantities of both goods and is preferable to the original budget line.

Problem 4 Suppose that you are on a desert island and possess exactly 20 coconuts. Your neighbor, Friday, is a fisherman, and he is willing to trade 2 fish for every 1 coconut that you are willing to give him. Another neighbor, Kwame, is also a fisherman, and he is willing to trade 3 fish for every 1 coconut. LO4 a. On a single figure, draw budget lines for trading with Friday and for trading with Kwame. (Put coconuts on the vertical axis.) b. What is the slope of the budget line from trading with Friday (coconuts for fish)? c. What is the slope of the budget line from trading with Kwame (coconuts for fish)? d. Which budget line features a larger set of attainable combinations of coconuts and fish? e. If you are going to trade coconuts for fish, would you rather trade with Friday or Kwame?

Answer

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a.

25

20

15

Coconuts

Kwame Friday

10

5

0 0

10

20

30

40

50

60

70

Fish

b. The slope of the budget line from trading with Friday equals –(1/2). This implies that for every coconut you give up, Friday must give up two fish. Or, for every fish that Friday gives up, you must give up (1/2) of a coconut. c. The slope of the budget line from trading with Kwame equals –(1/3). This implies that for every coconut you give up, Kwame must give up three fish. Or, for every fish that Kwame gives up, you must give up (1/3) of a coconut. d. The budget line from trading with Kwame features a larger set of attainable combinations of coconuts and fish. Because Kwame is willing to give up one more fish per coconut, you can consume more of both goods (assuming you make a trade). This implies that you would prefer to trade with Kwame. e. Because Kwame is willing to give up more fish per coconut, you can consume more of both (assuming you make a trade). This implies that you would prefer to trade with Kwame.

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Problem 5 Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts): LO5

a. Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift? Which characteristic of the production possibilities curve reflects the law of increasing opportunity costs: its shape or its length? c. If the economy characterized by this production possibilities table and curve is producing 3 automobiles and 20 forklifts, what could you conclude about its use of its available resources? d. Is production at a point outside the production possibilities curve currently possible?

Could a future advance in technology allow production beyond the current production possibilities curve? Could international trade allow a country to consume beyond its current production possibilities curve?

Answer Part a: (See figure below.) The assumptions are full employment, fixed supplies of resources, fixed technology and two goods.

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automobiles

D (12,6) C (21,4) 8 B (27,2)

30

forklifts

Part b: 4 automobiles and 21 forklifts; its shape.

Feedback: Consider the following example:

Assume the economy is producing at point C.Thus, the economy is producing 4 automobiles and 21 forklifts.

The cost of producing 2 more automobile (4 automobiles to 6 automobiles) can be found by moving to point D and calculating the number of forklifts given up for the 2 additional automobiles. At point D the economy is producing 12 forklifts, which is a loss of 9 forklifts (moving from C to D) for the 2 additional automobiles.

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The cost of producing one more forklift can be found in an equivalent fashion. First, we will move to point B (from point C). Here we must give up 2 automobiles to get 6 forklifts. T. Increasing opportunity cost implies that we must give up more of a particular good to get an additional unit of a different good. This implies as we move along the production possibilities curve (from left to right) I must give up more automobiles to get an additional forklift. Thus, the SHAPE of the schedule captures the increasing opportunity cost concept.

This production possibilities curve assumes that resources are not perfect substitutes and therefore there in an increasing opportunity cost. Increasing opportunity cost implies that we must give up more of a particular good to get an additional unit of a different good.

This implies as we move along the production possibilities curve (from left to right), we must give up more automobiles to get an additional forklift. Thus, the shape of the schedule captures the increasing opportunity cost concept.

Part c: Underutilizing.

Feedback: The economy is underutilizing resources (inside the PPC).

Part d: No; Yes; Yes. Feedback: No, the country cannot produce outside its PPC. Yes, a technological advance would shift the PPC outward allowing the country produce more with a given amount of inputs. Yes, by specializing in goods we have a comparative advantage producing we can trade to gain access to goods beyond our own PPC.

Problem 6 Referring to the table in problem 5, suppose improvement occurs in the technology of producing forklifts but not in the technology of producing automobiles. Draw the new production possibilities curve. Now assume that a technological advance occurs in producing automobiles but not in producing forklifts. Draw the new production possibilities curve. Now draw a production possibilities curve that reflects technological improvement in the production of both goods. LO6

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Answer Technological advance in producing forklifts and not automobiles: This implies we can produce more forklifts with the given resources, so the schedule will shift out along the horizontal axis.

Technological advance in producing automobiles and not forklifts: This implies we can produce more automobiles with the given resources, so the schedule will shift up along the vertical axis.

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Technological advance in producing automobiles and forklifts: This implies we can produce more forklifts and automobiles with the given resources, so the schedule will shift up and out along the vertical and horizontal axes.

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Problem 7 Because investment and capital goods are paid for with savings, higher savings rates reflect a decision to consume fewer goods in the present and more goods in the future. households in China save 40 percent of their annual income each year, whereas households in the United States save less than 5 percent. At the same time, production possibilities are growing at roughly 7 percent annually in China and 3 percent in the United States. Use graphical analysis of ―present goods‖ versus ―future goods‖ to explain the difference between China's growth rate and the U.S. growth rate. LO6 Answer See figures below United States

China Future Goods

Future Goods

B

A Present Goods

Present Goods

Feedback: Since the United States is consuming more today rather than saving, their production possibilities curve will shift out slower (less) over time because they are accumulating less capital. China's production possibilities curve will shift out faster (more) over time because they are accumulating more capital. See diagrams above.

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Brue, McConnell, Flynn Essentials of Economics 5e Chapter 1 Appendix Graphs and Their Meaning QUESTIONS Question 1 What is an inverse relationship? Give an example What is a direct relationship? Give an example LO7 Answer Graphs help us visualize relationships between key economic variables in the data. For example, the relationship between the price of oranges and the number of oranges purchased is likely to be an inverse relationship. An inverse relationship is one where we observe one variable increasing and the other variable decreasing as a result (moving in opposite directions). Thus, as the prices of oranges increase we would expect to see a decrease in the quantity of oranges purchased.

Graphically, we represent this inverse relationship as follows.

As another example, the relationship between the quality of a textbook and the number of textbooks sold is likely to be a direct relationship. A direct relationship is one where we observe one variable increasing and the other variable increasing as a result (moving in the same direction). Thus, as the quality of the textbook increases the number of books sold also increases.

Graphically, we represent this direct relationship as follows.

Question 2 Describe the graphical relationship between ticket prices and the number of people choosing to visit amusement parks. Is that relationship consistent with the fact that, historically, park attendance and ticket prices have both risen? Explain. LO7 Answer There is likely an inverse relationship between ticket prices and the number of people visiting amusement parks. As ticket prices increase relative to other goods, people will spend their income on these other goods. For example, they may decide to go to the movies instead of visiting the now more expensive amusement park.

The fact that, historically, park attendance and ticket prices have both risen over time does not change our story. This relationship is most likely the result of a change in demand, not a change in quantity demanded. The demand schedule for amusement parks has probably shifted to the right (an increase in demand) over time leading to an increase in attendance and prices.

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Look back at Figure 2, which shows the inverse relationship between ticket prices and game attendance at Gigantic State University. (a) Interpret the meaning of both the slope and the intercept. (b) If the slope of the line were steeper, what would that say about the amount by which ticket sales respond to increases in ticket prices? LO7

Answer Part a: The slope of this relationship tells us how much the price of a ticket must fall to induce someone to buy an additional ticket. In this case, the slope of -2.5 tells us that the price must fall by $2.50 to sell one thousand more ticket .

Part b: If the slope of this line were steeper this would imply that the price must fall by more than $2.50 to sell one more ticket. Or, thinking about this in the other direction, a steeper line would result in a smaller decrease in tickets purchased for a given increase in price. In other words, ticket sales (purchases) are less responsive to price movements.

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Problem 1 Graph and label as either direct or indirect the relationships you would expect to find between (a) the number of inches of rainfall per month and the sale of umbrellas, (b) the amount of tuition and the level of enrollment at a university, and (c) the popularity of an entertainer and the price of her concert tickets. LO7 Answer Answer: Part a: Direct Relationship Sale of Umbrellas

Inches of Rainfall

Part b:

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Inverse Relationship Student Enrollment

Tuition

Part c:

Direct Relationship Price of Concert Tickets

Popularity of the Entertainer

Feedback: Consider the following situations: Part a: The number of inches of rainfall per month and the sale of umbrellas: There is likely a direct relationship between the number of inches of rainfall per month and the sale of umbrellas (more rain implies more umbrellas).

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Direct Relationship Sale of Umbrellas

Inches of Rainfall

Part b: The amount of tuition and the level of enrollment at a university: There is likely an inverse relationship between the amount of tuition and the level of enrollment at a university. As tuition increases less students will attend the university.

Inverse Relationship Student Enrollment

Tuition

Part c: The popularity of an entertainer and the price of her concert tickets: There is likely a direct relationship between the popularity of an entertainer and the price of her concert tickets.

The more popular the entertainer, the more people are willing to pay to see her in concert.

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Direct Relationship Price of Concert Tickets

Popularity of the Entertainer

Problem 2 Indicate how each of the following might affect the data shown in the table and graph in Figure 2 of this appendix: LO7

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a. BTU’s athletic director schedules higher-quality opponents. b. An NBA team locates in the city where BTU plays. c. BTU contracts to have all its home games televised.

Answer (a) increase in demand; shift to the right; (b) decrease in demand; shift to the left; (c) decrease in demand; shift to the left.

Feedback: Consider the three scenarios: Part a: By scheduling higher quality opponent the will be an increase in demand. That is, more tickets will be purchased at every price. The demand schedule will shift to the right.

Part b: If an NBA team locates in the same city, this will reduce demand because the NBA games are likely a substitute for BTU's games. That is, fewer tickets will be purchased at every price. The demand schedule will shift to the left.

Part c: If BTU contracts to have all its home games televised, this will reduce demand because individuals can watch the game on television. That is, fewer tickets will be purchased at every price. The demand schedule will shift to the left.

Problem 3 The following table contains data on the relationship between saving and income. Rearrange these data into a logical order and graph them on the accompanying grid. What is the slope of the line? What would you predict saving to be at the $12,500 level of income? LO7

Answer Income per Year

Saving per Year

0

-$500 1-22

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$5,000

0

$10,000

$500

$15,000

$1,000

$20,000

$1,500

Slope equals (500/5000) or 0.10; the vertical intercept equals -$500. The equation representing this data is : Saving = -$500 + 0.1 x Income. The predicted level of saving is $750.

Feedback: Consider the following data: Income per Year

Saving per Year

$15,000

$1,000

0

-$500

$10,000

$500

$5,000

0

$20,000

$1,500

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To rearrange the above data into a meaningful order, we start with the lowest income and saving pair. We then continue with sequentially higher values of both income and saving.

The reason for this ordering is that economic theory (and data) suggests that as income increases so does saving. The data are reordered as follows (you could also reorder from highest to lowest, but this is less intuitive).

Income per Year

Saving per Year

0

-$500

$5,000

0

$10,000

$500

$15,000

$1,000

$20,000

$1,500

Graphically, we have the following.

The slope of the saving line can be found by dividing the change in saving by the change in income between any two points. For example we have the entry (5000 (income), 0 (savings)) and the entry (10000 (income), 500 (savings)). This implies that the change in 1-24 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

saving equals 500 minus zero (= 500) and the change in income equals 10000 minus 5000 (= 5000), therefore the slope equals (500/5000) or 0.10. That is, for every additional dollar an individual earns (net income) she will save 10 cents and consume 90 cents. The vertical intercept equals -$500. This implies that if the individual does not earn an income she either borrows $500 or reduces past savings (stock variable) by $500.

The equation representing this data is : Saving = -$500 + 0.1xIncome.

To find the predicted amount of saving for a given level of income we substitute the income level into the equation above. For example if income equals $12,500, then the predicted level of saving equals -$500 + (0.1 × $12,500). Thus the predicted level of saving is $750 (= -$500 + $1,250).

Problem 4 Construct a table from the data shown on the graph below. Which is the dependent variable and which the independent variable? Summarize the data in equation form. LO7

Answer Study Time (hours)

Exam Score (points)

0

10

2

30

4

50

6

70 1-25

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8

90

9

100

The dependent variable is Exam Score (points); Study Time (hours) i influences your score. The more hours you spend studying will increase your exam score

Feedback: The table for this data is as follows:

Study Time (hours)

Exam Score (points)

0

10

2

30

4

50

6

70

8

90

9

100

Problem 5 Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2-percentagepoint decline in the interest rate. Describe the relevant relationship between the interest rate and investment in a table, on a graph, and as an equation. LO7

Answer

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Interest rate (in percent)

Amount of investment (billions of dollars)

16 14 12 10 8 6 4 2 0

$ 0 5 10 15 20 25 30 35 40

Equation: i = 16 - (2/5)I or I = 16 – (0.4)I

Feedback: Consider the following data as an example: Suppose that when the interest rate on loans is 16 percent, businesses find it unprofitable to invest in machinery and equipment. However, when the interest rate is 14 percent, $5 billion worth of investment is profitable. At 12 percent interest, a total of $10 billion of investment is profitable. Similarly, total investment increases by $5 billion for each successive 2-percentagepoint decline in the interest rate.

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Interest rate (in percent)

Amount of investment (billions of dollars)

16 14 12 10 8 6 4 2 0

$ 0 5 10 15 20 25 30 35 40

When the interest rate is 16%, investment spending will be zero. When the interest rate is 14%, investment spending will be $5 billion. For each successive drop of 2 percentage points in the interest rate, investment spending will increase by $5 billion.

Using equation i  a  bI i  16  16  14  / 5  0 I 2  16    I 5  16  0.4 I Graphically we have the following relationship.

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Problem 6 The accompanying graph shows curve XX’ and tangents at points A, B, and C. Calculate the slope of the curve at these three points. LO7

Answer Point A, slope = 4; Point B, slope = 0; Point C, slope = -4 Feedback: To calculate the slope of the function use the "rise-over-run" approach. The "rise" is the change in the variable on vertical axis as you move between entries (points) and the "run" is the change in the variable on the horizontal axis as you move between the SAME two entries (points).

Point A has a slope that equals 4. To see this, we use the two entries (2,10) and (12,50). The "rise" equals 50 - 10 = 40. The "run" equals 12 - 2 = 10. To find the slope we use the rule "(rise/run)", which equals (40/10) = 4.

Point B has a slope equal to zero. There is no "rise" here, so we do not need coordinates to calculate this value.

Point C has a slope that equals -4. To see this, we use the two entries (16,50) and (26,10). The "rise" equals 10 - 50 = -40 (note that "rise" can be negative). The "run" equals 26 - 16 = 10. To find the slope we use the rule "(rise/run)", which equals (-40/10) = -4.

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Problem 7 In the accompanying graph, is the slope of curve AA’ positive or negative? Does the slope increase or decrease as we move along the curve from A to A’? Answer the same two questions for curve BB’. LO7

Answer Slope of AA’ is positive; increases; Slope of BB’ is negative; decreases.

Feedback: Slope of AA’ is positive (rising from left to right). The slope increases as we move from A to A’.

Slope of BB’ is negative (dropping from left to right). The slope becomes more negative, thereby decreasing, as we move from B to B’.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 2 The Market System and the Circular Flow QUESTIONS Question 4 1-30 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Contrast how a market system and a command economy try to cope with economic scarcity.

LO1 Answer A market system allows for the private ownership of resources and coordinates economic activity through market prices. Participants act in their own self-interest and seek to maximize satisfaction or profit through their own decisions regarding consumption or production. Goods and services are produced and resources are supplied by whoever is willing to do so. The result is competition and widely dispersed economic power.

The command economy is characterized by public ownership of nearly all property resources and economic decisions are made through central planning. The planning board, appointed by the government, determines production goals for each enterprise. The division of output between capital and consumer goods is centrally decided based on the board’s long-term priorities.

Question 5 How does self-interest help achieve society’s economic goals? Why is there such a wide variety of desired goods and services in a market system? In what way are entrepreneurs and businesses at the helm of the economy but commanded by consumers? LO2 Answer The motive of self-interest gives direction and consistency to the economy. The primary driving force of the market system is self-interest. Entrepreneurs try to maximize their profits; property owners want the highest price for their resources; workers choose the job with the best wages, fringe benefits, and working conditions. Consumers apportion their expenditures to maximize their utility while seeking the lowest possible prices. As individuals express their free choice, the economy is directed to produce the mostwanted goods at the lowest possible cost.

Each individual consumer will choose a variety of goods and services that in combination will maximize hisor her satisfaction (utility). To maximize profits, producers must respond to the desires of the individual consumer ; therefore, the market supplies a wide variety of goods and services.

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Although producers are free to choose what products they will produce, if the producers are to maximize profits, these goods and services must be what consumers desire. Entrepreneurs can drive the economic ship where they want (at least for a while), but the ship will run aground (businesses will fail) if the entrepreneurs at the helm don’t listen to the consumers that command them.

Question 6 Why are private property, and the protection of property rights, so critical to the success of the market system? How do property rights encourage cooperation? LO2 Answer The ownership of private property and the protection of property rights encourages investment, innovation, and, therefore, economic growth. Property rights encourage the maintaining of the property and they facilitate the exchange of the property. However, the most important consequence of property rights is that they encourage people to cooperate by helping to ensure that only mutually agreeable economic transactions take place.

Question 7 What are the advantages of using capital in the production process? What is meant by the term ―division of labor‖? What are the advantages of specialization in the use of human and material resources? Explain why exchange is the necessary consequence of specialization. LO2 Answer Capital goods enable producers to operate more efficiently and to produce more output. ―Division of labor‖ means that workers perform those tasks that are best suited to their individual abilities and skills.

The advantages of specialization for workers are that they can choose work according to their natural aptitudes, have the opportunity to perfect those skills, and save time in not having to shift continually from one task to another. Material resources will be developed and adapted for a specific use. On a regional basis, each region will produce those products for which it is best suited. By specializing in its comparative advantage, each region or set of human and material resources is being used to maximize efficiency.

When resources are specialized, they are no longer self-sufficient. To obtain the goods and services one needs, exchange is necessary. Also, specialization will result in a surplus of a specific good being produced. The surplus of one good will be exchanged for the surplus production of other goods.

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Question 8 What problem does barter entail? Indicate the economic significance of money as a medium of exchange. What is meant by the statement ―We want money only to part with it‖? LO2 Answer Barter requires the ―double coincidence of wants.‖ If someone wants something, he/she will have to find someone who wishes to part with that good and at the same time wishes to exchange the good for something that the first party wishes to part with.

With money as a medium of exchange, one knows the purchase price of the item to be purchased and its relative price to other items. Money is a very convenient common denominator, a common measure of value that is also used as a medium of exchange. Money also encourages specialization. Without money, workers and other resources could not be paid except in the output produced. All those who participated in the production of the good would have to collectively exchange it for all the goods and service desired by the resource owners.

Money itself has value only in relation to the resources, goods, and services that can be obtained with it. When people say that they want money, they really mean that they want the things that money can buy. In this sense, money imparts value only when someone parts with it.

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Question 9 Evaluate and explain the following statements: LO2 a. The market system is a profit-and-loss system. b. Competition is the disciplinarian of the market economy.

Answer a. The quotation is accurate. In a market system, producer decisions are motivated by the attempt to earn profits. Those products that enable a firm to earn at least a normal profit (minimum compensation for the entrepreneur for his/her time and talents) will be produced. If the product cannot be produced for a profit—in other words, if losses are involved in production—the capitalist firm will respond by seeking lowercost production methods and may halt the production of goods completely. Because profits and/or losses are the motivation behind the fundamental decisions made in a market system, it could be called a ―profit and loss economy.‖

b. Competition provides discipline in two ways. First, it forces firms to seek the least-cost production methods or face being driven out of business by their rivals. Second, it prevents successful producers from charging whatever the market will bear. Competition keeps prices at a level where total revenue will just cover the total cost of production including a normal profit, but no more in the long run. If sellers try to charge a price that will earn them economic profits, new firms will enter the industry, increasing supply, and lowering prices until the economic profits are eliminated. Competition is indispensable in this role because otherwise some other method would have to be found to direct firms to use the least-cost production technique and to charge a price that provides only a normal return. Where competition does not exist, such as in natural monopolies like public utility companies, regulators or publicly owned companies must assume the role of disciplinarian. Experience has shown that this is a difficult process and does not achieve the same results as easily as a competitive market situation.

Question 10 In the 1990s thousands of ―dot-com‖ companies emerged with great fanfare to take advantage of the Internet and new information technologies. A few, like Google, eBay, and Amazon, have generally thrived and prospered, but many others struggled and eventually failed. Explain these varied outcomes in terms of how the market system answers the question ―What goods and services will be produced?‖ LO3

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Answer The expectation of economic profits lured many new firms into the ―dot-com‖ industries.

However, because of a lack of information and a market unable to sustain so many firms, many failed to realize even a normal profit and failed. [Technically, many of the early dot-coms were not earning economic profits, but their shareholders were reaping huge windfalls from the stock market speculation.] When these new firms found that they could not profitably produce in this industry, they dropped out and the industry declined. The problem was not so much one of consumer sovereignty—consumers demonstrated an interest in these services. The heavy competition of so many firms trying to establish themselves in the market led to prices that were insufficient to cover economic costs. In a few cases, most notably Napster (an Internet company that allowed users to download music at little or no cost), government restrictions on activities (copyright infringement in Napster’s case) led to firm failure (at least for a time).

Question 11 Some large hardware stores such as Home Depot boast of carrying as many as 20,000 different products in each store. What motivated the producers of those individual products to make them and offer them for sale? How did the producers decide on the best combinations of resources to use? Who made those resources available, and why? Who decides whether these particular hardware products should continue to be produced and offered for sale? LO3 Answer The quest for profit led firms to produce these goods. Producers looked for and found the leastcost combination of resources in producing their output. Resource suppliers, seeking income, made these resources available. Consumers, through their dollar votes, ultimately decide on what will continue to be produced.

Question 12 What is meant by the term ―creative destruction‖? How does the emergence of self-driving cars relate to this idea? LO3 Answer Creative destruction refers to the process by which the creation of new products and production methods destroys the market positions of firms committed to existing products and outdated ways of doing business.

Once developed to the point where the public has full confidence in their safety, self-driving cars will likely cause a large decline in the production of conventional automobiles, just as cars once replaced horse and buggies. In addition, self-driving cars will likely reduce or eliminate the need for professional drivers such as taxi drivers and delivery drivers.

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Question 13 In a sentence, describe the meaning of the phrase ―invisible hand.‖ LO4 Answer Market prices act as an ―invisible hand,‖ coordinating an economy by rationing what is scarce, and providing incentives to produce the most desired goods and services.

Question 14 Distinguish between the resource market and the product market in the circular flow model. In what way are businesses and households both sellers and buyers in this model? What are the flows in the circular flow model? LO5 Answer The resource markets are where the owners of the resources (the households) sell their resources to the buyers of the resources (businesses). In the product markets, businesses sell the goods and services they have produced to the buyers of the goods and services, the households.

Households (individuals) either own all economic resources directly or own them indirectly through their ownership of business corporations. These households are willing to sell their resources to businesses because attractive prices draw them into specific resource markets.

Businesses buy resources because they are necessary for producing goods and services. The interaction of the buyers and sellers establishes the price of each resource.

In the product market, businesses are the sellers and householders are the buyers; their role in the market has been reversed. Each group of economic units both buys and sells.

Question 15 What are the three major legal forms of business enterprises? Which form is the most prevalent in terms of numbers? Which form is dominant in terms of total sales revenues? LO5 Answer The three legal forms of business organizations are sole proprietorship, partnership, and corporation. Proprietorships are the most prevalent (72 percent). They are easy to start (relatively low cost), often don’t require a large customer base to be profitable, and provide maximum freedom for the proprietor to do what she/he thinks best.

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Corporations are dominant in terms of total sales revenues (84 percent). They can access large amounts of money by issuing stocks and bonds; their limited liability is attractive to potential owners; their size and broader ownership base help ensure continuity that helps to build a large customer base and gain cost advantages (a preview for economies of scale).

Question 16 What are the major forms of household income? Contrast the wage and salary share to the profit share in terms of relative size. Distinguish between a durable consumer good and a nondurable consumer good. How does the combined spending on both types of consumer goods compare to the spending on services? LO5 Answer The major forms of household income, from largest to smallest, are wages and salaries (63.9%), corporate profits (15.4%), proprietors’ income (11.4%), interest income (3.9%), and rents (5.4%). Wages and salaries generate three times more income than profits (corporate and noncorporate profits combined).

Durable goods (cars, appliances, personal computers) are expected to live three years or longer.

Nondurables (food, clothing, gasoline) are expected to last less than three years. Combined spending on goods is less than total spending on services (64% of consumer expenditures).

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PROBLEMS Problem 8 Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV company. She then develops two possible entrepreneurial business opportunities. In one, she will quit her job to start an organic soap company. In the other, she will try to develop an Internetbased competitor to the local cable company. For the soap-making opportunity, she anticipates annual revenue of $465,000 and costs for the necessary land, labor, and capital of $395,000 per year. For the Internet opportunity, she anticipates costs for land, labor, and capital of $3,250,000 per year as compared to revenues of $3,275,000 per year. (a) Should she quit her current job to become an entrepreneur? (b) If she does quit her current job, which opportunity would she pursue? LO5 Answer Natasha should quit her job only if the net revenue from the entrepreneurial business opportunity exceeds that of her current wage (net revenue equals revenue minus cost. This could also be defined as accounting profit).

For example, consider the following values. Suppose Natasha currently makes $50,000 per year working as a manager at a cable TV company. She then develops two possible entrepreneurial business opportunities. In one, she will quit her job to start a hand-made soap company. In the other, she will try to develop an Internet-based competitor to the cable company. For the soapmaking opportunity, she anticipates annual revenue of $465,000 and costs for the necessary land, labor, and capital of $395,000 per year. For the WiFi opportunity, she anticipates costs for land, labor, and capital of $3,250,000 per year as compared to revenues of $3,275,000 per year.

Net revenue from the hand-made soap company equals $465,000 (revenue) minus $395,000 (cost). This net revenue of $70,000 (= $465,000 – $395,000) exceeds Natasha’s current wage of $50,000; thus, she should develop this company instead of working for the TV company.

The net revenue from the WiFi company equals $3,275,000 (revenue) minus $3,250,000 (cost).

This net revenue of $25,000 (= $3,275,000 – $2,250,000) is less than Natasha’s current wage of $50,000; thus, she should not develop this company and should continue working for the TV company.

In summary, Natasha should quit her job and start the hand-made soap company.

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Problem 9 With current technology, suppose a firm is producing 400 loaves of banana bread daily. Also assume that the least-cost combination of resources in producing those loaves is 5 units of labor, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 loaves at $2 per unit, what is its total revenue? Its total cost? Its profit or loss? Will it continue to produce banana bread? If this firm’s situation is typical for the other makers of banana bread, will resources flow toward or away from this bakery good? LO3 Answer Consider the following example. A firm is producing 400 loaves of banana bread daily. The least-cost combination of resources in producing those loaves is 5 units of labor, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at prices of $40, $60, $60, and $20, respectively. The firm can sell these 400 loaves at $2 per unit.

To calculate total profit, multiply the selling price by the number of units sold. For our example, total revenue equals $2 (price) multiplied by 400 (loaves of bread sold). So, total revenue equals $800 (= $2 × 400).

To calculate total cost, multiply each input usage (number of units employed) by the price of the input and then add these values together. Total cost equals 5 × $40 (cost of labor) + 7 × $60 (cost of land) + 2 × $60 (cost of capital) + 1 × $20 (cost of entrepreneurial ability) = $760.

The profit for this firm equals total revenue minus total cost. Here, profit equals $800 (total revenue) minus $760 (total cost) = $40. If total cost happened to be greater than total revenue, this firm would have a loss.

Since the firm in our example is earning positive profit, it will continue to produce banana bread.

However, if the firm were losing money (suffering a loss because total cost exceeds total revenue), the firm would stop producing banana bread.

Since the firm (again in our example) is earning positive profit, other firms or individuals will want to produce banana bread. Thus, resources will flow toward this bakery good. If the firm had been suffering from a loss, then resources would flow away from this bakery good as firms or individuals exited the market to avoid the loss.

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Problem 10 Let’s put dollar amounts on the flows in the circular flow diagram of Figure 2.2. a. Suppose that businesses buy a total of $100 billion of the four resources (labor, land, capital, and entrepreneurial ability) from households. If households receive $60 billion in wages, $10 billion in rent, and $20 billion in interest, how much are households paid for providing entrepreneurial ability? b. If households spend $55 billion on goods and $45 billion on services, how much in revenues do businesses receive in the product market? LO5 Answer a. Households are paid $10 billion for entrepreneurial ability (= $100 billion in total factor payments – $60 billion in wages – $10 billion in rent – $20 billion in interest). b. Businesses receive $100 billion (= $45 billion + $55 billion) because household expenditures equal business revenues.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 3

Demand, Supply, and Market Equilibrium

QUESTIONS

Question 1 Explain the law of demand. Why does a demand curve slope downward? How is a market demand curve derived from individual demand curves? LO1

Answer As prices change because of a change in supply for a commodity, buyers will change the quantity they demand of that item. If the price drops, a larger quantity will be demanded. If the price rises, a lesser quantity will be demanded.

The demand curve slopes downward because of diminishing marginal utility, and the substitution and income effects. Because successive units of a good provide less additional utility than the previous units, buyers will only pay for these smaller amounts of utility if the price is lowered. When the price of a commodity decreases relative to that of substitutes, a buyer will substitute the now cheaper commodity 1-40 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

for those whose prices have not changed. At the same time, the decreased price of the commodity under discussion will make the buyer wealthier in real terms. More can be bought of this commodity (as well as of others whose prices have not changed). Thus, the substitution and income effects reinforce each other: more will be bought of a normal (or superior) commodity as its price decreases. On a graph with price on the vertical axis and quantity on the horizontal axis, this is shown as a demand curve sloping downward from left to right.

To determine the market demand schedule, add up the individual quantities (demanded) at each price. This is referred to as horizontal summation for a private good. In other words, fix the price and add up the quantity demanded for each individual in the market.

Question 2 What are the determinants of demand? What happens to the demand curve when any of these determinants changes? Distinguish between a change in demand and a change in the quantity demanded, noting the cause(s) of each. LO1

Answer The fundamental determinant of demand is the price of the commodity under consideration: a change in price causes movement along the commodity’s demand curve. This movement is called a change in quantity demanded. Decreased price leads to movement down the demand curve: There is an increase in quantity demanded. Increased

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price leads to movement up the demand curve: There is a decrease in quantity demanded.

In addition, there are determinants of demand, which are factors that may shift the demand curve, i.e., cause a ―change in demand.‖ These are the number of buyers, the tastes (or desire) of the buyers for the commodity, the income of the buyers, the changes in price of related commodities (substitutes and complements), and expectations of the buyers regarding the future price of the commodity under discussion.

The following will lead to increased demand: more buyers, greater desire for the commodity, higher incomes (assuming a normal good), lower incomes (assuming an inferior good), an increased price of substitutes, a decreased price of complements, and an expectation of higher future prices or incomes. This increased demand will show as a shift of the entire demand curve to the right.

Question 3 What effect will each of the following have on the demand for small cars such as the Mini-Cooper and Fiat 500? LO1 a. Small cars become more fashionable. b. The price of large cars rises (with the price of small cars remaining the same). c. Income declines and small cars are an inferior good. d. Consumers anticipate that the price of small cars will decrease substantiallyin the near future. e. The price of gasoline substantially drops.

Answer a. Demand increases due to a change in tastes. b. Demand increases due to a change in the price of a substitute. c. Demand increases due to a change in income. d. Demand decreases due to a change in expectations e. Demand is ambiguous. Since cars and gas are complements, one could argue that the decrease in gas prices would stimulate demand for all cars, including small ones. However, one could also argue that small cars are attractive to consumers because of fuel efficiency, and that a decrease in gas prices effectively reduces the price of the ―gas- guzzling‖ substitutes. That would encourage consumers to 1-42 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

switch from smaller to larger cars (SUVs), and demand for small cars would fall. This presents a good illustration of the complexity of many of these changes.

Question 4 Explain the law of supply. Why does the supply curve slope upward? How is the market supply curve derived from the supply curves of individual producers? LO2

Answer As prices rise because of increased demand for a commodity, producers find it more and more profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward from left to right.

Clearly, firms would rather sell at a higher price than at a lower price. Moreover, it is necessary for firms to demand a higher price as they increase production. This comes about because as they produce more and more, they start to run up against capacity constraints and costs rise. At any given time, a plant has a given size. As production increases, the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It may run out of warehouse space and have to rent at higher cost from another firm. It may have to pay extra to get increasingly urgent raw material, and so on.

The market supply curve is derived by horizontally adding the individual supply curves.

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Question 5 What are the determinants of supply? What happens to the supply curve when any of these determinants changes? Distinguish between a change in supply and a change in the quantity supplied, noting the cause(s) of each. LO2

Answer Price is the most significant influence on the quantity supplied of any product. As price increases, the quantity supplied increases. An increase in price causes a movement up a given supply curve. A decrease in price causes a movement down a given supply curve. The nonprice determinants of supply are resource (input) prices, technology, taxes and subsidies, prices of other alternative goods, expectations, and the number of sellers. If one or more of these change, there will be a change in supply and the whole supply curve will shift to the right or the left.

The following will cause an increase in supply: a decrease in resource (input) prices; improved (lowercost) technology; a decrease in business taxes; an increase in subsidies to business; a decrease in the price of another commodity that this firm was making, provided that commodity is a substitute in production (the firm can switch from the now lower-priced one to our commodity); an expectation of lower prices in the future; and an increase in the number of sellers. The increase in supply caused by the noted change in one or more of the above will cause the entire supply curve to shift to the right. More will now be supplied at any given price. Alternatively expressed, any given amount will now be supplied at a lower price.

The reverse of any or all the above changes in the determinants of supply will cause a decrease in supply and will be shown as a shift of the supply curve to the left. Less will now be supplied at any given price.

Alternatively expressed, any given amount will now be supplied at a higher price.

Question 6 What effect will each of the following have on the supply of auto tires? LO2 a. A technological advance in the methods of producing tires. b. A decline in the number of firms in the tire industry. c. An increase in the price of rubber used in the production of tires. d. The expectation that the equilibrium price of auto tires will be lower in the future than currently. e. A decline in the price of the large tires used for semitrucks and earth-hauling rigs (with no change in the price of auto tires). f. The levying of a per-unit tax on the producer for each auto tire sold. g. The granting of a 50-cent-per-unit subsidy for each auto tire produced.

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Answer a. Supply will increase because the technological advance allows the tire manufacturers to produce more tires using the same amount of inputs. b. Supply will decrease because there are fewer firms in the industry. c. Supply will decrease because the increase in the price of rubber results in an increase in production costs. Thus, each firm will need to charge a higher price at each level of output (or supply less at each price). d. Changes in supply cannot be determined. Changes in expectations about the future price of a product may affect the producer's current willingness to supply that product. It is difficult, however, to generalize about how a new expectation of lower prices affects the present supply of a product. For example, the expectation of lower prices in the future may cause suppliers to sell their inventories today while the price is still high, thus, increasing the supply. On the other hand, the expectation of lower prices may cause suppliers to cut back on production, thus, reducing the supply. e. Supply will increase because the decline in the price of large tires used for semi trucks and earthhauling rigs (with no change in the price of auto tires) will cause firms to reduce production of large tires (now commanding a lower price) and produce more auto tires. f. Supply will decrease because per-unit tax on each auto tire sold increases the cost of production since the tire manufacturers must now pay for input costs PLUS the per-unit tax. g. Supply will increase because the 50-cent-per-unit subsidy decreases the cost of production. The tire manufacturers receive the subsidy, which they can subtract from their input costs.

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Question 7 ―In the latte market, demand often exceeds supply and sup-ply sometimes exceeds demand.‖ ―The price of a latte rises and falls in response to changes in supply and demand.‖ In which of these two statements are the concepts of supply and demand used correctly? Explain. LO4

Answer In the first statement, ―supply‖ and ―demand‖ are used incorrectly. Supply and demand are both schedules or curves that intersect where quantity supplied and quantity demanded are equal. One cannot talk of curves that intersect as exceeding or not exceeding each other.

Supply and/or demand can change (the entire curves can shift). Each time this happens, it will create a new intersection of the two curves that will lead to changes in the equilibrium quantity and price of lattes.

Thus, the terms ―supply‖ and ―demand‖ are used correctly in the second statement.

Question 8 In 2001 an outbreak of hoof-and-mouth disease in Europe led to the burning of millions of cattle carcasses. What impact do you think this had on the supply of cattle hides, hide prices, the supply of leather goods, and the price of leather goods? LO4

Answer The supply of cattle hides was reduced, raising the price of hides. Because hides were more expensive, it became more costly to produce leather, reducing the supply and raising the price of leather goods.

Question 9 Critically evaluate: ―In comparing the two equilibrium positions in Figure 3.7b, I note that a smaller amount is actually demanded at a lower price. This observation refutes the law of demand.‖ LO4

Answer

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Most scalping laws make it illegal to sell—but not to buy—tickets at prices above those printed on the tickets. Assuming that is the case, use supply and demand analysis to explain why the equilibrium ticket price in an illegal secondary market tends to be higher than in a legal secondary market.

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Question 10 For each stock in the stock market, the number of shares sold daily equals the number of shares purchased. That is, the quantity of each firm’s shares demanded equals the quantity supplied. Why, then, do the prices of stock shares change? LO4

Answer During any given stock trading session, there will be both prospective buyers and sellers, each willing to buy or sell a certain number of shares depending on price. If at the current price (e.g., the day’s opening price) the quantity of shares demanded exceeds the quantity of shares supplied, buyers must increase their price offers to induce sellers to offer enough shares. This will cause share prices to rise until quantity demanded equals quantity supplied. Suppose that during the trading session there is a report of bad economic news. Sellers may respond by trying to sell more shares than buyers are wanting at the current price. In order to find enough willing buyers, sellers will have to offer their shares at lower prices. On any given trading day, there will be multiple equilibrium prices, many of them not lasting for more than a few minutes (or even seconds).

Question 11 Suppose the total demand for wheat and the total supply of wheat per month in the Kansas City grain market are as shown in the table below. Suppose that the government establishes a price ceiling of $3.70 for wheat. What might prompt the government to establish this price ceiling? Explain carefully the main effects. Demonstrate your answer graphically. Next, suppose that the government establishes a price floor of $4.60 for wheat. What will be the main effects of this price floor? Demonstrate your answer graphically. LO5

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Answer The equilibrium price is found where quantity supplied equals quantity demanded. This occurs at the price of $4.00, where 75 thousand bushels are demanded and 75 thousand bushels are supplied (equilibrium quantity).

If the government establishes a price ceiling at $3.70 (sellers cannot charge a price above $3.70), there will be an excess demand of 7 thousand bushels. Buyers demand 80 thousand bushels at the price of $3.70, but sellers only supply 73 thousand bushels.

If the government establishes a price floor at $4.60 (sellers cannot charge a price below $4.60), there will be an excess supply of 14 thousand bushels. Buyers demand 65 thousand bushels at the price of $4.60, but sellers supply 79 thousand bushels.

Question 12 What do economists mean when they say ―Price floors and ceilings stifle the rationing function of prices and distort resource allocation‖? LO5

Answer When unrestrained, prices rise and fall to correct imbalances between the quantity supplied and the quantity demanded in a market. If sellers find themselves at a given price with more output than consumers are willing to purchase, the price will fall. Likewise, if the market is not offering enough of a good to satisfy consumer demand, the price will rise. Price floors and ceilings prevent price movements to correct these imbalances. When a price is set above equilibrium (i.e., a price floor), sellers will produce more than the market can support, diverting resources away from more highly valued uses. Price ceilings result in an under allocation of resources toward a particular good, where the excess demand (shortage) reveals that consumers value the good (and therefore the resources used to produce it) more than what the market currently offers.

PROBLEMS

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Problem 1 Suppose there are three buyers of candy in a market: Tex, Dex, and Rex. The market demand and the individual demands of Tex, Dex, and Rex are shown in the following table. LO1 a. Fill in the missing values. b. Which buyer demands the least at a price of $5? The most at a price of $7? c. Which buyer’s quantity demanded increases the most when the price decreasesfrom $7 to $6? d. In which direction would the market demand curve shift if Tex withdrew from the market? What if Dex doubled his purchases at each possible price? e. Suppose that at a price of $6, the total quantity demanded increases from 19 to 38. Is this a ―change in the quantity demanded‖ or a ―change in demand‖? Explain.

Answer a. At each price (row), the total quantity demanded will equal the sum of the individual quantities demanded. To find the total quantity demanded at the price of $8, add the quantities demanded by Tex, Dex, and Rex, which equals 4 (= 3 + 1 + 0). Total quantity demanded = 4 units. To find Rex’s quantity demanded at the price of $7, we use the same logic as above. The sum of the individual quantities demanded equals 12 (total quantity demanded). We also know that the sum for Tex and Dex equals 10 (= 8 + 2). This implies Rex’s quantity demanded at $7 must equal 2 (= 12 (Total) – 8 (Tex) – 2 (Dex)). The same algorithm can be applied to the other rows. At $6 the quantity demanded by Tex equals 12 (= 19 – 3 –4). At $5 the quantity demanded by Dex equals 4 (= 27 –17 – 6). At the price of $4, the total quantity demanded equals 36 (= 23 +5 + 8).

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b. At a price of $5, Dex demands the least amount of goods, which equals 4. Tex demands 17, and Rex demands 6. At a price of $7, Tex demands the most amount of goods, which equals 8. Dex demands 2, and Rex demands 2. c. When the price is lowered from $7 to $6, Tex’s quantity demanded increases by 4 (= 12 – 8), Dex’s quantity demanded increases by 1 (= 3 – 2), and Rex’s quantity demanded increases by 2 (= 4 – 2). Thus, Tex’s quantity demanded increases the most when the price is lowered from $7 to $6.

d. If Tex withdrew from the market, there would be less demand at every price level. This implies that the demand schedule would shift to the left. If Dex doubled his purchases at every price level, this would increase demand. This implies that the demand schedule would shift to the right. e. Since the price is fixed in the statement, this is a change in demand. A change in the quantity demanded results from a change in price.

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Problem 2 The figure below shows the supply curve for tennis balls, S1, for Drop Volley Tennis, a producer of tennis equipment. Use the figure and the table below to give your answers to the following questions. LO2

a. Use the figure to fill in the quantity supplied on supply curve S1 for each price in the table below.

b. If production costs were to increase, the quantities supplied at each price would be as shown by the third column of the table (―S2 Quantity Supplied‖). Use that data to draw supply curve S2 on the same graph as supply curve S1.

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c. In the fourth column of the table, enter the amount by which the quantity supplied at each price changes due to the increase in product costs. (Use positive numbers for increases and negative numbers for decreases.)

d. Did the increase in production costs cause a ―decrease in supply‖ or a ―decrease in quantity supplied‖?

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Answer a. The quantity supplied is 15 at $3, 10 at $2, and 5 at $1. This is found by reading the values of the supply curve. b.

c. The increase in production costs causes supply to decrease at each price level. Supply falls from 15 to 4 for at the price of $3; thus, the change is –11. Supply falls from 10 to 2 at the price of $2; thus, the change is –8. Supply falls from 5 to 0 at the price of $1; thus, the change is –5. d. This is a decrease in supply because the schedule shifts left (less quantity supplied at every price).

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Problem 3 Refer to the expanded table below from question 11. a. What is the equilibrium price? At what price is there neither a shortage nor a surplus? Fill in the surplus-shortage column and use it to confirm your answers. b. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph correctly.

Label equilibrium price P and equilibrium quantity Q. c. How big is the surplus or shortage at $3.40? At $4.90? How big a surplus or shortage results if the price is 60 cents higher than the equilibrium price? 30 cents lower than the equilibrium price? LO3

Answer a. Pe = $4.00. Equilibrium occurs where there is neither a shortage nor surplus of wheat. At the immediately lower price of $3.70, there is a shortage of 7,000 bushels. At the immediately higher price of $4.30, there is a surplus of 7,000 bushels. Thus, data from top to bottom in the shortage and surplus column is –13; –7; 0; +7; +14; and +21.

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b.

c. Note: shortages will be negative and surpluses will be positive. At the price of $3.40, there will be a 13,000-bushel shortage (= 72,000 – 85,000 = –13,000). At the price of $4.90, there will be a 21,000bushel surplus (= 81,000 – 60,000 = 21,000). At the price of $4.60 (60 cents higher than the equilibrium price), there will be a surplus of 14,000 bushels (= 79,000 – 65,000 = 14,000). At the price of $3.70 (30 cents lower than the equilibrium price), there will be a shortage of 7,000 bushels (= 73,000 – 80,000 = – 7,000).

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Problem 4 How will each of the following changes in demand and/or supply affect equilibrium price and equilibrium quantity in a competitive market; that is, do price and quantity rise, fall, or remain unchanged, or are the answers indeterminate because they depend on the magnitudes of the shifts? Use supply and demand to verify your answers. LO4 a. Supply decreases and demand is constant. b. Demand decreases and supply is constant. c. Supply increases and demand is constant. d. Demand increases and supply increases. e. Demand increases and supply is constant. f. Supply increases and demand decreases. g. Demand increases and supply decreases. h. Demand decreases and supply decreases.

Answer a. The decrease in supply with a constant demand results in an increase in equilibrium price and a decrease in equilibrium quantity as shown in the figure.

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b. The decrease in demand with a constant supply results in a decrease in equilibrium price and a decrease in equilibrium quantity as shown in the figure.

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c. The increase in supply with a constant demand results in a decrease in equilibrium price and an increase in equilibrium quantity as shown in the figure.

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d. The increase in supply and the increase in demand unambiguously increase the equilibrium quantity.

This is because the increase in supply and the increase in demand both increase the equilibrium quantity.

However, the change in equilibrium price is indeterminate because the increase in supply puts downward pressure on the equilibrium price and the increase in demand puts upward pressure on the equilibrium price. The figure shows these effects when the demand effect dominates.

e. The increase in demand with a constant supply results in an increase in equilibrium price and an increase in equilibrium quantity as shown in the figure.

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f. The increase in supply and the decrease in demand unambiguously decrease the equilibrium price. This is because the increase in supply and the decrease in demand both put downward pressure on the equilibrium price. However, the change in equilibrium quantity is indeterminate because the increase in supply increases the equilibrium quantity and the decrease in demand decreases the equilibrium quantity.

The figure below shows these effects when the supply effect dominates.

g. The decrease in supply and the increase in demand unambiguously increase the equilibrium price. This is because the decrease in supply and the increase in demand both put upward pressure on the equilibrium price. However, the change in equilibrium quantity is indeterminate because the decrease in supply decreases the equilibrium quantity and the increase in demand increases the equilibrium quantity. The figure below shows these effects when the demand effect dominates.

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h. The decrease in supply and the decrease in demand unambiguously decrease the equilibrium quantity.

This is because the decrease in supply and the decrease in demand both decrease the equilibrium quantity.

However, the change in equilibrium price is indeterminate because the decrease in supply puts upward pressure on the equilibrium price and the decrease in demand puts downward pressure on the equilibrium price. The figure below shows these effects when the supply effect dominates.

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Problem 5 Use two market diagrams to explain how an increase in state subsidies to public colleges might affect tuition and enrollments in both public and private colleges. LO4

Answer Consider the case of subsidies to public colleges. The state subsidies to public colleges shift the supply curve of the public colleges to the right, thus reducing tuition and increasing enrollments in these institutions. The decreased cost of public college education leads to some substitution away from the private colleges, where the enrollment demand curve shifts to the left. The final result is a lower cost of tuition in both public and private colleges.

Problem 6 Assume that demand for a commodity is represented by the equation = 10 - 0.2Qd and supply by the equation P = 2 + 0.2Qs, where Qd and Qs are quantity demanded and quantity supplied, respectively, and P is price. Using the equilibrium condition Qs = Qd, solve the equations to determine equilibrium price and equilibrium quantity. LO4

Answer Consider the following equations: Demand for a commodity is P = 10 – 0.2Qd Supply of the commodity is P = 2 + 0.2Qs To solve this system of equations, we use the fact that the equilibrium price in both equations must be the same. Therefore, we can equate the two (eliminate P from the system).

This gives us: 10 – 0.2Qd = 2 + 0.2Qs We now use the equilibrium condition for quantity: Qs = Qd= Q We substitute Q for Qd and Qs. This gives us: 10 – 0.2Q = 2 + 0.2Q 1-68 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Solving for Q: 0.2Q + 0.2Q = 8 or 0.4Q = 8 The equilibrium quantity is: Q = (8/0.4) = 20

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To find the equilibrium price, we substitute the equilibrium quantity Q = 20 into either the demand function or supply function.

The demand function P = 10 – 0.2Q = 10 – 0.2 × 20 = 10 – 4 = 6 The supply function P = 2 + 0.2Q = 2 + 0.2 × 20 = 2 + 4 = 6 The answers are the same; this is the equilibrium price, or P = 6.

Problem 7 Suppose that the demand and supply schedules for rental apartments in the city of Gotham are as given in the table below. LO5

a. What is the market equilibrium rental price per month and the market equilibrium number of apartments demanded and supplied?

b. If the local government can enforce a rent-control law that sets the maximum monthly rent at $1500, will there be a surplus or a shortage? Of how many units? And how many units will actually be rented each month?

c. Suppose that a new government is elected that wants to keep out the poor. It declares that the minimum rent that can be charged is $2500 per month. If the government can enforce that price floor, will there be a surplus or a shortage? Of how many units? And how many units will actually be rented each month? d. Suppose that the government wishes to decrease the market equilibrium monthly rent by increasing the supply of housing. Assuming that demand remains unchanged, how many additional units of housing 1-70 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

would the government need to supply to get the market equilibrium rental price to fall to $1500 per month? To $1000 per month? To $500 per month?

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Answer a. The market equilibrium price is determined by the relationship quantity supplied equals quantity demanded. Thus, to find the equilibrium price, we find the price where the quantities are equal, which occurs at the rent (price) of $2,000. The equilibrium quantity at this price is 12,500 apartments. b. If the government imposes a maximum rent of $1,500, the quantity of apartments supplied equals 10,000 and the quantity of apartments demanded equals 15,000. Thus, there is a shortage of 5,000 apartments (= 15,000 (quantity demand) – 10,000 (quantity supply)). The amount of apartments actually rented will be determined by supply here. There are only 10,000 available for rent, so only 10,000 will be rented

c. If the government imposes a minimum rent of $2,500, the quantity of apartments supplied equals 15,000 and the quantity of apartments demanded equals 10,000. Thus, there is a surplus of 5,000 apartments (= 15,000 (quantity supply) – 10,000 (quantity demand)). The amount of apartments actually rented will be determined by demand here. There are only 10,000 households that want to rent, so only 10,000 will be rented. d. If the government wants to reduce the market equilibrium rent to $1,500 per month, the government would need to increase the supply of apartments by 2,500 units. To see this, start in equilibrium. Here the equilibrium rent is $2,000 and the equilibrium quantity is 12,500 units. If the government adds 2,500 units, there will now be 15,000 units for rent in the market. The equilibrium price is now $1,500 (the rent desired by government) and the equilibrium quantity is 15,000.

If the government wanted to reduce the equilibrium rent to $1,000, they would need to add 5,000 units.

This would result in 17,500 units on the market (12,500 already on the market plus the 5,000 new apartments), which has an equilibrium rent of $1,000.

If the government wanted to reduce the equilibrium rent to $500, they would need to add 7,500 units. This would result in 20,000 units on the market (12,500 already on the market plus the 7,500 new apartments), which has an equilibrium rent of $500.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 3 Appendix

Additional Examples of Supply and Demand

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QUESTIONS

Question 13 Why are shortages or surpluses more likely with preset prices (such as those on tickets) than with flexible prices (such as those on gasoline)? LO6

Answer Preset prices, rather than responding to demand conditions, attempt to predict the level of demand that will produce an equilibrium quantity. If these predictions are incorrect, there will be an imbalance between the quantity supplied and the quantity demanded. Preset prices often apply to one-time-only events, versus something like gasoline that is sold regularly and repeatedly. Sellers can learn from experience how to adjust prices to best meet demand.

Question 14 Most scalping laws make it illegal to sell—but not to buy—tickets at prices above those printed on the tickets. Assuming the existence of such laws, use supply and demand analysis to explain why the equilibrium ticket price in an illegal secondary market tends to be higher than in a legal secondary market.

LO6

Answer Ticket prices tend to be higher in illegal secondary markets because sellers face higher costs (thus reducing supply relative to what it would be in a legal secondary market). The additional costs include the higher transactions costs (finding secret locations to transact, monitoring for law enforcement, screening clients, etc.) and compensation for the risk of getting caught (with the associated costs of legal services, fines, incarceration, etc.).

Question 15 Go to the website of the Energy Information Administration, www.eia.doe.gov, and follow the links to find the current retail price of gasoline. How does the current price of regular gasoline compare with the price a year ago? What must have happened to supply, demand, or both to explain the observed price change? LO6

Answer The answer here will depend on the time of the exercise.

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Question 16 Suppose the supply of apples sharply increases because of perfect weather conditions throughout the growing season. Assuming no change in demand, explain the effect on the equilibrium price and quantity of apples. Explain why quantity demanded increases even though demand does not change. LO6

Answer The increase in supply will lower the equilibrium price and increase the equilibrium quantity of apples.

The increase in supply implies that the supply schedule shifts to the right (more apples are supplied at every price). Quantity demanded increases without a shift in the demand curve because the greater supply causes price to fall. This fall in price causes movement along the demand schedule.

Question 17 Assume the demand for lumber suddenly rises because of a rapid growth in demand for new housing.

Assume no change in supply. Why does the equilibrium price of lumber rise? What would happen if the price did not rise under the demand and supply circumstances described? LO6

Answer Buyers are willing to purchase more new housing, causing price and quantity to increase in that market.

In order to satisfy the increased demand for new housing, more lumber (and other building materials) is needed. The greater willingness to pay for housing implies a greater willingness to pay for the materials and labor needed to produce that housing. As the resources become increasingly scarce (because of a given supply and increasing demand), the price rises.

If something prevented an increase in the price of lumber (e.g., a price control by government), a shortage of lumber would result and not all of the new houses demanded could be built.

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Question 18 Suppose both the demand for olives and the supply of olives decline by equal amounts over some time period. Use graphical analysis to show the effect on equilibrium price and quantity. LO6

Answer

The supply and demand curves would shift left by an equal amount, reducing the equilibrium quantity and leaving the equilibrium price unchanged.

Question 19 Assume that both the supply of bottled water and the demand for bottled water rise during the summer but that supply increases more rapidly than demand. What can you conclude about the directions of the impacts on equilibrium price and equilibrium quantity? LO6

Answer The equilibrium price will fall and the equilibrium quantity will rise. Whenever supply and demand both increase, equilibrium quantity will rise. Equilibrium price falls because the increase in supply is greater than the increase in demand (see figure below).

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Price of Bottled Water

S1

S2 P1 P2 D2 D1

Q1

Q2

Quantity of Bottled Water

PROBLEMS

Problem 1 Demand and supply often shift in the retail market for gasoline. Here are two demand curves and two supply curves for gallons of gasoline in the month of May in a small town in Maine. Some of the data is missing. LO6

a. Use the following facts to fill in the missing data in the table. If demand is D1 and Supply is S1, the equilibrium quantity is 7,000 gallons per month. When demand is D2 and supply is S1, the 1-76 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

equilibrium price is $3.00 per gallon. When demand is D2 and supply is S1, there is an excess demand of 4,000 gallons per month at a price of $1.00 per gallon. If demand is D1 and supply is S2, the equilibrium quantity is 8,000 gallons per month. b. Compare two equilibriums. In the first, demand is D1 and supply is S1. In the second, demand is D1 and supply is S2. By how much does the equilibrium quantity change? By how much does the equilibrium price change? c. If supply falls from S2 to S1 while demand declines from D2 to D1, does the equilibrium price rise or fall or stay the same? What happens if only supply falls? What happens if only demand falls? d. Suppose that supply is fixed at S1 and that demand starts at D1. By how many gallons per month would demand have to increase at each price such that the equilibrium price per gallon would be $3.00? $4.00?

Answers: (a) See the complete table below for the missing values; (b) equilibrium quantity increases by 1,000 gallons per month, the equilibrium prices falls by $1.00; (c) equilibrium price stays the same (at $2.00), equilibrium price rises (from $2.00 to $3.00), equilibrium price falls (from $2.00 to $1.00); (d) 2,000 gallons per month, 4,000 gallons per month.

Answer Feedback: a. If demand is D1 and Supply is S1, the equilibrium quantity is 7,000 gallons per month. We can eliminate all rows except the third row in the table above because we actually have values for the first two rows for D1 and S1 and the fourth row has a value of 5,000 for S1. In equilibrium S1 must equal D1, so the only row where this can hold is row 3. So, the entry for row 3- D1 is 7,000 and the entry for row 3-S1 is 7,000 as well.

When demand is D2 and supply is S1, the equilibrium price is $3.00 per gallon. Equilibrium for D2 and S1 occurs at a quantity of 8,000. Therefore, the price in row 2 is $3.00.

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When demand is D2 and supply is S1, there is an excess demand of 4,000 gallons per month at a price of $1.00 per gallon. The excess demand of 4,000 occurs in row 4 for D2 and S1.

This implies the price in row 4 is $1.00.

If demand is D1 and supply is S2, the equilibrium quantity is 8,000 gallons per month. Since the equilibrium quantity must equal 8,000 for D1 and S2, and the only remaining missing quantity entries are in row 4 for D1 and S2, implies that the entries for D1 and S2 in row 4 (quantities) are 8,000.

b. The initial equilibrium for D1 and S1 is Q = 7,000 and P = $2.00. The second equilibrium for D1 and S2 (an increase in supply) is Q = 8,000 and P = $1.00. Thus, the change in quantity is an increase of 1,000 (= 8,000 – 7,000) and the change in price is a decrease of $1.00 (= $2.00 – $1.00).

c. The initial equilibrium for S2 and D2 is Q = 8,500 and P = $2.00. The second equilibrium for S1 and D1 (both supply and demand fall) is Q = 7,000 and P = $2.00. The equilibrium price remains the same at P = $2.00. The third equilibrium for D2 and S1 (only supply falls) is Q = 8,000 and P = $3.00. Compared to the initial equilibrium price increases from $2.00 to $3.00.

The fourth equilibrium for S2 and D1 (only demand falls) is Q = 8,000 and P = $1.00.

Compared to the initial equilibrium price falls from $2.00 to $1.00.

d. Since supply is fixed at S1 and demand starts at D1 the initial equilibrium is Q = 7,000 and P = $2.00. For the equilibrium price to increase to $3.00 (from $2.00) demand would need to increase by 2,000. This would result in an equilibrium Q = 8,000 and P = $3.00 (D2 and S1).

Note: the original demand at $3.00 is only 6000, so to support an equilibrium price of $3.00 demand would need to be 2,000 higher. The same logic applies for the equilibrium price of $4.00. If demand is going to support the equilibrium price of $4.00, then demand will need to increase from 5,000 (D1) to 9,000 (D2). Thus, demand will need to increase by 4,000 and the new equilibrium is Q = 9,000 and P = $4.00 (D2 and S1).

Problem 2 The table below shows two demand schedules for a given style of men’s shoes—that is, how many pairs per month will be demanded at various prices at Stromnord, a men’s clothing store.

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Suppose that Stromnord has exactly 65 pairs of this style of shoe in inventory at the start of the month of July and will not receive any more pairs of this style until at least August first. LO6

a. If demand is D1, what is the lowest price that Stromnord can charge so that it will not run out of this model of shoes in the month of July? What if demand is D2? b. If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, how many pairs of shoes should Stromnord order if it wants to end the month of August with exactly zero pairs of shoes in its inventory? How many pairs of shoes should it order if the price is set at $55 for both months?

Answers: (a) $70, $55; (b) Order 1 pair for August; order 49 pairs for August.

Feedback: a. If demand is D1, the lowest price Stromnord can charge $70 if it does not want to run out of shoes in the month of July. A price of $65 would result in a demand of 68 pairs of shoes and Stromnord only has 65 in inventory. (Note: answers must use the values in the table). If demand is D2, the lowest price Stromnord can charge $55 if it does not want to run out of shoes in the month of July because the demand for shoes is only 27 pairs at this price. This is the lowest value in the table.

b. If the price of shoes is set at $75 for both July and August and demand will be D2 in July and D1 in August, then the total demand for these months is 66 pairs of shoes. Since Stromnord 1-79 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

has 65 pairs in inventory they will need to order 1 more pair to meet demand for both months.

If the price is set at $55 total demand for both months will be 114. Here Stromnord will need to order 49 pairs (= 114 – 65).

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Problem 3 Use the table below to answer the questions that follow: LO6 a. If this table reflects the supply of and demand for tickets to a particular World Cup soccer game, what is the stadium capacity? b. If the preset ticket price is $45, would we expect to see a secondary market for tickets? Why or why not? Would the price of a ticket in the secondary market be higher than, the same as, or lower than the price in the primary (original) market? c. Suppose for some other World Cup game the quantities of tickets demanded are 20,000 lower at each ticket price than shown in the table. If the ticket price remains $45, would the event be a sellout?

Answers: (a) 60,000; (b) Yes, higher; (c) No.

Feedback: a. Stadium Capacity is 60,000. We can infer this from the constant supply independent of price. b. If the preset ticket price is $45, we would expect to see a secondary market because there is a shortage of tickets at this price. The shortage of tickets, which equals 10,000, would allow individuals who have the tickets (or get to purchase the tickets) to resell them for a higher price. This is because the market would result in a higher equilibrium price of $65, which implies some individuals are willing to pay between $46 and $65 for the tickets. Thus, the price in the secondary market would be higher.

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c. If demand were 20,000 less at each price, the quantity demanded at $45 would only be 50,000 [= 70,000 (original demand) – 20,000 (decline in demand)]. Since capacity is 60,000 this would not be a sellout.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 4

Elasticity of Demand and Supply

QUESTIONS

Question 1 What is the formula for measuring price elasticity of demand? What does it mean (in terms of relative price and quantity changes) if the price-elasticity coefficient is less than 1? Equal to 1? Greater than 1?

LO1

Answer Price elasticity of demand is found by dividing the percentage change in quantity demanded by the percentage change in price. Over a range of prices, we use the midpoint formula:

Change in Q Sum of Q 2 Ed  Change in P Sum of P 2 If the price elasticity coefficient is less than 1, this means that the percentage change in quantity demanded is relatively smaller than the change in price—consumers are relatively unresponsive to price changes. A coefficient of 1 means that the percentage changes are equal—a 10 percent price decrease will cause a 10 percent increase in quantity demanded. A coefficient greater than one means that consumers are relatively responsive to price changes—the quantity response is greater than the price change (in percentage terms).

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Question 2 Suppose that the total revenue received by a company selling basketballs is $600 when the price is set at $30 per basketball and $600 when the price is set at $20 per basketball. Without using the midpoint formula, identify whether demand is elastic, inelastic, or unit-elastic over this price range. LO2

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Answer The company is initially selling 20 basketballs at a price of $30, which results in a total revenue of $600.

The company then decreases its price to $20 a ball and still has a total revenue of $600. This implies that the company is now selling 30 basketballs. The decrease in price of $10 on the previous balls sold resulted in a decrease in revenue of $200 (= $10 × 20). However, the company sells 10 more balls at the lower price, resulting in a $200 increase in revenue (= $20 × 10). Thus, we know that demand is unitelastic over this range because there is no change in total revenue.

Question 3 What are the major determinants of price elasticity of demand? Use those determinants and your own reasoning in judging whether demand for each of the following products is probably elastic or inelastic: (a) bottled water; (b) toothpaste; (c) Crest toothpaste; (d) ketchup; (e) diamond bracelets; (f) Microsoft’s Windows operating system. LO1

Answer The key determinants of price elasticity are substitutability, proportion of income; luxury versus necessity, and time. a. bottled water. This good is likely elastic because there are a number of substitutes (water fountains, cans of soda, etc. . . .). b. toothpaste. This good is likely inelastic because there aren’t many substitutes and it is a necessity (in economic terms). c. Crest toothpaste. This specific brand of the good is likely elastic. There are a number of substitutes for this specific brand of the good. d. ketchup. This good is likely inelastic. There aren’t many substitutes for ketchup (for people who like ketchup) and it makes up a small percentage of income. e. diamond bracelets. This good is likely elastic because it is a luxury good and may make up a large fraction of income (more than ketchup). f. Microsoft’s Windows operating system. This good is likely inelastic because there aren’t many substitutes for this good and it has become a necessity in a number of workplaces.

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Question 4 What effect would a rule stating that university students must live in university dormitories have on the price elasticity of demand for dormitory space? How might this rule affect room rates? LO1

Answer The ruling would make the price elasticity of demand more inelastic than if there were no such rule, assuming that there is not another equivalent university nearby to which students could transfer. Although universities are nonprofit organizations, the rule would certainly allow them to raise rates without worrying so much about students moving out to live elsewhere.

Question 5 Calculate total-revenue data from the demand schedule in Problem 3. Referring to changes in Price and total revenue move in the opposite directions, when the demand is elasticity. LO2

Answer To calculate total revenue multiply price and quantity. At the price of $5 one unit is sold. Thus, total revenue is $5 × 1 = $5. At the price of $2 total revenue is $4 × 2 = $8; at $3 total revenue is $3 × 3 = $9; at $4 total revenue is $4 × 2 = $8; and at $1 total revenue is $1 × 5 = $5. When demand is elastic, price and total revenue move in the opposite direction. This is because the percentage change in quantity is greater than the percentage change in price. When demand is inelastic, price and total revenue move in the same direction because the percentage change in quantity is less than the percentage change in price.

Question 6 How would the following changes in price affect total revenue? That is, would total revenue increase, decrease, or remain unchanged? LO2 a. Price falls and demand is inelastic. b. Price rises and demand is elastic. c. Price rises and supply is elastic. d. Price rises and supply is inelastic. e. Price rises and demand is inelastic.

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f. Price falls and demand is elastic. g. Price falls and demand is of unit elasticity.

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Answer When demand is elastic, price and total revenue move in the opposite direction. This is because the percentage change in quantity is greater than the percentage change in price. When demand is inelastic, price and total revenue move in the same direction because the percentage change in quantity is less than the percentage change in price.

Supply is a simpler story. Since price and quantity move in the same direction, an increase in price will result in an increase in total revenue (a higher price and selling more) and a decrease in price will result in a decrease in total revenue (a lower price and selling less).

Using these rules, we have the following answers; a. Total revenue decreases. (As the price falls, individuals purchase more of the good. However, the decrease in price on the previous units sold outweighs the gains from selling more units.) b. Total revenue decreases. (As the price increases, individuals purchase less of the good, reducing total revenue. However, the increase in price on the previous units sold increases total revenue. Here the loss in quantity sold outweighs the increase in price effect.) c. Total revenue increases. d. Total revenue increases. e. Total revenue increases. f. Total revenue increases. g. No change. (Here the decrease in total revenue that results from the decrease in price is offset by the increase in total revenue from selling more units.)

Question 7 You are chairperson of a state tax commission responsible for establishing a program to raise new revenue through excise taxes. Why would elasticity of demand be important to you in determining the products on which the taxes should be levied? LO4

Answer Elasticity of demand would be very important to me. I would select goods for which the demand was price inelastic. When demand is price inelastic, the decrease in quantity demanded as a result of the price increase caused by the excise tax is proportionately less than the increase in price. As a result, tax revenues will increase. An ideal good would be one for which the demand was perfectly inelastic. In such a case, there would be no decrease in quantity demanded at all when an excise tax was levied. Also, it would be helpful to find a good whose consumption is harmful. On these two counts, cigarettes and liquor 1-88 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

make excellent candidates for excise taxes; to the extent that there is any cutback in consumption at all, the majority view now is that this is a good thing.

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Question 8 In 2017, Leonardo da Vinci's painting Salvador Mundi sold for $450 million. Portray this sale in a demand and supply diagram and comment on the elasticity of supply. Comedian George Carlin once mused, ―If a painting can be forged well enough to fool some experts, why is the original so valuable?‖ Provide an answer. LO4

Answer The supply is perfectly inelastic—vertical—at a quantity of 1 unit. The $450 million price is determined where the downward sloping demand curve intersected this supply curve. Since the supply curve intersects the demand curve above its midpoint, the elasticity of demand must be elastic at the existing price of $450 million.

There can be many forged copies of a painting but only one original, even if buyers can be fooled by a forgery.

Question 9 The income elasticities of demand for movies, dental services, and clothing have been estimated to be +3.4, +1.0, and +0.5, respectively. Interpret these coefficients. What does a negative income-elasticity coefficient mean? LO5

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All are normal goods—income and quantity demanded move in the same direction. These coefficients reveal that a 1 percent increase in income will increase the quantity of movies demanded by 3.4 percent, of dental services by 1 percent, and of clothing by 0.5 percent. A negative coefficient indicates an inferior good—income and quantity demanded move in the opposite direction.

Question 10 Suppose the cross-elasticity of demand for products A and B is +3.6, and for products C and D is -5.4.

What can you conclude about how products A and B are related? Products C and D? LO5

Answer The cross elasticity relates the percentage change in quantity to the percentage change in price of a different good. If the cross elasticity is positive, this implies that an increase in the price of one good results in an increase in the quantity purchased of another good. This implies the goods are substitutes; as the price of one good increases, consumers substitute into the other good (purchase more).

This implies that goods A and B are substitutes and that goods C and D are complements. For reference, if the cross elasticity is negative, this implies that an increase in the price of one good results in a decrease in the quantity purchased of another good. This implies that the goods are complements; as the price of one good increases, consumers reduce the consumption of the other good (purchase less).

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PROBLEMS

Problem 1 Look at the demand curve in Figure 4.2a. Use the midpoint formula and points a and b to calculate the elasticity of demand for that range of the demand curve. Do the same for the demand curves in Figures 4.2b and 4.2c using, respectively, points c and d for Figure 4.2b and points e and f for Figure 4.2c. LO1

Answer To calculate the elasticity, we use the midpoint formulas. Recall that the elasticity is the percentage change in quantity divided by the percentage change in price. We take the absolute value to convert the elasticity to a positive number.

Given the two points in the left figure (10,2) and (40,1) [note that the ordered pair is (Q,P)], we can calculate the elasticity.

Given the two points in the right figure (10,4) and (20,1), we can calculate the elasticity.

Given the two points in the third figure (10,3) and (30,1), we can calculate the elasticity. (Note this is an approximation of the nonlinear schedule.)

Problem 2 Investigate how demand elasticities are affected by increases in demand. Shift each of the demand curves in Figures 4.2a, 4.2b, and 4.2c to the right by 10 units. For example, point a in Figure 4.2a would shift rightward from location (10 units, $2) to (20 units, $2), while point b would shift rightward from location (40 units, $1) to (50 units, $1). After making these shifts, apply the midpoint formula to calculate the demand elasticities for the shifted points. Are they larger or smaller than the elasticities you calculated in 1-92 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

problem 1 for the original points? In terms of the midpoint formula, what explains the change in elasticities? LO1

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Answer To calculate the elasticity, we use the midpoint formulas. Recall that the elasticity is the percentage change in quantity divided by the percentage change in price. We take the absolute value to convert the elasticity to a positive number.

Given the two points in Figure 4.2a (10,2) and (40,1) [note that the ordered pair is (Q,P)], we can calculate the elasticity.

The price changes stay the same. In the numerator we have: (50 – 20)/((50 + 20)/2).

The elasticity calculation becomes: 0.86/–0.67 = 1.30 in absolute value.

Given the two points in Figure 4.2b (10,4) and (20,1), we can calculate the elasticity.

The price changes stay the same. In the numerator we have: (30 – 20)/((30 + 20)/2).

The elasticity calculation becomes: 0.4/–1.2 = 0.33 in absolute value.

Given the two points in Figure 4.2c (10,3) and (30,1), we can calculate the elasticity. (Note this is an approximation of the nonlinear schedule.)

The price changes stay the same. In the numerator we have: (40 – 20)/((40 + 20)/2).

The elasticity calculation becomes: 0.67/–1.0 = 0.67 in absolute value.

If we compare the elasticities, we can see that an increase in quantity at every price (shift the demand schedule to the right) reduces the elasticity. The percentage change in quantity is smaller given the higher quantity purchased at every price.

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Problem 3 Graph the accompanying demand data, and then use the midpoint formula for Ed to determine price elasticity of demand for each of the four possible $1 price changes. What can you conclude about the relationship between the slope of a curve and its elasticity? Explain why nontechnical way why demand is elastic in the upper-left segment of the demand curve and inelastic in the lower-right segment. LO1

Answer

Feedback:

To calculate the elasticity, we use the midpoint formula. First, we calculate the percentage change in quantity. Second, we calculate the percentage change in price.

Then we divide the percentage change in quantity by the percentage change in price.

To report the values as positive numbers, we then take the absolute value of the answer. For example, we have the following elasticities as we move down the demand schedule (demand elasticities are reported as positive values).

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Moving from $5 to $4: elasticity = 3 in absolute value Moving from $4 to $3: elasticity = 1.4 in absolute value As we move from $3 to $2, the elasticity is 0.714, and as we move from $2 to $1, the elasticity is 0.333.

This demand curve has a constant slope of – 1 (= – 1/1), but elasticity declines as we move down the curve.

When the initial price is high and the initial quantity is low, a unit change in price is a low percentage change while a unit change in quantity demanded is a high percentage change. The percentage change in quantity demanded exceeds the percentage change in price, making demand elastic. When the initial price is low and the initial quantity demanded is high, a unit change in price is a high percentage change while a unit change in quantity demanded is a low percentage change. The percentage change in quantity demanded is less than the percentage change in price, making demand inelastic.

Problem 4 Danny ―Dimes‖ Donahue is a neighborhood’s 9-year old entrepreneur. His most recent venture is selling homemade brownies that he bakes himself. At a price of $1.50 each, he sells 100. At a price of $1.00 each, he sells 300. Is demand elastic or inelastic over this price range? If demand had the same elasticity for a price decline from $1.00 to $0.50 as it does for the decline from $1.50 to $1.00, would cutting the price from $1.00 to $0.50 increase or decrease Danny’s total revenue? LO2

Answer The total revenue rule implies that demand is elastic when revenue and price move in opposite directions.

In other words, a decrease in price results in an increase in total revenue. We can use this rule to answer this question.

Consider the following values: At a price of $1.50 each, Danny sells 100. At a price of $1.00 each, he sells 300. Is demand elastic or inelastic over this price range?

Total revenue at the price $1.50 and the quantity of 100 equals $150 (= $1.50 × 100). Danny then decreases his price to $1.00 and sells 300 brownies now. Total revenue at this new price equals $300 (= $1.00 × 300). Since total revenue increased after Danny decreased his price, we know from the rule above that demand is elastic over this range.

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We can also answer the following question now: If demand had the same elasticity for a price decline from $1.00 to $0.50 as it does for the decline from $1.50 to $1.00, would cutting the price from $1.00 to $0.50 increase or decrease Danny’s total revenue?

The answer is obviously yes. A decrease in price would increase total revenue because demand is elastic over this range as well.

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Problem 5 What is the formula for measuring the price elasticity of supply? Suppose the price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies 1,200 boxes of apples instead of 1,000 boxes. Compute the coefficient of price elasticity (midpoints approach) for Goldsboro’s supply. Is its supply elastic or inelastic? Explain. LO3

Answer

elasticity of supply = percentage change in quantity supplied percentage change in price Es = 1.91; supply is elastic Here we have two ordered pairs (1000, 20) and (1200, 22), note the form is (Q,P).

The same interpretation for the price elasticity of demand also applies. Supply is elastic if greater than 1, inelastic if less than 1, and is unit elastic if the elasticity equals 1. Thus, in this case, supply is elastic.

Problem 6 ADVANCED ANALYSIS Currently, at a price of $1 each, 100 popsicles are sold per day in the perpetually hot town of Rostin. Consider the elasticity of supply. In the short run, a price increase from $1 to $2 is unit-elastic (Es =1.0). How many popsicles will be sold each day in the short run if the price rises to $2 each? In the long run, a price increase from $1 to $2 has an elasticity of supply of 1.50. How many popsicles will be sold per day in the long run if the price rises to $2 each? (Hint: Apply the midpoint approach to the elasticity of supply.) LO3

Answer

Answers: 200 per day in the short run; 300 per day in the long run.

Feedback: To answer this question we need to use the midpoint formula. Assume we have the two ordered pairs (Q1,P1) and (Q2,P2).

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We can then solve this equation to determine the quantity sold as a result of a price increase.

Consider the following values: At a price of $1 each, 100 popsicles are sold per day in Rostin. In the short run, a price increase from $1 to $2 is unit elastic (Es = 1.0). So how many popsicles will be sold each day in the short run if the price rises to $2 each? In the long run, a price increase from $1 to $2 has an elasticity of 1.50. So how many popsicles will be sold per day in the long run if the price rises to $2 each?

For the short run we have the following information: Es = 1 with the ordered pairs of (100,1) and (Q2,2). Here we need to solve for Q2. Substituting the values into the above formula, we have:

This implies,

Solving for Q2 we have the following:

We can do the same exercise for the long run. Here we have the following information.: Es = 1.5 with the ordered pairs of (100,1) and (Q2,2). Here we need to solve for Q2.

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This implies:

Thus, we sell 200 popsicles in the short run and 300 in the long run when price increases from $1 to $2. (Note, this implies an increase in demand (shift right)).

Problem 7 Ariya likes to play golf. The number of times per year that she plays depends on the price of playing a round of golf, Ariya’s income, and the price of other types of entertainment—in particular, the price of going to a movie instead of playing golf. The three demand schedules in the following table show how many rounds of golf per year Ariya will demand at each price per round under three different scenarios.

In scenario D1, Ariya’s income is $50,000 per year and movies cost $9 each. In scenario D2, Ariya’s income is also $50,000 per year, but the price of seeing a movie rises to $11. And in scenario D3, Ariya’s income goes up to $70,000 per year, while movies cost $11. LO5

a. Using the data under D1 and D2, calculate the cross elasticity of Ariya’s demand for golf at all three prices. (To do so, apply the midpoint approach to the cross elasticity of demand.) Is the cross elasticity the same at all three prices? Are movies and golf substitute goods, complementary goods, or independent goods? Explain. b. Using the data under D2 and D3, calculate the income elasticity of Ariya’s demand for golf at all three prices. (To do so, apply the midpoint approach to the income elasticity of demand.) Is the income elasticity the same at all three prices? Is golf an inferior good?

Explain.

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Answer (a) -2.00, -2.50, -3.33; No, the cross price elasticity is not the same at the three prices; Movies and golf are complementary goods. (b) 1.20, 2.00, 2.57; No, the income elasticity is different at each of the three prices; No, golf is not an inferior good—it is a normal good.

Feedback: a. To calculate the cross elasticity, we use the percentage change in quantity of one good divided by the percentage change in the price of another good. For the current problem we will look at the percentage in the quantity of golf games divided by the percentage change in the price of movies.

At the price of $50 for a golf game (hold constant for this calculation because we are looking at how golf games respond to a change in the price of movies) we have the following ordered pairs (15, 9) and (10, 11). Note that the ordered pair is (golf games, price of a movie).

Here we use the same formula:

We do the same exercise for $35. Here we have the ordered pairs (25,9) and (15,11).

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Finally we have the ordered pairs (40,9) and (20,11) at the price of $20 for a game of golf.

The cross-elasticities are not the same at all three golf game prices. The percentage change in quantity is larger the lower the price.

To determine if movies and golf are substitute goods, complementary goods, or independent goods we have the following rule.

If the cross elasticity is negative, then the goods are complements. The logic underlying this rule is as follows: If the price of a movie increases, we know that we will see fewer movies. This implies that the quantity of movies declines. Also, given the negative cross elasticity we know that golf games decline as the price of a movie increases. This implies that as the price of movies goes up, we consume less movies and golf games. This implies the goods are complements.

Thus, our answer is golf and movies are complements.

A similar logic applies to substitute goods. If the price of good A increases, then the quantity demanded of good A goes down. If the cross elasticity is positive, then this implies the demand for the good B increases as a result of the price increase for good A. Thus, the quantity of good A decreases and the quantity of good B increases. This implies good A and good B are substitutes.

Finally, two goods are independent if the cross elasticity is zero. A price change in one good does not change the quantity of the other good. b. To calculate the income elasticity, we use a similar approach. Here we divide the percentage change in quantity demanded by the percentage change in income. We do this at every price for the good.

For our golf example we have the following income elasticities: At the price of $50 for a golf game (hold constant for this calculation because we are looking at how golf games respond to a change in income) we have the following ordered pairs (10, 50000) and (15, 70000). Note that the ordered pair is (golf games, income).

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We do the same exercise for $35. Here we have the ordered pairs (15, 50000) and (30, 70000).

Finally, we have the ordered pair of (20, 50000) and (50, 70000) at the price of $20 for a game of golf.

The income elasticity is not the same at each price of a game of golf. Golf games are more responsive to changes in income the lower the price of golf.

To determine if golf is a normal good or inferior good, we have the following rule: If the income elasticity is positive then the good is a normal good. The higher an individual's income the more of the good they consume. Thus, golf is a normal good.

If the income elasticity is negative, then the good is an inferior good. The higher an individual's income, the less of the good they consume.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 5

Market Failures: Public Goods and Externalities

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Question 20 Explain the two causes of market failures. Given their definitions, could a market be affected by both types of market failures simultaneously? LO1

Answer The two cases of market failure are demand-side market failures and supply-side market failures.

Demand-side market failures happen when demand curves do not reflect consumers’ full willingness to pay for a good or service. For example, consider a public good where consumption is nonrival and nonexcludable. So, if I want to set off fireworks and charge for the event I probably wouldn’t generate much revenue. I can’t keep people from watching the fireworks outside the event (nonexcludability) and the fireworks display can be watched by all (nonrival: if one person watches the fireworks display, this does not reduce or eliminate someone else’s ability to see the same fireworks display). Thus, the demand curve for fireworks does not reflect consumers’ full willingness to pay for this good or service.

Supply-side market failures occur when supply curves do not reflect the full cost of producing a good or service. For example, consider the case of a negative externality. Externalities occur when the costs or benefits accrue to someone other than the buyer or seller (third parties). If a firm releases harmful chemicals into the watershed during the production process, but does not have to pay for the damage, then the supply curve does not reflect the full cost of production. Yes, it is possible for both to occur if both demand-side market failures and supply-side market failures are present. For example, consider the case where an individual values a good, such as fireworks. This implies that the individual will set off fireworks (because he values them for himself). However, he would like to charge for the event so it can be larger than the display the individual would pay for himself. The problem is that everyone will free ride on his display (demand-side market failure—the public good is underprovided). Now if his fireworks display causes pollution (noise and smoke) or potential fire damage, a negative externality may be present (supply-side market failures).

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Question 21 What are the two characteristics of public goods? Explain the significance of each for public provision as opposed to private provision. What is the free-rider problem as it relates to public goods? Is U.S. border patrol a public good or a private good? Why? What type of good is satellite TV? Explain. LO2

Answer Public goods are nonrival (one person’s consumption does not prevent consumption by another) and nonexcludable (once the goods are produced, nobody—including free riders—can be excluded from the goods’ benefits). If goods are nonrival, there is less incentive for private firms to produce them—those purchasing the good could simply allow others the use without compensation. Similarly, if goods are nonexcludable, private firms are unlikely to produce them as the potential for profit is low.

The free-rider problem occurs when people benefit from the public good without contributing to the cost (tax revenue proportionate to the benefit received).

The U.S. border patrol is a public good—my use and benefit does not prevent yours.

Satellite TV is a private good—if the dish, receiver, and service go to my residence, it can’t go to my neighbors. The fact that I could invite my neighbors over to watch does not change its status from being a private good.

Question 22 Draw a production possibilities curve with public goods on the vertical axis and private goods on the horizontal axis. Assuming the economy is initially operating on the curve, indicate how the production of public goods might be increased. How might the output of public goods be increased if the economy is initially operating at a point inside the curve? LO2

Answer On the curve, the only way to obtain more public goods is to reduce the production of private goods (from C to B). An economy operating inside the curve can expand the production of public goods without sacrificing private goods (say, from A to B) by making use of unemployed resources.

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Question 23 Use the distinction between the characteristics of private goods and public goods to determine whether the following should be produced through the market system or provided by government: (a) French fries, (b) airport screening, (c) court systems, (d) mail delivery, and (e) medical care. Explain your answers.

LO2

Answer a. b. c. d.

French fries: Market system (rival and excludable) Airport screening: Government (nonrival and nonexcludable).

Court systems: Government (nonrival and nonexcludable).

Mail delivery: Combined market and government. The law gives the postal service a monopoly, but services such as package delivery have private competition. e. Medical care: Combined market and government. The mix of private and public production is a controversial topic addressed in the chapter on the economics of health care.

Question 24 What divergences arise between equilibrium output and efficient output when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text examples) of an external cost and an external benefit. LO3

Answer (a) When negative externalities are present, the equilibrium output will be greater than the efficient output. This is because the producer, who is not bearing the full cost of production, will be able to produce more at a lower price than the efficient level, which would exist if true costs were reflected in the production decision. (b) When positive externalities are present, the equilibrium output will be smaller than the efficient output because the consumer is willing to pay a price equal to the consumer’s individual marginal benefit, but no more. Since social benefits exist in addition to the private benefit, the government must either aid the producer to encourage more output or engage in its own production of the item with the external benefits.

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costs. This effectively shifts the supply curve to the left as costs of production rise, and the new equilibrium output will be less and closer to the efficient level. External benefits can be encouraged by government subsidies to the producers of these products or by government production. In either case, the supply curve shifts to the right, which lowers the equilibrium price and leads to a greater equilibrium output level.

Other examples of external costs might include secondhand smoke, noise from the stereo down the hall, or road congestion. External benefits might be generated from outdoor Christmas lights, music from the stereo down the hall, or attractive landscaping in the neighborhood.

Question 25 Why are spillover costs and spillover benefits also called negative and positive externalities? Show graphically how a tax can correct for a negative externality and how a subsidy to producers can correct for a positive externality. How does a subsidy to consumers differ from a subsidy to producers in correcting for a positive externality? LO3

Answer Spillover costs are called negative externalities because they are external to the participants in the transaction and reduce the utility of affected third parties (thus ―negative‖). Spillover benefits are called positive externalities because they are external to the participants in the transaction and increase the utility of affected third parties (thus ―positive‖). To show how taxes and subsidies can correct externalities, see Figures 5.2 and 5.3. Compare (b) and (c) in Figure 5.3.

One policy approach to negative externalities is for government to levy taxes or charges specifically on the related good. The tax raises the marginal cost of producing the product, shifting the private supply curve for this product leftward (or upward). In Figure 5.7b, a tax equal to T per unit increases the firm’s marginal cost, shifting the supply curve from S to St. The equilibrium price rises, and the equilibrium output declines from Qe to the economically efficient level Qo. The tax thus eliminates the initial overallocation of resources and therefore the efficiency loss.

Government could correct the underallocation of resources by subsidizing consumers of the product shifting the demand curve to the right and raising the price. A subsidy to producers is a tax in reverse.

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government that decrease producers’ costs. A subsidy reduces the marginal cost and shifts the supply curve rightward, lowering the price.

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Question 26 An apple grower’s orchard provides nectar to a neighbor’s bees, while the beekeeper’s bees help the apple grower by pollinating his apple blossoms. Use Figure 5.5b to explain why this situation of dual positive externalities might lead to an underallocation of resources to both apple growing and beekeeping. How might this underallocation get resolved via the means suggested by the Coase theorem? LO3

Answer Using the figure, the following can be said: The market demand curves for apples and honey would not include the spillover benefits accruing to the production of the other good. Both of these outputs are greater than equilibrium outputs, leading to an underallocation of resources to both apple growing and beekeeping. Using the Coase theorem, we note that it will be to the advantage of individual apple growers and beekeepers to negotiate so that beekeepers (whose hives can be moved) locate their production in or near orchards. This negotiation will occur as long as property ownership is well defined, only a few people are involved, and bargaining costs are low. For example, an apple grower who owns an orchard could allow a beekeeper to use a portion of his or her land, charging below market rents so that both parties gain from the agreement.

Question 27 The LoJack car recovery system allows the police to track stolen cars. As a result, they not only recover 90 percent of LoJack-equipped cars that are stolen but also arrest many auto thieves and shut down many ―chop shops‖ that rip apart stolen vehicles to get at their used parts. Thus, LoJack provides both private benefits and positive externalities. Should the government consider subsidizing LoJack purchases? LO3

Answer If the government were to subsidize LoJack purchases, this would reduce the private cost of the anti-theft devices. In turn, this reduction in the private cost would, in-turn, increase the purchase of the LoJack system. The fact that this good was under-utilized in the private sector without the subsidy (because part of the benefit accrued to society, not the individual, in the form of reduced crime shutting down "chop shops") implies this subsidy is appropriate. Yes, the government should consider subsidizing LoJack purchases.

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Use marginal cost/marginal benefit analysis to determine if the following statement is true or false: ―The optimal amount of pollution abatement for some substances, say, dirty water from storm drains, is very low; the optimal amount of abatement for other substances, say, cyanide poison, is close to 100 percent.‖ LO3

Answer Reducing water flow from storm drains has a low marginal benefit, meaning the MB curve would be located far to the left of where it is in the text diagram. It will intersect the MC curve at a low amount of pollution abatement, indicating the optimal amount of pollution abatement (where MB = MC) is low.

Any cyanide in public water sources could be deadly.

Question 29 Explain why zoning laws, which allow certain land uses only in specific locations, might be justified in dealing with negative externalities. Explain why in areas where buildings sit close together tax breaks to property owners for installing extra fire prevention equipment might be justified due to positive externalities. LO3

Answer

Zoning could force businesses producing negative externalities to locate in regions where these costs would not spill over onto third parties, or where such costs would at least be reduced.

Businesses wanting to locate in regions where external costs would cause the most damage (but where zoning restricts their location) would be forced to eliminate or reduce those external costs.

In either case, a more efficient allocation of resources would result.

Tax breaks to property owners who install fire prevention equipment reduces the potential of fire spreading to nearby buildings. Thus, the fire prevention equipment will have positive externalities because of the additional benefit to the community. At the individual level the building owners take into account the benefits for their own business, which implies that fire prevention equipment will be underutilized without the tax break (which reduces direct cost).

Question 30 Distinguish between the benefits-received and the ability-to-pay principles of taxation. Which philosophy is more evident in our present tax structure? Justify your answer. To which principle of taxation do you subscribe? Why? LO4

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Answer The benefits received principle holds that governments should supply public goods and services in much the same manner as a private business would. Those who make use of government services should pay for them. This principle is at work in the gasoline tax, with the proceeds going to the building and upkeep of roads, and in the sale of postage stamps. However, even here the principle is hardly fully respected.

Some drivers get paved highways, while others who drive just as much, do so on dirt roads. And the same first-class postage stamp will move a letter ten miles or three thousand.

The redistribution of income by government—transfer payments—would be impossible on the benefits received principle. People on welfare receive benefits because they need more from government than they could possibly contribute in taxes.

The ability to pay principle of taxation takes account of this fact and assesses tax liability based on a person’s ability to pay: The higher one’s income, the higher the tax and the higher the percentage of one’s income paid in tax. The objection to this principle is that it cannot be decided in principle how much more a wealthy person should pay than one of restricted means. The decision then becomes a political one—with the decision everywhere being not to make the wealthy pay fully in accordance with their ability to pay. In summary, it seems that the ability to pay principle is the one that is the most, if half heartedly, respected in the United States.

Question 31 What is meant by a progressive tax? A regressive tax? A proportional tax? Comment on the progressivity or regressivity of each of the following taxes, indicating in each case where you think the tax incidence lies: (a) the federal personal income tax, (b) a 4 percent state general sales tax, (c) a federal excise tax on automobile tires, (d) a municipal property tax on real estate, (e) the federal corporate income tax, (f) the portion of the payroll tax levied on employers. LO4

Answer A progressive tax is one whose average rate increases as income increases. One pays in tax a larger proportion of one’s income as income increases.

A regressive tax is one whose average rate declines as income increases. One pays in tax a smaller and smaller proportion of one’s income as income increases, though it is possible for the absolute amount to increase.

A proportional tax is one whose average rate remains the same regardless of the size of income.

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(a) Mildly progressive (―mildly‖ because of loopholes). Incidence is usually on the taxpayer. However, those who charge a fee for services (that is, the self-employed) may be able to increase their fees enough to have the fee-payer in effect pay the tax. Also, some unions may be able to get big enough wage increases to pay increased income tax. (b) Regressive. The poor spend all their income, mostly on commodities subject to the sales tax. Thus the sales tax is, in effect, on all their income. The wealthier one is, the smaller the proportion of one’s income is spent on commodities subject to the sales tax. (Stocks and bonds and real estate are not subject to this tax.) Thus, the average tax rate declines as income increases. The incidence of the tax is mostly on the consumers who buy the taxed commodities. (c) Regressive for the same reasons as for state general sales taxes. The incidence, again, is mostly on the buyer. There are no substitutes for automobile tires (assuming one does not give up driving a car), so the demand is relatively inelastic. (d) The incidence is on (1) owners in the case of an owner-occupied residence or land; (2) tenants if the property is rented; (3) consumers if the property is used in business. In the case of (1) and (2), the tax tends to be proportional since the tax is based on the value of the property, and the lower one’s income, the lower the value of the property one owns or rents. In the case of (3), the tax will be regressive for the same reasons the state general sales tax is regressive. (e) The incidence is probably shared between the corporation’s shareholders and the buyers of the corporation’s products. To the extent it is on the shareholders, the tax is proportional. To the extent it is on the consumers, it is regressive for the same reasons the general sales tax is regressive. (f) The incidence is probably shared by both the worker and the employer. The actual distribution of the tax incidence will depend on the relative labor supply and demand elasticities.

Question 32 Is it possible for a country with a regressive tax system to have a tax-spending system that transfers resources from the rich to the poor? LO5

Answer Yes. The rich may be paying a lower fraction of their incomes in taxes (because the country has a regressive tax system), but just as long as the spending of the country is tilted sufficiently towards the poor that the poor get more in spending than they pay in taxes (and vice versa for the rich), the country can have a tax-spending system that transfers resources from the rich to the poor.

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PROBLEMS

Problem 1 The accompanying table shows the total costs and total benefits, in billions of U.S. dollars, for four different antipollution programs of increasing scope. Use cost-benefit analysis to determine which program should be undertaken. LO2

Answer The programs are increasing in scope, so the marginal benefits can be computed. Net benefit from top to bottom: 4; 5; 4; 1. Program B should be undertaken since the marginal benefit exceeds the marginal cost (5 > 4). For programs that are larger in scope, the marginal benefit no longer exceeds the marginal cost.

Plan B is where net benefits—the excess of total benefits over total costs ($5)—are maximized.

Problem 2 On the basis of the three individual demand schedules below, and assuming these three people are the only ones in the society, determine (a) the market demand schedule on the assumption that the good is a private good and (b) the collective demand schedule on the assumption that the good is a public good.

LO2

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Answer a. Derive the market demand schedule on the assumption that the good is a private good. To accomplish this we use the principle of horizontal summation. That is, we fix price and add up the quantities demanded by the individuals. At a price of $8: individual 1 (I1) demands 0, individual 2 (I2) demands 1, and individual 3 (I3) demands 0. Thus, we have the following market demand ordered pair (1,8).

At a price of $7: I1 demands 0, I2 demands 2, and I3 demands 0. Thus, we have the following market demand ordered pair (2,7).

At a price of $6: I1 demands 0, I2 demands 3, and I3 demands 1. Thus, we have the following market demand ordered pair (4[=3+1],6).

At a price of $5: I1 demands 1, I2 demands 4, and I3 demands 2. Thus, we have the following market demand ordered pair (7[=1+4+2],5).

At a price of $4: I1 demands 2, I2 demands 5, and I3 demands 3. Thus, we have the following market demand ordered pair (10,4).

At a price of $3: I1 demands 3, I2 demands 6, and I3 demands 4. Thus, we have the following market demand ordered pair (13,3).

At a price of $2: I1 demands 4, I2 demands 7, and I3 demands 5. Thus, we have the following market demand ordered pair (16,2).

At a price of $1: I1 demands 5, I2 demands 8, and I3 demands 6. Thus, we have the following market demand ordered pair (19,1).

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b. Derive the collective demand schedule on the assumption that the good is a public good. To accomplish this, we use the principle of vertical summation. That is, we fix quantity and add up the price (willingness to pay) for the individuals. The logic here is that the individuals (society) can pool resources to purchase a given quantity because this good will be shared (public good).

At the quantity 1: I1 is willing to pay $5, I2 is willing to pay $8, and I3 is willing to pay $6. Thus, we have the following collective demand ordered pair (1,19=5+8+6).

At the quantity 2: I1 is willing to pay $4, I2 is willing to pay $7, and I3 is willing to pay $5. Thus, we have the following collective demand ordered pair (2,16).

At the quantity 3: I1 is willing to pay $3, I2 is willing to pay $6, and I3 is willing to pay $4. Thus, we have the following collective demand ordered pair (3,13).

At the quantity 4: I1 is willing to pay $2, I2 is willing to pay $5, and I3 is willing to pay $3. Thus, we have the following collective demand ordered pair (4,10).

At the quantity 5: I1 is willing to pay $1, I2 is willing to pay $4, and I3 is willing to pay $2. Thus, we have the following collective demand ordered pair (5,7).

At the quantity 6: I1 is willing to pay $0, I2 is willing to pay $3, and I3 is willing to pay $1. Thus, we have the following collective demand ordered pair (6,4).

At the quantity 7: I1 is willing to pay $0, I2 is willing to pay $2, and I3 is willing to pay $0. Thus, we have the following collective demand ordered pair (7,2).

At the quantity 8: I1 is willing to pay $0, I2 is willing to pay $1, and I3 is willing to pay $0. Thus, we have the following collective demand ordered pair (8,1).

Problem 3 Use your demand schedule for a public good, determined in problem 2, and the following supply schedule to ascertain the optimal quantity of this public good. LO2

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Answer From the example table, we calculated the collective demand schedule from the individual demand schedules:

P

Qd (D1)

Qd (D2)

Qd (D3)

$8

0

1

0

7

0

2

0

6

0

3

1

5

1

4

2

4

2

5

3

3

3

6

4

2

4

7

5

1

5

8

6

Combining this collective demand schedule with the following supply schedule, we can determine the optimal provision (quantity) of the public good.

The optimal quantity can be found by finding the price where the willingness to pay equals price required by the firm to supply that last unit (basically, the price that clears the market). For example, at $19 society demands one unit, but firms are willing to supply 10 units. At $16 society demands 2 units, but firms are 1-119 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

willing to supply 8 units. This continues until we reach the price of $10 where society demands 4 units and firms are willing to supply 4 units. Thus, the optimal quantity is 4 units.

Problem 4 Look at the following tables, which show, respectively, buyers’ willingness to pay for and sellers’ willingness to accept, bags of oranges. For the following questions, assume that the equilibrium price and quantity will depend on the indicated changes in supply and demand. Assume that the only market participants are those listed by name in the two tables. LO3

a. What are the equilibrium price and quantity for the data displayed in the two tables? b. What if, instead of bags of oranges, the data in the two tables dealt with a public good like fireworks displays? If all the buyers free ride, what will be the quantity supplied by private sellers? c. Assume that we are back to talking about bags of oranges (a private good), but that the government has decided that tossed orange peels impose a negative externality on the public that must be rectified by 1-120 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

imposing a $2-per-bag tax on sellers. What are the new equilibrium price and quantity? If the new equilibrium quantity is the optimal quantity, by how many bags were oranges being overproduced before?

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Answer a. To determine the equilibrium price of oranges, we begin by comparing the highest willingness to pay with the lowest minimum acceptable price. Bob is willing to pay $13 and Carlos is willing to accept at minimum $3. This trade is made because Bob is willing to pay more than Carlos requires for the sale. We then move on to the trade between Barb and Courtney. This trade is also made because Barb is willing to pay $12 and Courtney only requires $4 to make the sale. This goes on until the ―maximum willingness to pay‖ equals the ―minimum acceptable price.‖ This occurs for the trade between Betty and Chad. Betty’s ―maximum willingness to pay‖ is $8 and Chad’s ―minimum acceptable price‖ is also $8. Since the six purchasers (each purchases 1 unit) buy the 6 units produced by the six producers (each produces 1 unit), the equilibrium quantity is 6 at the equilibrium price of $8. b. If, instead of bags of oranges, the data in the two tables dealt with a public good like fireworks displays, and all the buyers free ride, then the quantity supplied will be zero. Everyone will try to pay a zero price. c. If the government decides that tossed orange peels impose a negative externality on the public that must be rectified by imposing a $2-per-bag tax on sellers, then the ―minimum acceptable price‖ will increase by the amount of the tax. The reason behind this increase is that the producers must now pay an additional $2 on top of their production costs. This implies that the ―minimum acceptable price‖ for Carlos is $5 (= $3 + $2); Courtney, $6: Chuck, $7; Cindy, $8; Craig, $9; and Chad, $10. Comparing this new ―minimum acceptable price‖ schedule with the original ―maximum willingness to pay‖ schedule, we have the following new equilibrium.

Bob is willing to pay $13 and Carlos is willing to accept at minimum $5. This trade is made because Bob is willing to pay more than Carlos requires for the sale. We then move on to the trade between Barb and Courtney. This trade is also made because Barb is willing to pay $12 and Courtney only requires $6 to make the sale. This goes on until the ―maximum willingness to pay‖ equals the ―minimum acceptable price.‖ This occurs for the trade between Brent and Craig now. Brent’s ―maximum willingness to pay‖ is $9 and Craig’s ―minimum acceptable price‖ is also $9. The potential trade between Betty and Chad no longer takes place. Betty is only willing to pay $8 and Chad requires $10 to make the sale. Since only five purchasers (each purchases 1 unit) buy the 5 units produced by the five producers (each produces 1 unit), the new equilibrium quantity is 5 at the equilibrium price of $9.

If this is the optimal quantity, then the market was overproducing by 1 unit before the tax was imposed on orange producers.

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Problem 5 Suppose a tax is such that an individual with an income of $10,000 pays $2000 of tax, a person with an income of $20,000 pays $3000 of tax, a person with an income of $30,000 pays $4000 of tax, and so forth. What is each person’s average tax rate? Is this tax regressive, proportional, or progressive? LO5

Answer Consider the following example. Suppose a tax is such that an individual with an income of $10,000 pays $2,000 of tax, a person with an income of $20,000 pays $3,000 of tax, a person with an income of $30,000 pays $4,000 of tax.

To calculate the average tax an individual pays, divide the tax payment by the individual’s income.

For the individual with an income of $10,000, the average tax rate is 0.2, or 20 percent (= $2,000/$10,000).

For the individual with an income of $20,000, the average tax rate is 0.15, or 15 percent (= $3,000/$20,000).

For the individual with an income of $30,000, the average tax rate is 0.1333, or 13.33 percent (= $4,000/$30,000).

This tax is regressive because the average tax rate declines as individual income increases.

Problem 6 Suppose in Fiscalville there is no tax on the first $10,000 of income, but there is a 20 percent tax on earnings between $10,000 and $20,000 and a 30 percent tax on income between $20,000 and $30,000.

Any income above $30,000 is taxed at 40 percent. If your income is $50,000, how much will you pay in taxes? Determine your marginal and average tax rates. Is Fiscalville's income tax progressive? LO5

Answer Since the individual has an income of $50,000, we must calculate the taxes paid over each of the relevant tax brackets.

From $0 to $10,000, the tax rate is 0 percent. So the individual pays $0 on his or her income from $0 to $10,000.

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From $10,000 to $20,000, the tax rate is 20 percent. So the individual pays $2,000 on his or her income from $10,000 to $20,000 (= 0.2 × $10,000).

From $20,000 to $30,000, the tax rate is 30 percent. So the individual pays $3,000 on his or her income from $20,000 to $30,000 (= 0.3 × $10,000).

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From $30,000 to higher, the tax rate is 40 percent. So the individual pays $8,000 on his or her income from $30,000 to $50,000 (= 0.4 × $20,000).

Adding up the taxes paid over this income range, the total tax paid by this individual is $13,000 (= $0 (first $10,000) + $2,000 (second $10,000) + $3,000 (third $10,000) + $8,000 (last $20,000)).

The marginal tax rate is 40 percent. This is the tax rate on the last dollar earned.

The average tax rate is 26 percent (= $13,000/$50,000).

This tax rate is progressive because the average tax rate will increase with income. This follows from the fact that the marginal tax rate is higher for higher income brackets. As income increases above $30,000, the average tax rate will get closer and closer to the marginal rate of 40 percent.

Problem 7 For tax purposes, ―gross income‖ is all the money a person receives in a given year from any source. But income taxes are levied on ―taxable income‖ rather than gross income. The difference between the two is the result of many exemptions and deductions. To see how they work, suppose you made $60,000 last year in wages, earned $10,000 from investments, and were given $5,000 as a gift by your grandmother.

Also assume that you are a single parent with one small child living with you. LO5

a. What is your gross income? b. Gifts up to $15,000 per year are not counted as taxable income. Also, the personal exemption allows you to reduce your taxable income by $4,050 for each member of your household. Given that exemption, what is your taxable income? c. Next, assume you paid $700 in interest on your student loans last year, put $2,000 into a health savings account (HSA), and deposited $4,000 into an individual retirement account (IRA). These expenditures are all tax exempt, meaning that any money spent on them reduces taxable income dollar-for-dollar. Knowing that fact, now what is your taxable income? d.

Next, you can either take the so-called standard deduction or apply for itemized deductions (which involve a lot of tedious paperwork). You opt for the standard deduction that allows you as head of your household to exempt another $18,350 from your taxable income. Taking that into account, what is your taxable income?

e. Apply the tax rates shown in Table 20.1 to your taxable income. How much federal tax will you owe? What is the marginal tax rate that applies to your last dollar of taxable income?

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f.

As the parent of a dependent child, you qualify for the government’s $2,000 per-child ―tax credit.‖ Like all tax credits, this $2,000 credit ―pays‖ for $2,000 of whatever amount of tax you owe. Given this credit, how much money will you actually have to pay in taxes? Using that actual amount, what is your average tax rate relative to your taxable income? What about your average tax rate relative to your gross income?

Answer (a) $75,000. (b) $61,900 [= $75,000 – $5,000 – (2 × $4,050)]. (c) $55,200 [= $61,900 − $2,000 − $4,000 − $700]. (d) $36,850. [= $55,200 − $18,350]. (e) You will owe the Feds $4,033.88 (= $1,940 + $2,093.88). (f) You will pay only $2,033.88 (= $4,033.88 − $2,000). Thus, your average tax rate on taxable income will be is 5.5 percent [= 100 × ($2,033.88 / $36,850)]. And your average tax rate on gross income will be 2.7% [= 100 × ($2,033.88 / $75,000].

Feedback: a. To calculate gross income, add up income from the different sources. You made $60,000 in wages plus $10,000 from investments plus a $5,000 gift from your grandmother. Thus, your gross income was $75,000. b. Your taxable income equals your gross income minus any gifts up to $15,000 minus the personal exemption for the two members in the household (single parent with a child). Thus, your taxable income equals $61,900 [= $75,000 (gross income) − $5,000 (gift) – 2 × $4,050 (exemption for two household members)]. c. The additional deductions from taxable income result in a NEW taxable income of $55,200 [= $61,900 − $700 (interest on student loan) − $2,000 (HSA) − $4,000 (IRA)]. d. Your taxable income after taking the standard deduction is $36,850 [= $55,200 (from part c) − $18,350 (standard deduction)]. e. Your taxable income is $36,850.

The tax schedule is: 1-126 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

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From $0 to $19,400 the tax rate is 10 percent. So, the individual pays $1,940 on his or her income from $0 − $19,400.

From $19,401 to $78,950 the tax rate is 12 percent. So, the individual pays $2,093.88 on his or her income from $19,401 to $36,850. [= 0.12 × ($36,850 − $19,401) = 0.12 × $17,449 = $2,093.88].

The total taxes paid by this individual is $4,033.88 (= $1,940 + $2,093.88).

The marginal tax rate is 12 percent on the last dollar of taxable earnings.

f:

From part e, the taxes owed are $4,033.88. After subtracting the child tax credit from taxes owed, the final tax obligation is $2,033.88 (= $4,033.88 − $2,000).

Your average tax rate relative to your taxable income is 5.5 percent [= 100 × ($2,033.88 / $36,850)]

Your average tax rate relative to your gross income is 2.7% [= 100 × ($2,033.88 / $75,000].

McConnell, Brue, Flynn Essentials of Economics 5e Chapter 6 Businesses and Their Costs QUESTIONS Question 1 Distinguish between explicit and implicit costs, giving examples of each. What are some explicit and implicit costs of attending college? LO1 Answer Explicit costs are payments the firm must make for inputs to nonowners of the firm to attract them away from other employment, for example, wages and salaries to its employees. Implicit 1-128 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

costs are nonexpenditure costs that occur through the use of self-owned, self-employed resources, for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else.

The explicit costs of going to college are the tuition costs, the cost of books, and the extra costs of living away from home (if applicable). The implicit costs are the income forgone and the hard grind of studying (if applicable).

Question 2 Distinguish between accounting profit, economic profit, and normal profit. Which type of profit determines how entrepreneurs allocate resources among different business ventures? Explain.

LO1 Answer Accounting profit equals sales revenue minus explicit costs, such as material, the wages of employees, etc.

Economic profit equals the accounting profit minus the additional implicit costs of the business.

This includes entrepreneurial ability, forgone interest, forgone labor income, etc. Economic profit determines how entrepreneurs allocate resources between different business ventures. If economic profit is greater zero this implies the business venture is earning above average normal profits (more than other alternative business ventures on average), thus more resources will flow towards this activity. The opposite is true when economic profit is negative.

Normal profit equals the accounting profit you could have potentially earned in a different (or alternative) business venture. This gives us a true measure of the opportunity cost of the current business venture. Economists classify normal profits as costs, since in the long run the owner of a firm would close it down if a normal profit were not being earned. Since a normal profit is required to keep the entrepreneur operating the firm, a normal profit is a cost.

Question 3 Complete the table directly below by calculating marginal product and average product. LO2

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Plot the total, marginal, and average products and explain in detail the relationship between each pair of curves. Explain why marginal product first rises, then declines, and ultimately becomes negative. What bearing does the law of diminishing returns have on short-run costs? Be specific. ―When marginal product is rising, marginal cost is falling. And when marginal product is diminishing, marginal cost is rising.‖ Illustrate and explain graphically.

Answer Inputs of labor 0 1 2 3 4 5 6 7 8

Total product

Marginal product

Average product

NA 15 19 17 14 9 6 3 -1

NA 15 17 17 16.25 14.8 13.33 11.86 10.25

0 15 34 51 65 74 80 83 82

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Question 4 Why can the distinction between fixed costs and variable costs be made in the short run? Classify the following as fixed or variable costs: advertising expenditures, fuel, interest on companyissued bonds, shipping charges, payments for raw materials, real estate taxes, executive salaries, insurance premiums, wage payments, sales taxes, and rental payments on leased office machinery. ―There are no fixed costs in the long run; all costs are variable.‖ Explain. LO3 Answer The distinction can be made because there are some costs that do not vary with total output.

These are the fixed costs that, fundamentally, are related to the scale or size of the plant. In the short run, by definition, the scale of the plant cannot change: The firm cannot bring in more machinery or move to a larger building. All costs that are related to the scale of the plant—costs that continue to be incurred even though the firm’s output may be zero—are fixed costs. On the other hand, the firm can increase its output by using its plant—its fixed capital—more intensively, that is, by hiring more labor, or by using more materials. But by doing so, it will increase its operating costs, its variable costs.

Advertising expenditures: variable costs (although it may be reasonable to argue a fixed component). Fuel: variable costs. Interest on company-issued bonds: fixed costs. Shipping charges: variable costs. Payments for raw materials: variable costs. Real estate taxes: fixed costs.

Executive salaries: fixed costs. Insurance premiums: fixed costs. Wage payments: variable costs.

Rental payments on leased office machinery: fixed costs (although it is possible that short-term lease arrangements on some types of office equipment may rise or fall with output).

In the long run, the firm can, by definition, get out of paying all of its short-run fixed costs; its lease is up, it can fire its executives without penalty, the insurance has run out, and so on. All of its costs at this moment, then, are variable. It can decide to continue producing at the same scale and thus reassume all its previous fixed costs for the next short-run period; or it can decide to increase its scale and thus increase its fixed costs; or it can decide to go out of business and thus have no costs at all.

Question 5 A firm has fixed costs of $60 and variable costs as indicated in the table. LO3 Complete the table and check your calculations by referring to problem 4 at the end of Chapter 7.

Answer a. Graph the AFC, ATC, and MC curves. Why does the AFC curve slope continuously downward? Why does the MC curve eventually slope upward? Why does the MC curve intersect both the AVC and the ATC curve at their minimum points? b. Explain how the location of each curve graphed in question 5a would be altered if (1) total fixed cost is $100 rather than $60 and (2) total variable cost is $10 less at each level of output.

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Question 6 A firm has fixed costs of $60 and variable costs as indicated in the accompanying table.

Complete the table and check your calculations by referring to question 3 at the end of Chapter 7.

LO

a. Graph the AFC, ATC, and MC curves. Why does the AFC curve slope continuously downward? Why does the MC curve eventually slope upward? Why does the MC curve intersect the ATC curve at its minimum point? b. Explain how the location of each curve graphed in question 9a would be altered if (1) total fixed cost had been $100 rather than $60 and (2) total variable cost had been $10 less at each level of output.

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Answer

Total product

Total fixed cost

Total variable cost

Total cost

0 1 2 3 4 5 6 7 8 9 10

$60 60 60 60 60 60 60 60 60 60 60

$0 45 85 120 150 185 225 270 325 390 465

$0 105 145 180 210 245 285 330 385 450 525

Average Average Average fixed variable total Marginal cost cost cost cost $60 30 20 15 12 10 8.57 7.5 6.67 6

$45 42.5 40 37.5 37 37.5 38.57 40.63 43.33 46.5

$105 72.5 60 52.5 49 47.5 47.14 48.13 50 52.5

$45 40 35 30 35 40 45 55 65 75

a. See the graph below. Over the 0 to 4 range of output, the TVC and TC curves slope upward at a decreasing rate because of increasing marginal returns. The slopes of the curves then increase at an increasing rate as diminishing marginal returns occur.

b. See the graph below. AFC (= TFC/Q) falls continuously since a fixed amount of capital cost is spread over more units of output. The MC (= change in TC/change in Q), AVC (= TVC/Q), and ATC (= TC/Q) curves are U-shaped, reflecting the influence of first increasing and then diminishing returns. The ATC curve sums AFC and AVC vertically. The ATC curve falls when the MC curve is below it; the ATC curve rises when the MC curve is above it. This means the MC curve must intersect the ATC curve at its lowest point. The same logic holds for the minimum point of the AVC curve.

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Question 6 Indicate how each of the following would shift the (1) MC curve, (2) AVC curve, (3) AFC curve, and (4) ATC curve of a manufacturing firm. In each case specify the direction of the shift. LO3 a. reduction in business property taxes. b. An increase in the nominal wages of production workers. c. A decrease in the price of electricity. d. An increase in insurance rates on plant and equipment. e. An increase in transportation costs.

Answer a.

This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is a decrease in fixed cost AFC shifts down and ATC shifts down (sum of AVC and AFC). b.

This is a change in variable cost. Since wages are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC. c.

This is a change in variable cost. The lower price of electricity implies MC shifts down, AVC shifts down, and ATC shifts down. There is no change in AFC. d.

This is a change in the fixed cost. This implies there will be no change in MC or AVC. Since this is an increase in fixed cost AFC shifts up and ATC shifts up. e. This is a change in variable cost. Since transportation costs are now higher, MC shifts up, AVC shifts up, and ATC shifts up. There is no change in AFC.

Question 7 Suppose a firm has only three possible plant-size options, represented by the ATC curves shown in the figure. What plant size will the firm choose in producing (a) 50, (b) 130, (c) 160, and (d) 250 units of output? Draw the firm’s long-run average-cost curve on the diagram and describe this curve. LO4

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(a) To produce 50 units, the firm will choose plant size #1, since its ATC is lower for this size firm in producing less than 80 units. (b) To produce 130 units, the firm will choose plant size #2, since its ATC is lower for size #2 in producing between 80 and 240 units. (c) To produce 160 units, the firm will choose plant size #2, since its ATC is lowest for producing between 80 and 240 units. (d) To produce 250 units, the firm will choose plant size #3, since its ATC is lowest for production of more than 240 units.

The firm’s long-run average total cost curve will be the lower sections of the different plant size ATC schedules. Specifically, to the left of 80 units ATC1 will be the first section of the long-run ATC. Between 80 and 240 ATC2 will make up the second section of the long-run ATC. Finally, to the right of 240 ATC3 will make up the rest of the firm’s long-run ATC.

Question 8 Use the concepts of economies and diseconomies of scale to explain the shape of a firm’s longrun ATC curve. What does ―minimum efficient scale‖ mean? What bearing can the shape of the long-run ATC curve have on the structure of an industry? LO4 Answer The long-run ATC curve is U-shaped. At first, long-run ATC falls as the firm expands and realizes economies of scale from labor and managerial specialization and the use of more efficient capital. The long-run ATC curve later turns upward when the enlarged firm experiences diseconomies of scale, usually resulting from managerial inefficiencies.

The MES (minimum efficient scale) is the smallest level of output needed to attain all economies of scale and minimum long-run ATC. If long-run ATC drops quickly to its minimum cost which then extends over a long range of output, the industry will likely be composed of both large and small firms. If long-run ATC descends slowly to its minimum cost over a long range of output, the industry will likely be composed of a few large firms. If long-run ATC drops quickly to its minimum point and then rises abruptly, the industry will likely be composed of many small firms.

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PROBLEMS Problem 1 Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor.

He estimates his entrepreneurial talents are worth $3000 per year (input cost for organizing resources). Total annual revenue from pottery sales is $72,000. Calculate the accounting profit and the economic profit for Gomez’s pottery firm. LO2 Answer Explicit costs are the direct costs incurred from production: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials).

Implicit costs are the costs that are indirectly incurred by the activity: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship).

Accounting profit = $35,000 (= $72,000 of revenue – $37,000 of explicit costs); Economic profit = $13,000 (= $72,000 – $37,000 of explicit costs – $22,000 of implicit costs).

Problem 2 Imagine you have some workers and some handheld computers that you can use to take inventory at a warehouse. There are diminishing returns to taking inventory. If one worker uses one computer, he can inventory 100 items per hour. Two workers sharing a computer can together inventory 150 items per hour. Three workers sharing a computer can together inventory 160 items per hour. And four or more workers sharing a computer can together inventory fewer than 160 items per hour. Computers cost $100 each and you must pay each worker $25 per hour.

If you assign one worker per computer, what is the cost of inventorying a single item? What is the cost if you assign two workers per computer? Three? How many workers per computer should you assign if you wish to minimize the cost of inventorying a single item? LO3 Answer Consider the following example. If one worker uses one computer, he can inventory 100 items per hour. Two workers can together inventory 150 items per hour. Three workers can together inventory 160 items per hour. And four or more workers can together inventory fewer than 160 items per hour. Computers cost $100 each and you must pay each worker $25 per hour.

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If you assign one worker per computer, the cost of inventorying a single item is $1.25. You incur the cost of the computer, $100, and the cost of employing one worker, $25, which is divided by the number of units inventoried, 100 (= ($100 + $25)/100)).

If you assign two workers per computer, the cost of inventorying a single item is $1.00. You incur the cost of the computer, $100, and the cost of employing two workers, $50 ($25 each), which is divided by the number of units inventoried by the two workers, 150 (= ($100 + $50)/150)).

If you assign three workers per computer, the cost of inventorying a single item is $1.09. You incur the cost of the computer, $100, and the cost of employing three workers, $75 ($25 each), which is divided by the number of units inventoried by the three workers, 160 (= ($100 + $75)/160)).

To minimize the cost of inventorying a single item, you should assign two workers to each computer. This is the lowest cost per unit inventoried given the information above.

Problem 3 You are a newspaper publisher. You are in the middle of a one-year rental contract for your factory that requires you to pay $500,000 per month, and you have contractual labor obligations of $1 million per month that you can’t get out of. You also have a marginal printing cost of $0.25 per paper as well as a marginal delivery cost of $0.10 per paper. If sales fall by 20 percent from 1 million papers per month to 800,000 papers per month, what happens to the AFC per paper, the MC per paper, and the minimum amount that you must charge to break even on these costs?

LO4 Answer Consider the following example. You are in the middle of a one-year rental contract for your factory that requires you to pay $500,000 per month, and you have contractual labor obligations of $1 million per month that you can’t get out of. You also have a marginal printing cost of $.25 per paper as well as a marginal delivery cost of $.10 per paper. Now assume sales fall by 20 percent from 1 million papers per month to 800,000 papers per month.

The original average fixed cost (AFC) was $1.50, which equals the total fixed cost of $1.5 million divided by the number of papers sold (1 million, the original amount). Note here that labor is treated as a fixed cost because of the contractual obligation (you must pay even if production stops, assuming the company does not file for bankruptcy) (= $1,500,000/1,000,000).

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Now assuming sales fall by 20 percent to 800,000 papers sold, the new average fixed cost (AFC) is $1.88. This equals the total fixed cost of $1.5 million divided by the new number of papers sold, 800,000 (= $1,500.000/800,000).

Thus, the AFC increases from $1.50 to $1.88 after the decrease in sales.

To break even before the decline in sales, the company needed to charge enough to cover the AFC, $1.50, and the average variable cost (AVC) of $0.35 (this is the sum of the printing cost and delivery cost per paper). Thus, the company needed to charge $1.85 per paper.

To break even after the decline in sales, the company needs to charge enough to cover the AFC, $1.88, and the average variable cost (AVC) of $0.35 (this is the sum of the printing cost and delivery cost per paper; note this does not change because the cost is per paper). Thus, the company needed to charge $2.23 per paper.

Problem 4 There are economies of scale in ranching, especially with regard to fencing land. Suppose that barbed-wire fencing costs $10,000 per mile to set up. How much would it cost to fence a single property whose area is one square mile if that property also happens to be perfectly square, with sides that are each one mile long? How much would it cost to fence exactly four such properties, which together would contain four square miles of area? Now, consider how much it would cost to fence in four square miles of ranch land if, instead, it comes as a single large square that is two miles long on each side. Which is more costly—fencing in the four, one-square-mile properties or the single four-square-mile property? LO5 Answer Consider the following example: Barbed-wire fencing costs $10,000 per mile to set up. How much would it cost to fence a single property whose area is one square mile if that property also happens to be perfectly square, with sides that are each one-mile long?

The answer is 4 times $10,000 for each side of the fence, or $40,000.

How much would it cost to fence exactly four such properties, which together would contain four square miles of area? The four squares below represent our 4 properties. Each of these cost $40,000 to fence. Thus, the cost of fencing these four properties equals $160,000 (= 4 × $40,000).

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Now, consider how much it would cost to fence in four square miles of ranch land if, instead, it comes as a single large square that is two-miles long on each side. Here, we only need to fence the outside perimeter in the diagram above. First, recognize that each side of the square below is twice as long as the problem above (separate properties), which implies it is going to cost $20,000 to fence each side (two miles long). There are four sides, so the total cost of fencing this area is $80,000 (= 4 × $20,000).

This implies that it is cheaper to fence aproperty of four square miles than four properties of one square mile. The cost savings comes from the fact that we do not need to fence off the inner sides of the square miles (the dashed lines).

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 7 Pure Competition QUESTIONS 1-139 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Question 1 Briefly state the basic characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Into which of these market classifications does each of the following most accurately fit? (a) a supermarket in your hometown; (b) the steel industry; (c) a Kansas wheat farm; (d) the commercial bank in which you or your family has an account; (e) the automobile industry. In each case, justify your classification. LO1 Answer Pure competition: very large number of firms; standardized products; no control over price: price takers; no obstacles to entry; no nonprice competition. Pure monopoly: one firm; unique product with no close substitutes; much control over price: price maker; entry is blocked; mostly public relations advertising. Monopolistic competition: many firms; differentiated products; some control over price in a narrow range; relatively easy entry; much nonprice competition: advertising, trademarks, brand names. Oligopoly: few firms; standardized or differentiated products; control over price circumscribed by mutual interdependence: much collusion; many obstacles to entry; much nonprice competition, particularly product differentiation. (a) Hometown supermarket: oligopoly. Supermarkets are few in number in any one area; their size makes new entry very difficult; there is much nonprice competition. However, there is much price competition as they compete for market share, and there seems to be no collusion. In this regard, the supermarket acts more like a monopolistic competitor. Note that this answer may vary by area. Some areas could be characterized by monopolistic competition, while isolated small towns may have a monopoly situation. (b) Steel industry: oligopoly within the domestic production market. Firms are few in number; their products are standardized to some extent; their size makes new entry very difficult; there is much nonprice competition; there is little, if any, price competition; while there may be no collusion, there does seem to be much price leadership. (c) Kansas wheat farm: pure competition. There are a great number of similar farms; the product is standardized; there is no control over price; there is no nonprice competition. However, entry is difficult because of the cost of acquiring land from a present proprietor. Of course, government programs to assist agriculture complicate the purity of this example.

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(d) Commercial bank: monopolistic competition. There are many similar banks; the services are differentiated as much as the bank can make them appear to be; there is control over price (mostly interest charged or offered) within a narrow range; entry is relatively easy (maybe too easy!); there is much advertising. Once again, not every bank may fit this model—smaller towns may have an oligopoly or monopoly situation. (e) Automobile industry: oligopoly. There are the Big Three automakers, so they are few in number; their products are differentiated; their size makes new entry very difficult; there is much nonprice competition; there is little true price competition; while there does not appear to be any collusion, there has been much price leadership. However, imports have made the industry more competitive in the past two decades, which has substantially reduced the market power of the U.S. automakers.

Question 2 Use the following demand schedule to determine total revenue and marginal revenue for each possible level of sales: LO2

a. What can you conclude about the structure of the industry in which this firm is operating?

Explain. b. Graph this firm’s demand, TR, and MR curves for this firm. c. Why do the demand and MR curves coincide? d. ―Marginal revenue is the change in total revenue associated with additional units of output.‖ Explain verbally and graphically, using the data in the table.

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Answer Quantity Marginal Total Revenue Demanded Revenue $2 0 0 $NA 2 1 2 2 2 2 4 2 2 3 6 2 2 4 8 2 2 5 10 2 a. The industry is purely competitive—this firm is a ―price taker.‖ The firm is so small relative to the size of the market that it can change its level of output without affecting the market price.

Product Price

b.

See graph.

c. The firm’s demand curve is perfectly elastic; MR is constant and equal to P.

d. True. When output (quantity demanded) increases by 1 unit, total revenue increases by $2.

This $2 increase is the marginal revenue. Figure: The change in TR is measured by the slope of the TR line, 2 (= $2/1 unit).

Question 3 ―Even if a firm is losing money, it may be better to stay in business in the short run.‖ Is this statement ever true? If so, under what condition(s)? LO5 Answer Yes, a firm may want to stay in business even if it is losing money. For example, assume the firm has a fixed cost of $1,000 which it must pay even if it stops production. Now assume that average variable cost is $10 per unit and price of the product is $15 per unit. Finally assume that output equals 100 units using the MR = MC rule. This implies total revenue equals $1,500, variable cost equals $1,000, and total cost equals $2,000 (the sum of variable and fixed cost).

The firm is losing money because profit equals -$500 (= $1500 – $2000). However, this loss is less than the fixed cost it would incur in the short run if it shut down, which equals a $1,000.

Thus, it is better to stay in business and lose $500 rather than close down and lose a $1000 in the short run.

In conclusion, as long as price exceeds the average variable cost the firm should produce in the short run given fixed cost are present by definition.

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Question 4 Why is the equality of marginal revenue and marginal cost essential for profit maximization in all market structures? Explain why price can be substituted for marginal revenue in the MR = MC rule when an industry is purely competitive. LO3 Answer If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced—the marginal unit—is adding more to revenue than to costs.

Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.

In pure competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus, MR is equal to price. This being so, P can be substituted for MR in the MR = MC rule. (Note, however, that it is not good practice to use MR and P interchangeably because in imperfectly competitive models, price is not the same as marginal revenue.)

Question 5 ―The segment of a competitive firm’s marginal-cost curve that lies above its AVC curve constitutes the firm’s short-run supply curve.‖ Explain using a graph and words. LO4 Answer The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P (= MR) is equal to its increasing MC. Therefore, the MC curve above the AVC curve is the firm’s short-run supply curve, it shows the quantity of output the firm will supply at each price level.

Question 6 Using diagrams for both the industry and a representative firm, illustrate competitive long-run equilibrium. Assuming constant costs, employ these diagrams to show how (a) an increase and (b) a decrease in market demand will upset that long-run equilibrium. Trace graphically and describe verbally the adjustment processes by which long-run equilibrium is restored. Now rework your analysis for increasing- and decreasing-cost industries, and compare the three longrun supply curves. LO6 Answer An increase in demand in the market (industry) will lead to a shortage and thus an increase in market price. The representative firm, being a price taker, will react to this higher price (which also represents demand for the firm’s product and the firm’s marginal revenue curve) by producing more. This output decision is based on P = MR = MC. 1-143 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

At this higher price, the firm is earning economic profits. This will act as a signal for other firms to enter this industry—there are no barriers to entry. As new firms enter, industry supply also shifts outward, placing downward pressure on market price. This process will continue until the market price is equal to the minimum average total cost of the representative firm. This represents the long-run equilibrium for the industry and firm such that neither economic profits nor losses are being realized.

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Question 7 In long-run equilibrium, P = minimum ATC = MC. Of what significance for economic efficiency the equality of P and minimum ATC? The equality of P and MC? Distinguish between productive efficiency and allocative efficiency in your answer. LO6 Answer The equality of P and minimum ATC means the firm is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources. The equality of P and MC means the firm is achieving allocative efficiency; the industry is producing the right product in the right amount based on society’s valuation of that product and other products.

Question 8 Suppose that purely competitive firms producing cashews discover that P exceeds MC. Is their combined output of cashews too little, too much, or just right to achieve allocative efficiency? In the long run, what will happen to the supply of cashews and the price of cashews? Use a supplyand-demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews. LO7 Answer The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them.

In the long run, the supply will increase as firms enter (or expand) to capture the economic profits being earned. The increase in supply will reduce the price of cashews.

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PROBLEMS Problem 1 A purely competitive firm finds that the market price for its product is $20. It has a fixed cost of $100 and a variable cost of $10 per unit for the first 50 units and then $25 per unit for all successive units. Does price exceed average variable cost for the first 50 units? What about for the first 100 units? What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? What output level will yield the largest possible profit for this purely competitive firm?

(Hint: Draw a graph similar to Figure 10.2 using data for this firm.) LO3 Answer Yes; Yes; the MC per unit is $10 per unit for the first 50 units; the MC per unit is $25 per unit for subsequent units; Yes, MR > MC; For units 51 and up, MR < MC; Producing 50 units will maximize profit.

Feedback: Does price exceed average variable cost for the first 50 units? Yes, price ($20) exceeds average variable cost for the first 50 units since AVC for the first 50 units is $10 per unit [= ($10 per unit × 50 units)/50 units].

What about for the first 100 units? Yes, price ($20) exceeds average variable cost for the first 100 units since AVC for the first 100 units is $17.50 per unit [= ($10 per unit × 50 units + $25 per unit × 50 units)/100].

What is the marginal cost per unit for the first 50 units? What about for units 51 and higher? For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? The MC is $10 per unit for the first 50 units and the MC is $25 per unit for subsequent units.

For each of the first 50 units, MR > MC since $20 > $10 and for units 51 and up, MR < MC since $20 < $25.

What output level will yield the largest possible profit for this purely competitive firm? The firm will produce 50 units to maximize profit because the MC of the 51st unit exceeds marginal revenue.

Problem 2 A purely competitive wheat farmer can sell any wheat he grows for $10 per bushel. His five acres of land show diminishing returns because some are better suited for wheat production than 1-146 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

others. The first acre can produce 1000 bushels of wheat, the second acre 900, the third 800, and so on. Draw a table with multiple columns to help you answer the following questions. How many bushels will each of the farmer’s five acres produce? How much revenue will each acre generate? What are the TR and MR for each acre? If the marginal cost of planting and harvesting an acre is $7000 per acre for each of the five acres, how many acres should the farmer plant and harvest? LO3 Answer Acre # 1 2 3 4 5

That Acre’s Yield 1,000 900 800 700 600

That Acre’s Revenue $10,000 9,000 8,000 7,000 6,000

TR

MR

$10,000 19,000 27,000 34,000 40,000

$10,000 9,000 8,000 7,000 6,000

The first step is to calculate the revenue generated by each acre (column 3). Each entry, the acre’s revenue, is found by multiplying the price per bushel by the acre’s yield. The revenue generated by the first acre is $10,000 (= $10×x 1,000); the second acre, $9,000 (= $10 × 900); the third acre, $8,000 (= $10 × 800); etc.

The next step is to calculate total revenue (column 4). Total revenue equals the sum of revenue generated by each successive acre being cultivated. Total revenue for the first acre is $10,000; total revenue for first and second acres is $19,000 (= $10,000 + $9,000); total revenue for the first, second, and third acres is $27,000 (= $10,000 + $ 9,000 + $8,000); etc.

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The final step is to calculate marginal revenue (column 5). Marginal revenue equals the change in total revenue as each successive acre is cultivated. Marginal revenue for the first unit is $10,000 because as we move from cultivating zero acres to one acre, our total revenue changes by $10,000. The marginal revenue for the second acre equals $9,000, which is the total revenue of the second acre minus the revenue generated by the first acre (= $19,000 – $10,000), etc.

Using our MC = MR rule, the farmer should plant and harvest four acres. Marginal revenue for the fourth acre equals $7,000 and the marginal cost equals $7,000.

Problem 3 Karen runs a print shop that makes posters for large companies. It is a very competitive business.

The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1000 for the first thousand posters, $800 for the second thousand, and then $750 for each additional thousand posters. What is her AFC per poster (not per thousand!) if she prints 1000 posters? 2000? 10,000? What is her ATC per poster if she prints 1000? 2000? 10,000? If the market price fell to 70 cents per poster, would there be any output level at which Karen would not shut down production immediately? LO3 Answer To calculate average fixed cost (AFC), divide total fixed cost by the number of posters being produced (= Total fixed cost/# of posters).

Therefore, her AFC for 1,000 posters is $0.25 (= $250/1,000); for 2,000 posters, $0.125 (= $250/2,000); and for 10,000 posters, $0.025 (= $250/10,000).

What is her ATC per poster if she prints 1,000? 2,000? 10,000?

Before we calculate the average total cost (ATC) per poster, we need to find the average variable cost (AVC) per poster using the information above. The AVC is found by dividing the total variable cost by the number of posters produced.

AVC for 1,000 posters is $1.00. This is the total variable cost of $1,000 divided by the number of posters, 1,000 (= $1,000/1,000).

AVC for 2,000 posters is $0.90. This is the total variable cost of $1,800, $1,000 for the first 1,000 and $800 for the second 1,000, divided by the total number of posters, 2,000 (= $1,800/2,000).

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AVC for 10,000 posters is $0.78. This is the total variable cost of 7,800, $1,000 for the first 1,000, $800 for the second 1,000, and $6,000 for the next 8,000 ($750 per 1,000 or 8 × $750), divided by 10,000 posters (= $7,800/10,000).

Now we can find her ATC, which equals the sum of her average fixed cost and her average variable cost (= AFC + AVC).

ATC for 1,000 posters is $1.25 (= $0.25 + $1.00). ATC for 2,000 posters is $1.025 (= $0.125 + $0.90). ATC for 10,000 posters is $0.805 (= $0.025 + $0.78).

Since the price is 70 cents per poster, Karen will shut down because average variable cost never falls below 75 cents per poster.

Problem 4 Assume that the cost data in the table below are for a purely competitive producer: LO3

a. At a product price of $56, will this firm produce in the short run? If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? What economic profit or loss will the firm realize per unit of output? b. Answer the questions in part a assuming product price is $41. c. Answer the questions in part a assuming product price is $32. d. In the table below, complete the short-run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3).

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e. Now assume that there are 1500 identical firms in this competitive industry; that is, there are 1500 firms, each of which has the cost data shown in the table. Complete the industry supply schedule (column 4). f. Suppose the market demand data for the product are as follows:

What is the equilibrium price? What is the equilibrium output for the industry? For each firm?

What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?

Answer a. The rule is to produce at the level of output where marginal revenue equals (or is greater than if we are using integers) marginal cost as long as revenue is sufficient to cover fixed cost (price is greater than average fixed cost).

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In the case above, the market is competitive so marginal revenue equals the price of $56. From the table above we see that the marginal cost for the eighth unit is $55 and the marginal cost of the ninth unit is $65. The firm will want to produce eight units where the marginal revenue of $56 is greater than the marginal cost of $55. For the ninth unit of output, this is not the case.

We also need to verify that price exceeds average variable cost at this level of production. The answer is yes; average variable cost is $40.63, which is less than the price of $56.

At this level of production, the firm will earn a positive economic profit per unit of $7.87 (= $56 (price of product) – $48.13 (average total cost for the eighth unit). The total economic profit equals $62.96 (= 8 (number of units sold) × $7.87 (profit per unit)). b. The same process is applied here. The price of $41, which is marginal revenue, is greater than the marginal cost of the sixth unit in the table above. Beyond this level of production, marginal cost exceeds marginal revenue. Thus, the firm will produce six units as long as price covers average variable cost.

The average variable cost for six units is $37.50, which is less than the price. The firm will produce the six units of output. At this level of production, the firm will earn a negative economic profit per unit, or loss per unit, of –$6.50 (= $41 (price of product) – $47.50 (average total cost for the sixth unit). The total economic profit (loss) equals –$39.00 (= 6 (number of units sold) × (–$6.50) (loss per unit)). c. We could go through the same exercise here. However, by recognizing that the price of $32 is below average variable cost at all levels of production, the firm will not produce. Thus, the firm shuts down and incurs the loss of $60.00 (fixed cost). d and e.

(1) Price $26 32 38 41 46 56 66

(2) (3) (4) Quantity Quantity Profit (+) or Loss Supplied, Single Supplied, 1,500 (–) Firm Firms 0 $–60.00 0 0 –60.00 0 5 –55.00 7,500 6 –39.00 9,000 7 –7.98 10,500 8 62.96 12,000 9 144.00 13,500

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f. Suppose the market demand data for the product are as follows: Total Quantity Price Demanded $26 17,000 32 15,000 38 13,500 41 12,000 46 10,500 56 9,500 66 8,000 To determine the equilibrium price, we look at the total quantity demanded schedule and the total quantity supplied schedule (for the 1,500 firms above) to find the price where quantity demanded equals quantity supplied.

This occurs at the price of $46, where quantity demanded = 10,500 and quantity supplied = 10,500. The quantity 10,500 is the equilibrium output for the industry. Note that at prices below $46 quantity demanded exceeds quantity supplied and at prices above $46 quantity supplied exceeds quantity demanded.

The equilibrium output for each firm is 7 units (= 10,500 (industry output)/1,500 (number of firms)).

Since the equilibrium price of $46 is below the average total cost for 7 units of output at the firm level, there will be a loss. The per-unit loss for the firm is –$1.14 (= $46 (price) – $47.14 (average total cost for 7 units)).

The loss per firm is –$7.98 (= 7 units produced) × (–$1.14) (loss per unit)).

This industry will contract due to the negative economic profit (or economic loss).

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 8 Pure Monopoly QUESTIONS Question 1 ―No firm is completely sheltered from rivals; all firms compete for consumer dollars. Therefore, pure monopoly does not exist.‖ Do you agree? Explain. How might you use the concept of cross elasticity of demand to judge whether monopoly exists? LO1 1-152 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer Though it is true that ―all firms compete for the dollars of consumers,‖ it is playing on words to hold that pure monopoly does not exist. If you want electric lights, you have to deal with a single company. It is a pure monopoly in that regard, even though you can switch to oil or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for lighting too—but these are hardly convenient options.

The concept of cross elasticity of demand can be used to measure the presence of close substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater than one, then the demand that the monopoly faces is elastic with respect to substitute products, and the firm has less control over its product price than if the cross elasticity of demand were inelastic. In other words, the monopoly faces competition from producers of substitute products.

Note that a negative cross price elasticity of demand indicates that two goods are complements rather than substitutes.

Question 2 Discuss the major barriers to entry into an industry. Explain how each barrier can foster monopoly. Which barriers, if any, do you feel give rise to monopoly that is socially justifiable?

LO1 Answer Economies of scale are a barrier to entry because of the need for new firms to start big to achieve the low production costs of those already in the industry. However, not all industries need techniques of production that require large scale. In many industries the minimum efficient scale is only a small percentage of domestic consumption. Economies of scale can help protect an oligopoly. The already-established firms in the market are very efficient at production, with low costs. A new firm entering the market would have high start-up costs. Most consumers will choose to buy from the efficient firm because they can offer lower prices than the new firm.

Natural monopolies give rise to monopoly that is socially justifiable. The economies of scale are sometimes such that having two or more firms serving the market would increase costs unreasonably. Two telephone companies, or gas companies, or water companies, or electricity companies in the same city would be highly inconvenient and costly as long as transmission requires wires and pipes. In such instances, it makes sense for government to grant exclusive franchises and then regulate the resulting monopoly to ensure the public interest is protected.

Patents and licenses are legal barriers to entry that also, to some extent, are justifiable. These would give rise to a monopoly. If inventions were not protected at all from immediate copying by those who bore none of the costs, the urge to invent and innovate would be lessened and the costly secrecy that is enforced already would have to be much greater and more costly.

However, this does not mean that abuses do not exist in the present system and a case can be made for reducing the present 17 years for which patents are granted.

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Ownership of essential raw materials is another barrier to entry. It has little social justification except to the extent that the hope of gaining a monopoly in the supply of an essential raw material leads to more prospecting.

Unfair competition is the last of the barriers and has no social justification at all, which is why price-cutting to bankrupt a rival is illegal. The problem here, though, is to prove that cutthroat competition truly is what it appears to be. We see this mostly in oligopolies.

Question 3 How does the demand curve faced by a purely monopolistic seller differ from that confronting a purely competitive firm? Why does it differ? Of what significance is the difference? Why is the pure monopolist’s demand curve typically not perfectly inelastic? LO2 Answer The demand curve facing a pure monopolist is downward sloping; that facing the purely competitive firm is horizontal, perfectly elastic. This is so for the pure competitor because the firm faces a multitude of competitors, all producing perfect substitutes. In these circumstances, the purely competitive firm may sell all that it wishes at the equilibrium price, but it can sell nothing for even so little as one cent higher. The individual firm’s supply is so small a part of the total industry supply that it cannot affect the price.

The monopolist, on the other hand, is the industry and therefore is faced with a normal downward-sloping industry demand curve. Being the entire industry, the monopolist’s supply is big enough to affect prices. By decreasing output, the monopolist can force the price up.

Increasing output will drive it down.

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Part of the demand curve facing a pure monopolist could be perfectly inelastic; if the monopolist put only a very few items on the market, it is possible the firm could sell them all at, say, $1, or $2, or $3. But it is the very fact that the monopolist could sell the same amount at higher and higher prices that would ensure that the profit-maximizing monopolist would not, in fact, sell in this perfectly inelastic range of the demand curve. Indeed, the monopolist would not sell in even the still slightly inelastic range of the demand curve. The reason is that so long as the demand curve is inelastic, MR must be negative, but since the MC of any item can hardly be negative also, the monopolist’s profit must decrease if it produces here. To equate a positive MR with MC, the monopolist must produce in the elastic range of its demand curve.

Question 4 Use the following demand schedule to calculate total revenue and marginal revenue at each quantity. Plot the demand and MR curves, and explain the relationships between them. Suppose the marginal cost of successive units of output was zero. What output would the profit-seeking monopolist produce, and what price would it charge? LO2

Answer To calculate total revenue, multiply price (P) by quantity demanded (Q): TR = P × Q. To calculate marginal revenue, find the change in total revenue for each unit demanded: MR = ΔTR = TRi+1 – TRi. See the table below.

Price (P) $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00

Quantity Total Revenue Marginal Demanded (Q) (TR) Revenue (MR) 0 $ 0.00 NA 1 6.50 $ 6.50 2 12.00 5.50 3 16.50 4.50 4 20.00 3.50 5 22.50 2.50 6 24.00 1.50 7 24.50 0.50 8 24.00 –0.50 1-155

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2.50

9

22.50

–1.50

Because TR is increasing at a diminishing rate, MR is declining. When TR turns downward (starts decreasing), MR becomes negative.

Marginal revenue is below D because to sell an extra unit, the monopolist must lower the price on the marginal unit as well as on each of the preceding units sold. Four units sell for $5.00 each, but three of these four could have been sold for $5.50 had the monopolist been satisfied to sell only three. Having decided to sell four, the monopolist had to lower the price of the first three from $5.50 to $5.00, sacrificing $.50 on each for a total of $1.50. This ―loss‖ of $1.50 explains the difference between the $5.00 price obtained on the fourth unit of output and its marginal revenue of $3.50.

Demand is elastic from P = $6.50 to P = $3.50, a range where TR is rising. The curve is of unitary elasticity at P = $3.50, where TR is at its maximum. The curve is inelastic from then on as the price continues to decrease and TR is falling. When MR is positive, demand is elastic.

When MR is zero, demand is of unitary elasticity. When MR is negative, demand is inelastic.

If MC is zero, the monopolist should produce seven units, which is the last complete unit where MR still exceeds MC. It would never produce where demand is inelastic because MR is negative there while MC is positive.

The graph below summarizes the analysis discussed above.

Question 5 Assume a monopolistic publisher has agreed to pay an author 10 percent of the total revenue from the sales of a text. Will the author and the publisher want to charge the same price for the text? Explain. LO2 1-156 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer The publisher is a monopolist seeking to maximize profits. This will occur at the quantity of output where MC = MR. (See figure below.)

The author who will receive 10 percent of the total revenue will maximize his payment if the book is priced where MR = 0. This will occur where the price elasticity of demand is equal to 1 and total revenue is maximum. (See figure below.)

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The author would prefer a lower price than the publisher. Consult the graph above and compare the price charged where MC = MR and the price that would be necessary to maximize total revenue when MR = 0. This is a highly unlikely outcome since the publisher, whether economically literate or not, is certain to recognize the revenue-maximizing price as disadvantageous.

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Question 6 Assume that a pure monopolist and a purely competitive firm have the same unit costs. Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and (e) impact on the income transfers. Since both monopolists and competitive firms follow the MR = MC rule in maximizing profits, how do you account for the different results? Why might the costs of a purely competitive firm and those of a monopolist be different? What are the implications of such a cost difference? LO3 Answer With the same costs, the pure monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short run and the long run than the pure competitor. As a matter of fact, the pure competitor will have no economic profits in the long run even though it might have some in the short run. Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the pure competitor. Specifically, resources are underallocated to monopolistic industries. Since a pure monopolist is more likely than the pure competitor to make economic profits in the short run and is, moreover, the only one of the two able to make economic profits in the long run, the distribution of income is more unequal with monopoly than with pure competition.

In pure competition, MR = P because the firm’s supply is so insignificant a part of industry supply that its output has no effect on price. It can sell all that it wishes at the price established by demand and the total industry supply. The firm cannot force the price up by holding back part or all of its supply.

The monopolist, on the other hand, is the industry. When it increases the quantity it produces, price drops. When it decreases the quantity it produces, price rises. In these circumstances, MR is always less than price for the monopolist; to sell more it must lower the price on all units, including those it could have sold at the higher price had it not put more on the market. When the monopolist equates MR and MC, it is not selling at that price: The monopolist’s selling price is on the demand curve, vertically above the point of intersection of MR and MC. Thus, the monopolist’s price will be higher than the pure competitor’s.

Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steel-making and car manufacturing, pure competition would involve a very high cost. On the other hand, monopolies may suffer from X-inefficiency, the inefficiency that a lack of competition allows. Monopolies may also incur nonproductive costs through ―rentseeking‖ expenditures. For example, they may try to influence legislation that protects their monopoly powers.

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Question 7 Critically evaluate and explain each statement: LO3 a. Because they can control product price, monopolists are always assured of profitable production by simply charging the highest price consumers will pay. b. The pure monopolist seeks the output that will yield the greatest per-unit profit. c. An excess of price over marginal cost is the market’s way of signaling the need for more production of a good. d. The more profitable a firm, the greater its monopoly power. e. The monopolist has a pricing policy; the competitive producer does not. f. With respect to resource allocation, the interests of the seller and of society coincide in a purely competitive market but conflict in a monopolized market.

Answer a. The statement is false. If the monopolist charged the highest price consumers would pay, it would sell precisely one unit! (Conceivably, it might sell a little more than one if more than one consumer made matching bids for the first unit offered.) It is highly unlikely that the sale of one unit (or a very few) would cover the very high AFC of one or a very few units. And even a monopolist that does produce sensibly where MR = MC may still suffer a loss: P can be below ATC at all levels. b. The statement is false. The monopolist seeks the output that will yield the greatest profit. The profit equation is Q(P – ATC). It is not (P – ATC). If the monopolist sells one unit for $100 when ATC is $60, then its profit per unit and total profit are $40 (= $100 – $60). Nice, but if the same monopolist can sell 1,000 units for $40 when ATC is $39, then, though its per-unit profit is a mere $1 (= $40 – $39), its total profit is $1,000 [= 1,000($40 – $39)]. This is much better than $40. c. The statement is true. Price is the value society sets on the last item produced. Marginal cost is the value to society of the alternative production forgone when the last item is produced. When P > MC, society is willing to pay more than the opportunity cost of the last item’s production. d. This statement can be true and probably is in many cases. Large profits allow expansion to gain economies of scale and thus prevent the late entry of smaller rivals. Large profits also enable the firm to price below cost, to engage (illegally) in a price war. Moreover, large profits in the short run are often associated with monopoly power. In the long run, only a firm with monopoly power can gain economic profits; in pure competition such profits would invariably be competed away by a new entry.

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e. The statement is true. The monopolist must equate MR and MC. Having determined at what quantity this equality occurs, the monopolist simultaneously sets price. This price differs at each output because the demand curve is downsloping. The pure competitor accepts the price given by total industry supply and demand. Knowing this externally given price, the competitor then equates it with the firm’s MC and produces the amount determined by this equality. f. The statement is true. In pure competition, P = MC. This means that the value society sets on the last item produced (its price) is equal to the cost of the alternative commodities that are not produced because of producing the last item of the commodity in question (its MC). In monopoly, P > MC. This means that society values the last item produced more than its cost.

Question 8 U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in different nations, depending on elasticity of demand and government-imposed price ceilings.

Explain why these companies, for profit reasons, oppose laws allowing re-importation of drugs to the United States. LO4 Answer U.S. pharmaceutical companies are price discriminating based in part on the different elasticities of demand in different nations. Reimportation allows reselling of the goods, making it more difficult to price discriminate. To the extent they could still charge different prices, the difference in prices would have to be small enough so that reimportation was not profitable. Prohibition of reimportation would allow pharmaceutical companies to charge the profit-maximizing price in each nation, without fear of being undercut back in the United States by those in nations where the drugs are cheaper.

Question 9 How was De Beers able to control the world price of diamonds even though it produced only 45 percent of the diamonds? What factors ended its monopoly? What is its new strategy for earning economic profit, rather than just normal profit? LO1 Answer De Beers produces 50 percent of all rough-cut diamonds but buys a large portion of the diamonds produced by other mines. As a result, it marketed over 80 percent of the world’s diamonds.

New diamonds were discovered and mined in Angola, Canada, and Australia and some of these diamonds were leaking into the world market. In addition, Russia was allowed to sell a portion of its diamond stock directly into the world market.

De Beers’ new strategy is to transform itself into a firm selling premium diamonds and other luxury goods. This new image will be portrayed in an advertising campaign.

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Question 10 Under what law and on what basis did the federal district court find Microsoft guilty of violating the antitrust laws? What was the initial district court’s remedy? How did Microsoft fare with its appeal to the court of appeals? Was the final remedy in the case a structural remedy or a behavioral remedy?LO5 Answer Microsoft was found guilty of violating Section 2 of the Sherman Act. The court ruled that Microsoft had taken unlawful actions to maintain its Windows monopoly by tying Internet Explorer to Windows at no charge. Also under license from Sun, Microsoft developed Windowsrelated Java software that made Sun’s own software incompatible with Windows. The district court’s remedy was to break Microsoft into two companies that were prohibited from entering into joint ventures. The court of appeals upheld the lower court ruling that Microsoft had violated Section 2 but altered the remedy. The final remedy is behavioral, as Microsoft is not required to split into two companies, but they must alter their business practices.

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PROBLEMS Problem 1 Assume that the most efficient production technology available for making vitamins pills has the cost structure given in the following table. Note that output is measured as the number of bottles of vitamins produced per day and that costs include a normal profit. LO1

a. What is ATC per unit for each level of output listed in the table? b. Are there economies of scale in production? (Answer yes or no). c. Suppose that the market price for a bottle of vitamins is $2.50. At that price the total market quantity demanded is 75,000,000 bottles. How many firms will be in this industry? d. Suppose that, instead, the market quantity demanded at a price of $2.50 is only 75,000. How many firms will be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s market structure?

Answer a. See the table below for the ATC values.

Output 25,000 50,000 75,000 100,000

TC $100,000 150,000 187,500 275,500

MC $0.50 1.00 2.50 3.00

ATC $4.00 3.00 2.50 2.76

b. This is a decreasing-cost industry because the average total cost per unit produced (ATC) declines with every increase in output level. The higher the output, the lower the ATC.

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c. Since $2.50 is minimum ATC, firms will produce at this level of output. Any firm that deviated from this level would incur a higher ATC and would be unprofitable at the market price of $2.50.

The total number of firms can be found by dividing the market quantity demanded by output produced by a firm at the ATC of $2.50, which is 75,000.

Number of firms = Market quantity demanded/Output minimum ATC = 75,000,000/75,000 = 1,000. d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000. How many firms do you expect there to be in this industry?

The total number of firms under this assumption is: Number of firms = Market quantity demanded/Output minimum ATC = 75,000/75,000 =1. e. Yes, high demand will result in a competitive industry while very low demand can result in a monopoly industry.

Problem 2 A new production technology for making vitamins is invented by a college professor who decides not to patent it. Thus, it is available for anybody to copy and put into use. The TC per bottle for production up to 100,000 bottles per day is given in the following table. LO1

a. What is ATC for each level of output listed in the table? b. Suppose that for each 25,000-bottle-per-day increase in production above 100,000 bottles per day, TC increases by $5000 (so that, for instance, 125,000 bottles per day would generate total costs of $85,000 and 150,000 bottles per day would generate total costs of $90,000). Is this a decreasing-cost industry? c. Suppose that the price of a bottle of vitamins is $1.33. At that price the total quantity demanded by consumers is 75,000,000 bottles. How many firms will there be in this industry?

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d. Suppose that, instead, the market quantity demanded at a price of $1.33 is only 75,000. How many firms will be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s market structure?

Answer a. ATC = Total cost/Output Output TC 25,000 $50,000 50,000 70,000 75,000 75,000 100,000 80,000

ATC $2.00 1.40 1.00 0.80

b. The last two rows provide the additional cost and output information (you could continue to add rows for additional output).

Output TC ATC 25,000 $50,000 $2.00 50,000 70,000 1.40 75,000 75,000 1.00 100,000 80,000 0.80 125,000 $85,000 0.68 150,000 $90,000 0.60 From this additional information we can conclude this is a decreasing cost industry because ATC falls as output increases at all levels. c. Since this is a decreasing cost industry, there will only be one firm. d. Again, since this is a decreasing cost industry, there will only be one firm. e. No. Since this is a decreasing cost industry, there will only be one firm regardless of demand.

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Problem 3 Suppose a pure monopolist faces the following demand schedule and the same cost data as the competitive producer discussed in problem 4 at the end of Chapter 10. Calculate the missing TR and MR amounts, and determine the profit-maximizing price and profit-maximizing output for this monopolist. What is the monopolist’s profit? Verify your answer graphically and by comparing total revenue and total cost. LO2

Answer Production and Costs Total Average Average Product Fixed Variable Cost Cost 0 na na $60.00 $45.00 1

Average Total Cost na $105.00

Marginal Cost na $45

30.00 20.00 15.00 12.00 10.00 8.57 7.50 6.67 6.00

72.50 60.00 52.50 49.00 47.50 47.14 48.13 50.00 52.50

40 35 30 35 40 45 55 65 75

2 3 4 5 6 7 8 9 10

42.50 40.00 37.50 37.00 37.50 38.57 40.63 43.33 46.50

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Demand Price $115 100 83 71 63 55 48 42 37 33 29

Quantity Demanded 0 1 2 3 4 5 6 7 8 9 10

Total Revenue $ 0 100 166 213 252 275 288 294 296 297 290

Marginal Revenue $100 66 47 39 23 13 6 2 1 –7

To calculate total revenue, multiply price (P) by quantity demanded (Q): TR = P × Q. To calculate marginal revenue, find the change in total revenue for each unit demanded: MR = ΔTR = TRi+1 – TRi. See table below.

Price $115 100 83 71 63 55 48 42 37 33 29

Quantity Total Marginal Demanded Revenue Revenue $0 NA 0 100 100 1 166 66 2 213 47 3 252 39 4 275 23 5 288 13 6 294 6 7 296 2 8 297 1 9 290 –7 10

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To determine the profit-maximizing price and profit-maximizing output for this monopolist, use the cost data below.

Average Average Average Total Marginal Fixed Variable Total Product Cost Cost Cost Cost 0 1 $60.00 $45.00 $105.00 $45 2 30.00 42.50 72.50 40 3 20.00 40.00 60.00 35 4 15.00 37.50 52.50 30 5 12.00 37.00 49.00 35 6 10.00 37.50 47.50 40 7 8.57 38.57 47.14 45 8 7.50 40.63 48.13 55 9 6.67 43.33 50.00 65 10 6.00 46.50 52.50 75

To find the profit-maximizing quantity, compare marginal revenue from the first table above with the marginal cost from the second table.

Price (P) Quantity Marginal Marginal Demanded Revenue Cost (MC) (Q) (MR) $115 0 NA NA 100 1 $100 $45 83 2 66 40 71 3 47 35 63 4 39 30 55 5 23 35 48 6 13 40 42 7 6 45 37 8 2 55 33 9 1 65 29 10 –7 75 Starting with the first unit, (MR = $100) > (MC = $45), produce this unit. The same logic applies to units two, three, and four. However, for the fifth unit, (MR = $23) < (MC = $35). Thus, the firm does NOT produce this unit. (NOTE: We have modified the MR = MC rule to MR > MC, which is more general. Produce all units where MR > MC.)

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The profit-maximizing quantity produced is four units.

The profit-maximizing price is the price associated with the profit-maximizing quantity, four units. Thus, the profit-maximizing price is $63.

The monopolist’s profit equals total revenue minus total cost. Total revenue equals $252 at four units of output. We still need total cost. From the ―cost data‖ table we see that average total cost (ATC) equals $52.50. Since ATC equals total cost divided by quantity, we can determine total cost from the ATC cost data.

ATC = Total cost/Quantity or Total cost = Quantity × ATC = 4 × $52.50 = $210 Profit = $252 – $210 = $42 Another approach is to use the following relationship.

Profit = TR – TC Divide through by Q Profit/Q = TR/Q – TC/Q Since TR/Q = Average Rrvenue = P and TC/Q = ATC, we have: Profit/Q = P – ATC Rearranging: Profit = Q(P – ATC) = 4($63 – $52.50) = 4 × $10.5 = $42.

Either approach above will work.

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Problem 4 Suppose that a price-discriminating monopolist has segregated its market into two groups of buyers. The first group is described by the demand and revenue data that you developed for problem 3. The demand and revenue data for the second group of buyers is shown in the table.

Assume that MC is $13 in both markets and MC = ATC at all output levels. What price will the firm charge in each market? Based solely on these two prices, which market has the higher price elasticity of demand? What will be this monopolist’s total economic profit? LO4

Answer Price $71 63 55 48 42 37 33 29

Quantity Demanded 0 1 2 3 4 5 6 7

Total Revenue $ 0 63 110 144 168 185 198 203

Marginal Revenue $63 47 34 24 17 13 5

Let’s start with the second market (table above). Marginal cost is $13 for all output levels. The marginal revenue from producing the sixth unit is $13 (= $198 – $185), so this is the last unit produced by the firm for this market.

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Thus, the marginal revenue equals marginal cost rule results in six units being produced in this market (MR = MC = $13 at 6 units in this market).

The price the firm charges in this market is $33, which is the price associated with the sixth unit.

The firm’s profit in this market can be found using the following relationship (see problem 3 in this chapter for derivation).

ProfitMarket 2 = Q(P – ATC) = 6($33 – $13) = 6 × $20 = $120.

The first market is found in the table below: Price (P) Quantity Total Demanded Revenue (TR) (Q) $115 0 $ 0 100 1 100 83 2 166 71 3 213 63 4 252 55 5 275 48 6 288 42 7 294 37 8 296 33 9 297 29 10 290

Marginal Revenue (MR) NA 100 66 47 39 23 13 6 2 1 –7

Again, marginal cost is $13 for all output levels.

The marginal revenue equals marginal cost rule results in six units being produced in this market as well (MR = MC = $13 at 6 units in this market).

The price the firm charges in this market is $48, which is the price associated with the sixth unit.

The firm’s profit in this market can be found using the following relationship (see problem 3 in this chapter for derivation).

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ProfitMarket 1 = Q(P – ATC) = 6($48 – $13) = 6 × $35 = $210.

The combined profit from both markets gives us total profit.

Total profit = ProfitMarket 1 + ProfitMarket 2 = $120 + $210 = $330 Since the firm charges a lower price in the second market (a price of $48), this market has the higher price elasticity of demand.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 9 Monopolistic Competition and Oligopoly QUESTIONS Question 1 How does monopolistic competition differ from pure competition? From pure monopoly?

Explain fully what product differentiation may involve. Explain how the entry of firms into its industry affects the demand curve facing a monopolistic competitor and its economic profit. LO1 Answer In monopolistic competition there are many firms but not the very large numbers of pure competition. The products are differentiated, not standardized. There is some control over price in a narrow range, whereas the purely competitive firm has none. There is relatively easy entry; in pure competition, entry is completely without barriers. In monopolistic competition, there is much nonprice competition, such as advertising, trademarks, and brand names. In pure competition, there is no nonprice competition.

In pure monopoly there is only one firm. Its product is unique and there are no close substitutes. The firm has much control over price, being a price maker. Entry to its industry is blocked. Its advertising is mostly for public relations.

Product differentiation may well only be in the eye of the beholder, but that is all the monopolistic competitor needs to gain an advantage in the market—provided, of course, the consumer looks upon the assumed difference favorably. The real differences can be in quality, in services, in location, or even in promotion and packaging, which brings us back to where we started: possibly nonexistent differences. To the extent that product differentiation exists in fact or in the mind of the consumer, monopolistic competitors have some limited control over price, for they have built up some loyalty to their brand.

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When economic profits are present, additional rivals will be attracted to the industry because entry is relatively easy. As new firms enter, the demand curve faced by the typical firm will shift to the left (fall). Because of this, each firm has a smaller share of total demand and now faces a larger number of close-substitute products. This decline firm’s demand reduces its economic profit.

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Question 2 Compare the elasticity of the monopolistic competitor’s demand with that of a pure competitor and a pure monopolist. Assuming identical long-run costs, compare the prices and outputs that would result in the long run under pure competition and under monopolistic competition.

Contrast the two market structures in terms of productive and allocative efficiency. Explain: ―Monopolistically competitive industries are characterized by too many firms, each of which produces too little.‖ LO2 Answer The monopolistic competitor’s demand curve is less elastic than a pure competitor and more elastic than a pure monopolist. Price is higher and output lower for the monopolistic competitor.

Pure competition: P = MC (allocative efficiency); P = minimum ATC (productive efficiency).

Monopolistic competition: P > MC (allocative inefficiency) and P > minimum ATC (productive inefficiency). Monopolistic competitors have excess capacity, meaning that fewer firms operating at capacity (where P = minimum ATC) could supply the industry output.

Question 3 ―Monopolistic competition is monopolistic up to the point at which consumers become willing to buy close-substitute products and competitive beyond that point.‖ Explain. LO2 Answer As long as consumers prefer one product over another regardless of relative prices, the seller of the product is a monopolist. But in monopolistic competition this happy state is limited because there are many other firms producing similar products. When one firm’s prices get ―too high‖ (as viewed by consumers), people will switch brands. At this point, our firm has entered the competitive zone unwillingly, which is why monopolistically competitive firms are forever trying to find ways to differentiate their products more thoroughly and thus to gain more monopoly price setting power.

Question 4 ―Competition in quality and service may be just as effective as price competition in giving buyers more for their money.‖ Do you agree? Why or why not? Explain why monopolistically competitive firms frequently prefer nonprice competition to price competition. LO2 Answer This can certainly be true. It depends on how much consumers value quality and service, and are willing to pay for it through higher product prices. In a monopolistically competitive market the consumer can buy a substitute brand for a lower price, if the consumer prefers a lower price to better quality and service.

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The monopolistically competitive firm frequently prefers nonprice competition to price competition because the latter can lead to the firm producing where P = ATC and thus making no economic profit or, worse, producing in the short run where P < ATC and thus losing money, with the possibility of eventually going out of business.

Nonprice competition, on the other hand, if successful, results in more monopoly power: The firm’s product has become more differentiated from now less-similar competitors in the industry.

This increase in monopoly power allows the firm to raise its price with less fear of losing customers. Of course, the firm must still follow the MR = MC rule, but its success in nonprice competition has shifted both the demand and MR curves upward to the right. This results in simultaneously a larger output, a higher price, and more economic profits.

Question 5 Why do oligopolies exist? List five or six oligopolists whose products you own or regularly purchase. What distinguishes oligopoly from monopolistic competition? LO3 Answer Oligopolies exist for several reasons, the most common probably being economies of scale. If these are substantial, as they are in the automobile industry, for example, only very large firms can produce at minimum average cost. This makes it virtually impossible for new firms to enter the industry. A small firm could not produce at minimum cost and would soon be competed out of the business; yet to start at the required very large scale would take far more money than an unestablished firm is likely to be able to raise before proving it will be profitable.

Other barriers to entry include ownership of patents by the oligopolists and, possibly, massive advertising that gives would-be newcomers no chance to establish a presence in the public’s mind. Finally, there is the urge to merge. Mergers have the clear advantage of reducing competition—of giving the emerging oligopolists more monopoly power. Also, they may result in more economies of scale and thereby increase that barrier to new entry.

Oligopolies with which we deal include manufacturers of automobiles, ovens, refrigerators, personal computers, gasoline, and courier services.

Oligopoly is distinguished from monopolistic competition by being composed of few firms (not many); by being mutually interdependent with regard to price (instead of control within narrow limits); by having differentiated or homogeneous products (not all differentiated); and by having significant obstacles to entry (not easy entry). Both engage in much nonprice competition.

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Question 6 Explain the general meaning of the following profit payoff matrix for oligopolists X and Y. All profit figures are in thousands. LO4

a. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic industries. b. Assuming no collusion between X and Y, what is the likely pricing outcome? c. In view of your answer to part b, explain why price collusion is mutually profitable. Why might there be a temptation to cheat on the collusive agreement?

Answer a. X and Y are interdependent because their profits depend not just on their own price, but also on the other firm’s price. Note that Y’s profits are in the lower corner and X’s profits are in the upper corner. b. Likely outcome: Both firms will set price at $35. If either charged $40, it would be concerned the other would undercut the price and its profit by charging $35. For example, if firm X chooses a price of $40 and firm Y chooses a price of $40 then firm X’s profits are $57,000 and firm Y's profits are $60,000. However, if firm Y chooses to charge $35, it can increase its profit to $69,000. In effect, firm Y has an incentive to deviate from the price of $40. The same logic applies to firm X. If firm X deviates from the price of $40, it can increase profits to $59,000. The catch is that both firms recognize this incentive structure and realize that if they continue to charge $40 and the other firm deviates from this price, their profits will fall (if firm X continues to charge $40 and firm Y charges $35, rather than $40, to capture higher profits, then firm X’s profits will fall to $50,000; if firm X also charged $35, its profits would be $55,000, which is better than $50,000). Thus, both firms charge a price $35; X’s profit is $55,000 and Y’s, $58,000.

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c. Through price collusion—agreeing to charge $40—each firm would achieve higher profits (X = $57,000; Y = $60,000). But once both firms agree on $40, each sees it can increase its profit even more by secretly charging $35 while its rival charges $40, which was discussed above.

Question 7 ADVANCED ANALYSIS Construct a strategic form payoff matrix involving two firms and their decisions on high versus low advertising budgets and the effects of each on profits. Show a circumstance in which both firms select high advertising budgets even though both would be more profitable with low advertising budgets. Why won’t they unilaterally cut their advertising budgets? LO7 Answer Consider the following example, where Firm B's profits are in the lower corner and Firm A's profits are in the upper corner:

Profits from each advertising strategy appear in the cells. In the payoff matrix above, each firm can choose between a low and a high advertising budget. If, for example, Firm A chooses a high budget and Firm B a low budget, Firm A’s profit will be $120 and Firm B’s, only $60.

The payoff matrix suggests that both firms would choose to have high advertising budgets, but if both choose to do so, they will both be worse off relative to if they both had low budgets. Neither firm will reduce its budget because if it does and its rival doesn’t, the firm reducing its budget will lose profits to the other firm. Unless they collude, the firms will both end up with large advertising budgets and reduced profits.

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Also note that any values with the ordering above can serve as an answer to this question:

The restrictions are $X > $Q > $Z > $Y. Question 8 What assumptions about a rival’s response to price changes underlie the kinked-demand curve for oligopolists? Why is there a gap in the oligopolist’s marginal-revenue curve? How does the kinked-demand curve explain price rigidity in oligopoly? LO5 Answer Assumptions: (1) Rivals will match price cuts; (2) Rivals will ignore price increases. The gap in the MR curve results from the abrupt change in the slope of the demand curve at the going price.

Firms will not change their price because they fear that if they do, their total revenue and profits will fall.

Question 9 Why might price collusion occur in oligopolistic industries? Assess the economic desirability of collusive pricing. What are the main obstacles to collusion? Speculate as to why price leadership is legal in the United States, whereas price fixing is not. LO6 Answer Price wars are a form of competition that can benefit the consumer but can be highly detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-fixing among themselves, that is, colluding with regard to price. In a recession, it is nice to know whether one’s rivals will cut prices or quantity, so that a mutually satisfactory solution can be reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be interloper in the industry. From the viewpoint of society, collusive pricing is not economically desirable.

From the oligopoly’s viewpoint it is highly desirable since, when entirely successful, it allows 1-178 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

the oligopoly to set price and quantity as would a profit-maximizing monopolist.

The main obstacles to collusion are demand and cost differences (which result in different points of equality of MR and MC); the number of firms (the more firms, the lower the possibility of getting together and reaching sustainable agreement); cheating (it pays to cheat by selling more below the agreed-on price—provided the other colluders do not find out); recession (when demand slumps, the urge to shave prices—to cheat—becomes much greater); potential entry (the above-equilibrium price that is the reason for collusion may entice new firms into this profitable industry—and it may be hard to get new entrants into the combine, quite apart from the unfortunate increase in supply they will cause); and legal obstacles (for a century, antitrust laws have made collusion illegal).

Price leadership is legal because although the firms may follow the dominant firm’s price, they are not compelled to. Also, the tacit agreement on price does not include an agreement to control quantity and to divide up the market.

Question 10 Why is there so much advertising in monopolistic competition and oligopoly? How does such advertising help consumers and promote efficiency? How does advertising promote inefficiency?

LO8 Answer Two ways for monopolistically competitive firms to maintain economic profits are through product development and advertising. Also, advertising will increase the demand for the firm’s product. The oligopolist would rather not compete on a basis of price. Oligopolists can increase their market share through advertising that is financed with economic profits from past advertising campaigns. Advertising can operate as a barrier to entry.

Advertising provides information about new products and product improvements to the consumer. Advertising may result in an increase in competition by promoting new products and product improvements. It may also result in increased output for a firm, pushing it down its ATC curve and closer to productive efficiency (P = minimum ATC).

Advertising may result in manipulation and persuasion rather than information. An increase in brand loyalty through advertising will increase the producer’s monopoly power. Excessive advertising may create barriers to entry into the industry. When advertising either leads to increased monopoly power or is self-canceling economic inefficiency results.

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Question 11 Why have tech firms with near-monopolies in their own sectors sought to compete with tech firms that have extremely strong, near-monopoly positions in other sectors? LO4 Answer When an industry has a small number of firms competing they are able to charge a price above the competitive market equilibrium. This allows firms to make profits. If another company is able to enter into the market they are able to capture some of the profits for themselves.

This is what occurs in the highly competitive tech industry. While many of the large tech firms specialize in one sector (Google: search engines, Amazon: online shopping, Microsoft: operating systems) and have near-monopolies in those industries. This allows them to earn economic profits and have the ability to reinvest those profits into moving into other sectors within the technology industry. For instance, Microsoft expanded into the search engine sector by introducing Bing. The hope was to capture some of the near monopoly profits that Google was earning.

Other examples of this includes Google moving into the social network sector (competing with Facebook) and Microsoft and Google moving into the cell phone/tablet sector (competing with Apple).

PROBLEMS Problem 1 Assume that in short-run equilibrium, a particular monopolistically competitive firm charges $12 for each unit of its output and sells 52 units of output per day. How much revenue will it take in each day? If its average total cost (ATC) for those 52 units is $10, will the firm (a) earn a shortrun economic profit, (b) break even with only a normal profit, or (c) suffer an economic loss? If a profit or loss, what will be the amount? Next, suppose that entry or exit occurs in this monopolistic industry and establishes a long-run equilibrium. If the firm’s daily output remains at 52 units, what price will it be able to charge? What will be its economic profit? LO2 Answer In short-run equilibrium, a particular monopolistically competitive firm charges $12 for each unit of its output and sells 52 units of output per day. The average total cost (ATC) for those 52 units is $10.

The revenue it will take in each day = price × quantity = ($12 × 52) = $624.

Its economic profit or loss will be revenue – cost = ($624 – $520) = $104.

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Assume that entry or exit occurs in this monopolistic industry and establishes a long-run equilibrium.

If the firm’s daily output remains at 52 units, the price the firm will be able to charge is the price where profits are zero or the ATC = $10.

Its economic profit or loss will be zero.

Problem 2 Suppose that a monopolistically competitive restaurant is currently serving 230 meals per day (the output where MR = MC). At that output level, ATC per meal is $10 and consumers are willing to pay $12 per meal. What is the firm’s profit or loss? Will there be entry or exit? Will this restaurant’s demand curve shift left or right? In long‐run equilibrium, suppose that this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is $8.

What is the firm’s profit? Suppose that the allocatively efficient output level in long-run equilibrium is 200 meals. Is the deadweight loss greater than or less than $60? Explain. LO3 Answer The firm will earn a profit of $460 [= ($12-$10)*230]; there will be entry, shifting the firm’s individual demand curve to the left; In long-run equilibrium, this firm will be earning zero profit so the information about what the firm is charging and what the MC is for the 180th meal are irrelevant pieces of information for this particular question; The deadweight loss will be less than $60—students can see this by noting that $60 must be an upper bound because even if the $3 per unit difference between marginal benefit as given by the demand curve ($11) and marginal cost as given by the MC curve ($8) continued for all units between the 180th and the 200th, the deadweight loss would only amount to $60 (= $3 per unit times 20 units). But with MC rising for all of these units and the demand curve falling, the deadweight loss would have to be smaller.

Feedback: Since the restaurant's ATC per meal is $10 and the restaurant receives $12 per meal, the restaurant's profit per meal is $2 (= $12 – $10). Given that the restaurant sells 230 meals at this price its profit is $460 (= $2 × 230).

Given that this restaurant is making an economic profit there will be entry into this industry since other firms will try to capture some of this economic profit. The entry of other firms will reduce demand for the restaurant causing its demand schedule to shift to the left.

Now assume that in long‐run equilibrium this restaurant charges $11 per meal for 180 meals and that the marginal cost of the 180th meal is $8. Also assume that the allocatively efficient output level in long-run equilibrium is 200 meals in the long-run.

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The economic profit in the long-run is always zero in this type of market (monopolistic competition).

The deadweight loss will be less than $60—students can see this by noting that $60 must be an upper bound because even if the $3 per unit difference between marginal benefit as given by the demand curve ($11) and marginal cost as given by the MC curve ($8) continued for all units between the 180th and the 200th, the deadweight loss would only amount to $60 (= $3 per unit × 20 units). But with MC rising for all of these units and the demand curve falling, the deadweight loss would have to be smaller.

Problem 3 Suppose than an oligopolist is charging $21 per unit of output and selling 31 units each day.

What is its daily total revenue? Also suppose that previously it had lowered its price from $21 to $19, rivals matched the price cut, and the firm’s sales increased from 31 to 32 units. It also previously raised its price from $21 to $23, rivals ignored the price hike, and the firm’s daily total revenue came in at $482. Which of the following is most logical to conclude? LO5 Answer An oligopolist is charging $21 per unit of output and selling 31 units each day; the daily total revenue is ($21 × 31) = $651.

Since the firm lost money with both a price increase and a price decrease, the expected kinked demand curve would be elastic above the initial price and inelastic below the initial price.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 10 GDP and Economic Growth QUESTIONS Question 1 Why do national income accountants compare the market value of the total outputs in various years rather than actual physical volumes of production? What problem is posed by any comparison over time of the market values of various total outputs? How is this problem resolved? LO1 Answer If it is impossible to summarize oranges and apples as one statistic, as the saying goes, it is surely even more impossible to add oranges and, say, computers. If the production of oranges increases by 100 percent and that of computers by 10 percent, it does not make any sense to add the 100 1-182 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

percent to the 10 percent, then divide by 2 to get the average and say total production has increased by 55 percent.

Since oranges and computers have different values, the quantities of each commodity are multiplied by their values or prices. Adding together all the results of the price times quantity figures leads to the aggregate figure showing the total value of all the final goods and services produced in the economy. Thus, to return to oranges and computers, if the value of orange production increases by 100 percent from $100 million to $200 million, while that of computers increases 10 percent from $2 billion to $2.2 billion, we can see that total production has increased from $2.1 billion (= $100 million + $2 billion) to $2.4 billion (= $200 million + $2.2 billion). This is an increase of 14.29 percent [= ($2.4 billion – $2.1 billion)/$2.1 billion) × 100]—and not the 55 percent incorrectly derived earlier.

Comparing market values over time has the disadvantage that prices change. If the market value in year 2 is 10 percent greater than in year 1, we cannot say the economy’s production has increased 10 percent. It depends on what has been happening to prices; on whether the economy has been experiencing inflation or deflation.

To resolve this problem, statisticians deflate (in the case of inflation) or inflate (in the case of deflation) the value figures for the total output so that only ―real‖ changes in production are recorded. To do this, each item is assigned a ―weight‖ corresponding to its relative importance in the economy. Housing, for example, is given a high weight because of its importance in the average budget. A pack of gum would be given a very low weight. Thus, the price of housing increasing by 5 percent has a much greater effect on the price index used to compare prices from one year to the next than would the price of a book of matches increasing by 100 percent.

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Question 2 Why do economists include only final goods and services when measuring GDP? Why don’t they include the value of the stocks and bonds bought and sold? Why don’t they include the value of the used furniture bought and sold? LO1 Answer The dollar value of final goods includes the dollar value of intermediate goods. If intermediate goods were counted, then multiple counting would occur. For example, the value of steel (an intermediate good) used in the production of automobiles is included in the price of the automobile (the final product).

The value of the stocks and bonds bought and sold is not included in GDP because such sales and purchases simply transfer the ownership of existing assets; such sales and purchases are not themselves (economic) investment and thus should not be counted as production of final goods and services.

Used furniture was produced in some previous year; it was counted in GDP then. Its resale does not measure new production.

Question 3 Provide three examples of each: consumer durable goods, consumer nondurable goods, and services. LO1 Answer Durable goods are products that have expected lives of three years or more. Examples are refrigerators, new cars, new furniture, etc...

Nondurable goods are products with less than three years of expected life. Examples are peanut butter, clothes, soda, etc...

Services are the work done by lawyers, accountants, mechanics, etc...

The students’ answers will vary.

Question 4 Why are changes in inventories included as part of investment spending? Suppose inventories decline by $1 billion during 2022. How would this $1 billion decrease affect the size of gross private domestic investment and gross domestic product in 2022? Explain. LO1 Answer Anything produced by business that has not been sold during the accounting period is something in which business has invested—even if the ―investment‖ is involuntary, as often is the case with inventories. But all inventories in the hands of business are expected eventually to be used by business—for instance, a pile of bricks for extending a factory building—or to be sold—for 1-184 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

instance, a can of beans on the supermarket shelf. In the hands of business both the bricks and the beans are equal assets to the business, something in which business has invested.

If inventories decline by $1 billion in 2022, $1 billion would be subtracted from both gross private domestic investment and gross domestic product. A decline in inventories indicates that goods produced in a previous year have been used up in this year’s production. If $1 billion is not subtracted as stated, then $1 billion of goods produced in a previous year would be counted as having been produced in 2022, leading to an overstatement of 2022’s production.

Question 5 Define net exports. How are net exports determined? Explain why net exports might be a negative amount. LO1 Answer Net exports are a country’s exports of goods and services less its imports of goods and services.

The United States’ exports are as much a part of the nation’s production as are the expenditures of its own consumers on goods and services made in the United States. Therefore, the United States’ exports must be counted as part of GDP. On the other hand, imports, being produced in foreign countries, are part of those countries’ GDPs. When Americans buy imports, these expenditures must be subtracted from the United States’ GDP, for these expenditures are not made on the United States’ production.

Consider the following values. If American exports are $7 billion and imports are $5 billion, then American net exports are +$2 billion. If the figures are reversed, so that Americans export $5 billion and imports $7 billion, then net exports are −$2 billion, a negative amount. Thus, if Americans import more goods and services than they export then net exports will be a negative amount.

Question 6 Which of the following are included in this year’s GDP? Which are excluded? Explain your answers. LO1 a. Interest received on an AT&T corporate bond. b. Social Security payments received by a retired factory worker. c. Unpaid services of a family member who painted the family home. d. Income of a dentist from the dental services they provided. e. A monthly allowance that a college student receives from home. f. Money received by Josh when he resells his nearly brand-new Honda automobile to Kim. g. The publication and sale of a new college textbook. h. An increase in leisure resulting from a 2-hour decrease in the length of the workweek, with no reduction in pay. i. A $2 billion increase in business inventories. j. The purchase of 100 shares of Alphabet (the parent company of Google) stock. .

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Answer a. Included. Income received by the bondholder for the services derived by the corporation for the loan of money. b. Excluded. A transfer payment to taxpayers for which no service is rendered (in this year). c. Excluded. Nonmarket production. d. Included. Payment for a final service. You cannot pass on a tooth extraction! e. Excluded. A private transfer payment— simply a transfer of income from one private individual to another for which no transaction in the market occurs. f. Excluded. The production of the car had already been counted at the time of the initial sale. g. Included. It is a new good produced for final consumption. h. Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done. i. Included. The increase in inventories could only occur as a result of increased production. j. Excluded. Merely the transfer of ownership of existing financial assets. e. Included: a $2 billion increase in business inventories is part of GDP. f. Included: government purchases of newly produced aircraft is a final good sale.

Question 7 What are the four supply factors of economic growth? What is the demand factor? What is the efficiency factor? Illustrate these factors in terms of the production possibilities curve. LO4 Answer The four supply factors are the quantity and quality of natural resources; the quantity and quality of human resources; the stock of capital goods; and the level of technology. The demand factor is the level of purchases needed to maintain full employment. The efficiency factor refers to both productive and allocative efficiency.

The figure below illustrates these growth factors by showing a rightward shift in the curve.

Question 8 What is growth accounting? To what extent have increases in U.S. real GDP resulted from more labor inputs? From greater labor productivity? Rearrange the following contributors to the growth of productivity in order of their quantitative importance: economies of scale, quantity of capital per worker, improved resource allocation, education and training, technological advance.

LO5 Answer Growth accounting is a procedure that decomposes the supply-side elements into its different components. Primarily increases in work hours and increases in labor productivity (these components me decrease as well).

The U.S. labor force grew by an average of about 1.5 million workers per year for the past 65 years, and this explains some of the growth in real GDP. The remainder, and the majority since 1-186 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

at least 1995, is from productivity growth. Other factors have also been important (contributing through productivity improvements).

Factor importance in descending order: (1) Technological advance—the discovery of new knowledge that results in the combining of resources in more productive ways. (2) The quantity of capital. (3) Education and training. (4) Economies of scale and (5) improved resource allocation.

Question 9 True or false? If false, explain why. LO5 a. Technological advance, which to date has played a relatively small role in U.S. economic growth, is destined to play a more important role in the future. b. Many public capital goods are complementary to private capital goods. c. Immigration has slowed economic growth in the United States.

Answer a. The first part is false because technology has played the most important role in U.S. economic growth of any growth factor. However, the second part of the statement is probably true. b. True. c. False; immigration has been a source for an expanded labor force and also for expansion in aggregate demand.

Question 10 Explain why there is such a close relationship between changes in a nation’s rate of productivity growth and changes in its average real hourly wage. LO6 Answer The average real hourly wage represents the average purchasing power that each worker receives. Purchasing power refers to the amount of output that can be obtained with that wage. If output per worker is not increasing, then the amount of output available per capita for workers to buy will not be growing either. In other words the ―real‖ wage changes only if there is an increase in productivity. Nominal wages don’t represent purchasing power.

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Question 11 Relate each of the following to the 1995–2010 increase in the productivity growth rate: LO6 a. information technology b. increasing returns c. network effects d. global competition Answer The rate of productivity growth has grown substantially due to innovations using microchips, computers, new telecommunications devices, and the Internet. All of these innovations describe features of what we call information technology, which connects information in all parts of the world with information seekers. New information products are often digital in nature and can be easily replicated once they have been developed. The start-up cost of new firms and new technology is high, but expanding production has a very low marginal cost, which leads to economies of scale—firms’ output grows faster than their inputs. Network effects refer to a type of economy of scale whereby certain information products become more valuable to each user as the number of buyers grows. For example, a fax machine is more useful to you when lots of other people and firms have one; the same is true for compatible word-processing programs.

Global competition is a factor of productivity growth because both transportation and communication can be accomplished at much lower cost and faster speed than previously, which expands market possibilities for both consumers and producers who are not very limited by national boundaries today.

Question 12 Provide three examples of products or services that can be simultaneously consumed by many people. Explain why labor productivity greatly rises as the firm sells more units of the product or service. Explain why the higher level of sales greatly reduces the per-unit cost of the product.

LO6 Answer Sample correct answer: Text examples include films, CD entertainment, television programs, software programs, and Internet information.

Labor productivity rises with some of these products when they are used as inputs because sharing compatible software programs, Internet information, and the same video training programs, for example, can expand output potential for many workers who benefit from the effects of using or learning from the information simultaneously.

Production of information goods has a high start-up or development cost, but additional units can be produced at little or no cost. Therefore, as more units are produced, the denominator rises, but the total cost won’t rise much and the cost per unit, therefore, will fall.

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PROBLEMS Problem 1 Suppose that annual output in year 1 in a three-good economy is 3 quarts of ice cream, 1 bottle of shampoo, and 3 jars of peanut butter. In year 2, the output mix changes to 5 quarts of ice cream, 2 bottles of shampoo, and 2 jars of peanut butter. If the prices in both years are $4 per quart for ice cream, $3 per bottle of shampoo, and $2 per jar of peanut butter, what was the economy’s GDP in year 1? What was its GDP in year 2? LO1 Answer Using the following table: Good Quarts of ice cream Bottles of shampoo Jars of peanut butter

Price Year 1 $4.00

Nominal Quantity of Value of Goods Year Goods Year 1 1 3 $12.00

Price Year 2 $4.00

Nominal Quantity of Value of Goods Year Goods Year 2 2 5 $20.00

$3.00

1

$3.00

$3.00

2

$6.00

$2.00

3

$6.00

$2.00

2

$4.00

NA

NA

$21.00

NA

NA

$30.00

The first step is to find the value of each good consumed. For example, in year 1 the price of a quart of ice cream is $4.00. Since three quarts are consumed, the value of these three quarts is $12.00 (= $4.00 × 3). This calculation is applied to each good for each year.

The second step is to add up the nominal value for the goods for each year separately in order to get GDP. The nominal value of goods for year 1 is $21.00 ( = $12.00 + $3.00 + $6.00).

The nominal value of goods for year 2 is $30.00 ( = $20.00 + $6.00 + $4.00).

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Problem 2 If in some country personal consumption expenditures in a specific year are $50 billion, purchases of stocks and bonds are $30 billion, net exports are -$10 billion, government purchases are $20 billion, sales of secondhand items are $8 billion, and gross investment is $25 billion, what is the country’s GDP for the year? LO1 Answer Given the information in the text, it is best to use the expenditures approach to calculate GDP. This approach adds personal consumption expenditures, gross investment, government purchases, and net exports. Thus, GDP equals $85 billion for this country (= $50 billion + $25 billion + $20 billion + (–$10 billion)).

Note that the purchase of stocks and bonds along with secondhand items are not part of GDP. This information is extraneous to the question.

Problem 3 Assume that a grower of flower bulbs sells its annual output of bulbs to an Internet retailer for $70,000. The retailer, in turn, brings in $160,000 from selling the bulbs directly to final customers. What amount would these two transactions add to personal consumption expenditures and thus to GDP during the year? LO1 Answer These two transactions would add $160,000 to personal consumption expenditures and to GDP during the year. The reason that we do not count the $70,000 is that this first sale is an intermediate step towards the final sale, and value, of the flower bulbs sold to consumers. This final sale price includes the cost of the bulbs purchased by the Internet retailer.

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Problem 4 Using the following NIPA data, compute GDP. All figures are in billions of U.S. dollars. LO1

Answer GDP = $404 = [$245 + 86 + 82 + (9-18)] or Personal consumption expenditures + Gross private domestic investment + Government purchases + (Exports - Imports).

Problem 5 Suppose that in 1994 the total output in a single-good economy was 7,000 buckets of chicken.

Also suppose that in 1994 each bucket of chicken was priced at $10. Finally, assume that in 2015 the price per bucket of chicken was $16 and that 22,000 buckets were produced. Determine the GDP price index for 1994, using 2015 as the base year. By what percentage did the price level, as measured by this index, rise between 1994 and 2015? What were the amounts of real GDP in 1994 and 2015? LO2 Answer Answer: GDP Price Index = 62.5; price level increased by 60%; Real GDP in 1994 = $112,000; Real GDP in 2015 = $352,000.

Feedback: To determine the GDP price index for 1994 using 2015 as a base year we proceed as follows: A version that extends to multiple goods is as follows: First, multiply the buckets of chicken in 2015 by the price of a bucket of chicken in 2015, which gives us a value of $352,000 (= $16 × 22,000). (We would do this for all goods and add up each value.) Second, multiply the buckets of chicken in 2015 by the price of a bucket of chicken in 1994, which gives us $220,000 (= $10 × 22,000). (We would do this for all goods and add up each value. Be sure to use 2015 quantities and 1994 prices.) This process fixes quantity in the base year and varies price (CPI). Finally, divide the value of the buckets of chicken using 1994 prices by the value of the bucket of chicken using 2015 prices (the base year). This gives us a GDP price index for 1994 = ($220,000/$352,000) × 100 = [($10 × 22,000) / ($16 × 22,000)] × 100 = ($10/$16) × 100 = 62.5.

In both cases, the price level increased by 60% = [(100 - 62.5)/62.5] = [(16-10)/10] × 100.

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Real GDP in 1994 and 2015, where 2015 is the base, can be found by dividing nominal GDP by the year’s price index (remember to convert the price index back into decimal form.)

Nominal GDP in 1994 is $70,000 = $10 (price 1994) × 7,000 (output 1994). The price index for 1994 is 62.5 (found above). Thus, real GDP = $70,000 (nominal output 1994) / (62.5/100) (the price index 1994 scaled to decimal form) = $70,000/0.625 = $112,000.

Nominal GDP in 2015 is $352,000 = $16 (price 2015) × 22,000 (output 2015). The price index for 2015 is 100 (by definition, base year). Thus, real GDP = $352,000 (nominal output 2015) / (100/100) (The price index 2015 scaled to decimal form) = $352,000/1 = $352,000.

Problem 6 Suppose an economy’s real GDP is $30,000 in year 1 and $31,200 in year 2. What is the growth rate of its real GDP? Assume that population is 100 in year 1 and 102 in year 2. What is the growth rate of real GDP per capita? LO3 Answer The growth rate of the economy's real GDP equals 4% (= (($31,200 - $30,000)/$30,000) x 100).

To determine the growth rate of real GDP per capita, we first need to find real GDP per capita for each year (= real GDP/population).

Real GDP per capita year 1 = $30,000/100 = $300 Real GDP per capita year 2 = $31,200/102 = $305.88 Thus, the growth rate of the economy's real GDP per capita equals 1.96% (= (($305.88 $300)/$300) x 100).

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Problem 7 What annual growth rate is needed for a country to double its output in 7 years? In 35 years? In 70 years? In 140 years? LO3 Answer The ―Rule of 70,‖ which is to divide 70 by the rate of growth, gives us the time it takes for a country to double its output.

Years to double = (70 / Rate of Growth).

Rearranging this equation: Rate of Growth = (70 / Years to double).

The annual growth rate needed for a country to double its output in 7 years is 10% (= 70/7).

The annual growth rate needed for a country to double its output in 35 years is 2% (= 70/35).

The annual growth rate needed for a country to double its output in 70 years is 1% (= 70/70).

The annual growth rate needed for a country to double its output in 140 years is 0.5% (= 70/140).

Problem 8 Assume that a leader country has real GDP per capita of $40,000, whereas a follower country has real GDP per capita of $20,000. Next suppose that the growth of real GDP per capita falls to zero percent in the leader country and rises to 7 percent in the follower country. If these rates continue for long periods of time, how many years will it take for the follower country to catch up to the living standard of the leader country? LO3 Answer 10 years.

Feedback: The ―rule of 70,‖ which is to divide 70 by the rate of growth, gives us the time it takes for a country to double its output.

Years to double = (70/Rate of Growth) Since the rate of growth for real GDP per capita is 7 percent in the follower country, the country's real GDP per capita will double every 10 years. So, in 10 years the follower country's real GDP per capita will be $40,000 given its current level of $20,000.

The rate of growth for real GDP per capita in the leader country is 0 percent (no growth). Thus, it will remain at $40,000 real GDP per capita.

Combining the two results above, it will take 10 years for the follower country to catch-up with the leader country.

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Problem 9 Suppose that work hours in New Zombie are 200 in year 1 and productivity is $8 per hour worked. What is New Zombie’s real GDP? If work hours increase to 210 in year 2 and productivity rises to $10 per hour, what is New Zombie’s rate of economic growth? LO5 Answer New Zombie’s real GDP in a given year equals hours worked multiplied by productivity.

New Zombie’s real GDP in year 1 equals $1600 (= 200 x $8).

New Zombie’s real GDP in year 2 equals $2100 (= 210 x $10).

We now use these values to find the rate of economic growth.

New Zombie's rate of economic growth equals 31.25% ( = (($2100 - $1600)/$1600) x 100)).

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 11 Business Cycles, Unemployment, and Inflation QUESTIONS Question 1 What are the two primary phases of the business cycle? What tends to happen to real GDP, unemployment, and inflation during these phases? LO1 Answer Two primary phases are expansions and recessions. During an expansionary phase, real GDP rises, inflation occurs, and unemployment falls. During a recessionary phase, real GDP declines, unemployment increases, and inflation is mild or falling.

Question 2 How many recessions has the United States experienced since 1950? Which ones were the longest in duration? Which ones were the most severe in terms of declines in real output? LO1 Answer Since 1950, the U.S. has experienced 11 recessions. The longest recession since 1950 was the recent "Great Recession" which lasted 18 months (from December 2007 to June 2009). The most severe in terms of real output decline was the 1973—1975 recession (real output dropped 4.9 percent).

Question 3 Even though the United States has an unemployment compensation program that provides income for those out of work, why should we worry about unemployment? LO3 Answer 1-194 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

The unemployment compensation program merely gives the unemployed enough funds for basic needs. Furthermore, many of the unemployed do not qualify for unemployment benefits. The programs applies only to those workers who were covered by the insurance, and this may be as few as one-third of those without jobs. Most of the unemployed get no sense of self-worth or accomplishment out of drawing this compensation. Moreover, from the economic point of view, unemployment is a waste of resources; when the unemployed go back to work, nothing is forgone except undesired leisure. The unemployed are producing nothing—their supply is zero— but unemployment the compensation helps keep demand in the economy high.

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Question 4 What are the three types of unemployment? Unemployment is seen by some as undesirable. Are all three types of unemployment undesirable? Explain. LO3 Answer The three types of unemployment are frictional, structural, and cyclical. Although unemployment may be seen as undesirable, frictional unemployment is desirable because the search process allows workers to move into higher-paying, higher-productive jobs. This provides greater income for workers, a better allocation of labor resources, and an increase in the production of goods and services for the economy.

Question 5 What is the Consumer Price Index (CPI), and how is it determined each month? What effect does inflation have on the purchasing power of a dollar? How does it explain differences between nominal and real interest rates? How does deflation differ from inflation? LO2 Answer The CPI is constructed from a ―market basket‖ sampling of goods that consumers typically purchase. Prices for goods in the market basket are collected each month, weighted by the importance of the good in the basket (cars are more expensive than bread, but we buy a lot more bread), and averaged to form the price level.

To calculate the rate of inflation, the BLS subtracts the CPI for the previous year from the CPI for the current year, and then divides this difference by the CPI for the previous year.

Multiplying this value by 100 gives us the percentage change in the price level.

Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number of dollars means that each dollar buys less than it did before.

The rate of inflation in the CPI approximates the difference between the nominal and real interest rates. A nominal interest rate of 10 percent with a 6 percent inflation rate will mean that real interest rates are approximately 4 percent.

Deflation means that the price level is falling, whereas with inflation overall prices are rising.

Deflation is undesirable because the falling prices mean that incomes are also falling, which reduces spending, output, employment, and, in turn, the price level (a downward spiral). Inflation in modest amounts (< 3 percent) is tolerable, although there is not universal agreement on this point.

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Question 6

Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is more likely to be associated with a negative GDP gap? Which is more likely to be associated with a positive GDP gap, in which actual GDP exceeds potential GDP?

Explanation: Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. It is sometimes expressed as "too much spending (or money) chasing too few goods." Cost-push inflation describes prices rising because of increases in per-unit costs of production.

Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising production costs reduce spending and output. Demand-pull inflation is more likely to occur with a positive GDP gap, because actual GDP will exceed its potential only when aggregate spending is strong and rising. As the economy produces above its potential, bottlenecks and more severe resource scarcity occur, driving up prices.

Question 7 How does unanticipated inflation hurt creditors and help borrowers? How can anticipating the inflation make these effects less severe? LO3 Answer Inflation causes the dollars repaid by the borrower to be worth less than the dollars initially borrowed from the creditor (lender); the lender receives back dollars with eroded purchasing power. If the rate of inflation exceeds the nominal interest rate, the creditor will lose (in absolute real terms) from the loan transaction.

Question 8 How might the falling prices that occur during deflation ultimately hurt consumers? LO3 Answer While consumers typically prefer lower prices on goods and services, lower prices on all goods and services can be harmful to households. Consumers may hold off on making purchases due to the expectation of future lower prices. As spending and demand for goods and services decline, firms may decide to lay off workers or lower wages. The end result of deflation can be reduced income for households.

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Explain how hyperinflation might lead to a severe decline in total output. LO3 Answer With inflation running into the double, triple, quadruple, or even greater number of digits per year, it makes little sense to save. The only sensible thing to do with money is to spend it before its value is cut in half within a month, a week, or a day. This very fact of everyone trying to spend as fast as possible will speed the inflationary spiral and cause people to spend more and more time trying to figure out what goods are most likely to go up fastest in price. More and more people will turn away from productive activity because wages and salaries are not keeping up with inflation. Instead, they will spend their time speculating, transferring goods already in existence and producing nothing.

Eventually, money may become worthless. No one will work for money. Barter and living by one’s wits become the only means of survival. Production falls for this reason and also because investment in productive capital practically ceases. Unemployment soars. A massive depression is at hand.

PROBLEMS Problem 1 Suppose that a country’s annual growth rates were 5, 3, 4, -1, - 2, 2, 3, 4, 6, and 3 in yearly sequence over a 10-year period. What was the country’s trend rate of growth over this period?

Which set of years most clearly demonstrates an expansionary phase of the business cycle?

Which set of years best illustrates a recessionary phase of the business cycle? LO1 Answer The trend rate of growth equals the average for the 10-year period, which is 2.7 percent. (= (5 + 3 + 4 – 1 – 2 + 2 + 3 + 4 + 6 + 3)/10).

The set of years that clearly demonstrates an expansionary phase is years 6 through 9. The rate of growth is positive and increasing over this period.

The set of years that best illustrate a recessionary phase is years 4 and 5. Growth is negative (declining GDP) for these years.

Problem 2 Assume the following data for a country: total population, 500; population under 16 years of age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10. What is the size of the labor force? What is the official unemployment rate?

LO2 Answer To find the size of the labor force, subtract population under 16 years of age or institutionalized (120) and those not in the labor force (150) from the population (500).

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The size of the labor force is 230 (= 500 – 120 –150).

The official unemployment rate is the number of individuals unemployed divided by the labor force converted into percentage form.

The unemployment rate for the values above is 10 percent (= (23/230) × 100).

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Problem 3 If the CPI was 110 last year and is 121 this year, what is this year’s rate of inflation? In contrast, suppose that the CPI was 110 last year and is 108 this year. What is this year’s rate of inflation?

What term do economists use to describe this second outcome? LO3 Answer The inflation rate is the percentage change in the CPI over a period of time. For the values in the text we have: If the CPI was 110 last year and is 121 this year, the inflation rate was 10 percent (= ((121 – 110)/110) × 100).

If the CPI was 110 last year and is 108 this year, the inflation rate was approximately –1.8 percent (= ((108 – 110)/110) × 100). This outcome is referred to as deflation by economists.

Problem 4 How long would it take for the price level to double if inflation persisted at (a) 2 percent per year, (b) 5 percent per year, and (c) 10 percent per year? LO3 Answer The "Rule of 70," which is to divide 70 by the inflation rate, gives us the time it takes for the price level to double. Years to double = (70 / Inflation Rate) Using this formula we have: a. The price level will double in 35 years if the inflation rate is 2 percent (= 70/2). b. The price level will double in 14 years if the inflation rate is 5 percent (= 70/14). c. The price level will double in 7 years if the inflation rate is 10 percent (= 70/10).

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Problem 5 If your nominal income rose by 5.3 percent and the price level rose by 3.8 percent in some year, by what percentage would your real income (approximately) increase? If your nominal income rose by 2.8 percent and your real income rose by 1.1 percent in some year, what must have been the (approximate) rate of inflation? LO3 Answer To find the approximate percentage change in the real value of your income, subtract the rate of inflation from the nominal percentage change in your income.

Percentage change in real income = Percentage change in nominal income – Inflation rate This implies the percentage change in real income is approximately 1.5 percent (= 5.3% – 3.8%).

We can also rearrange the equation above as follows: Inflation rate = Percentage change in nominal income – Percentage change in real income This implies the inflation rate is approximately 1.7 percent (= 2.8% – 1.1%) for the second set of values.

Problem 6 Suppose that the nominal rate of inflation is 4 percent and the inflation premium is 2 percent.

What is the real interest rate? Alternatively, assume that the real interest rate is 1 percent and the nominal interest rate is 6 percent. What is the inflation premium? LO4 Answer 2 percent; 5 percent.

Feedback: To find the approximate real interest rate subtract the inflation premium from the nominal interest rate.

Real interest rate = nominal interest rate - inflation premium This implies the real interest rate is 2 percent (= 4 percent – 2 percent).

We can also rearrange the equation above as follows: Inflation premium = nominal interest rate - real interest rate This implies the inflation premium is 5 percent (= 6 percent – 1 percent).

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If the inflation premium is 2 percent and the nominal interest rate is 1 percent, what is the real interest rate? What if the inflation premium is 3 percent while the nominal interest rate is 0.5 percent? LO3 Answer To find the approximate real interest rate subtract the inflation premium from the nominal interest rate.

Real interest rate = Nominal interest rate - Inflation premium This implies the real interest rate is 2% (= 4% - 2%).

We can also rearrange the equation above as follows: Inflation premium = Nominal interest rate Real interest rate This implies the inflation premium is 5% (= 6% - 1%).

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 12 Aggregate Demand and Aggregate Supply QUESTIONS Question 1 What is the general relationship between a country’s price level and the quantity of its domestic output (real GDP) demanded? Who are the buyers of U.S. real GDP? LO1 Answer The general relationship is inverse; the aggregate demand (AD) curve shows that as the price level drops, the quantity of real GDP demanded increases.

The buyers of U.S. real GDP are households (consumption), businesses (investment), government (purchases of final goods and resources), and foreign buyers (exports).

Question 2 What assumptions cause the immediate-short-run aggregate supply curve to be horizontal? Why is the long-run aggregate supply curve vertical? Explain the shape of the short-run aggregate supply curve. Why is the short-run curve relatively flat to the left of the full-employment output and relatively steep to the right? LO2 Answer The immediate short-run supply curve is horizontal because of contractual agreements. These ―contracts‖ for both input and output prices imply that prices do not change along the immediate short-run aggregate supply curve.

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The long-run aggregate supply curve is vertical (at the full-employment or potential output level) because the economy’s potential output is determined by the availability and productivity of real resources, not by the price level. The availability and productivity of real resources are reflected in the prices of inputs, and in the long run these input prices (including wages) adjust to match changes in the price level. Firms have no incentive to increase production to take advantage of higher prices if they simultaneously face equally higher resource prices.

The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more slowly than the price level, leaving room for firms to take advantage of these higher prices (temporarily) by increasing output. Firms face increasing per-unit production costs as they increase output, making higher prices necessary to induce them to produce more.

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To the left of full-employment output the curve is relatively flat because of the large amounts of unused capacity and idle human resources. Under such conditions, per-unit production costs rise slowly because of the relative abundance of available inputs. Additional resources are easily brought into production, as the suppliers of these resources (especially labor) are anxious to employ them and are happy to accept current prices.

To the right of full-employment output the curve is relatively steep because most resources are already employed. Those resources that are not yet in production require higher prices to induce them, or generate higher per-unit production costs because they are less productive than currently employed inputs. Firms trying to increase production bid up input prices as they attempt to attract resources away from other firms. Even if the firm succeeds in pulling resources from another firm, the aggregate increase in output is minimal at best, as resources are merely shifted from one productive process to another.

Question 3 What effects would each of the following have on aggregate demand or aggregate supply, other things equal? LO3 a. A widespread fear by consumers of an impending economic depression. b. A new national tax on producers based on the value-added between the costs of the inputs and the revenue received from their output. c. A reduction in interest rates. d. A major increase in spending for health care by the Federal government. e. The general expectation of coming rapid inflation. f. The complete disintegration of OPEC, causing oil prices to fall by one-half. g. A 10 percent across-the-board reduction in personal income tax rates. h. A sizable increase in labor productivity (with no change in nominal wages). i. A 12 percent increase in nominal wages (with no change in productivity). j. An increase in exports that exceeds an increase in imports (not due to tariffs).

Answer For both the AS and AD curves, shifts to the right are associated with increases and shifts to the left are associated with decreases.

For both the AS and AD curves, shifts to the right are associated with increases and shifts to the left are associated with decreases. a.Consumer fear causes the AD curve to shift left (decrease), which moves output down and the price level down (assuming no ratchet effect). b. The tax increases producers' costs, which causes the AS curve to shift left, which moves output down and the price level up. c. A reduction in interest rates increases the demand for investment, which causes the AD curve to shift right, which moves output and the price level up.

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d. An increase in government spending causes the AD curve to shift right, which moves output and the price level up (any real improvements in health care resulting from the spending would eventually increase productivity and shift AS right). e. An expectation of coming rapid inflation would likely cause consumers and businesses to make purchases now before prices increase. This causes the AD curve to shift right, which moves output and the price level up. f. The reduction in oil prices reduces producers' costs, which causes the AS curve to shift right, which moves output up and the price level down. g. The tax reduction gives consumers more disposable income, which causes the AD curve to shift right, which moves output and the price level up. h. Increased labor productivity means producers can produce more output with the same amount of labor. This reduces producers' costs, which causes the AS curve to shift right, which moves output up and the price level down. i. Increased wages (without a productivity increase) increase producers' costs, which causes the AS curve to shift left, which moves output down and the price level up. j. An increase in net exports means there is higher net demand from foreign consumers for domestic goods, so the AD curve shifts right (increased net exports), which moves output and the price level up.

Question 4 Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run?

LO3 a. An increase in aggregate demand. b. A decrease in aggregate supply, with no change in aggregate demand. c. Equal increases in aggregate demand and aggregate supply. d. A decrease in aggregate demand. e. An increase in aggregate demand that exceeds an increase in aggregate supply.

Answer The following are the effects on the equilibrium price level and equilibrium level of real output in the short run for each of the occurrences listed above. a. The price level rises rapidly, with little change in real output, because resources are fully employed and the demand increase simply reallocates resources that are already in use. b. The price level rises and real output decreases. Since the price level is flexible upward, a leftward shift in AS moves the price level up and output down. c. The price level does not change, but real output increases. A rightward shift in both the AS and AD curves moves output higher, but effects on the price level are offset. d. The price level does not change, but real output declines. A leftward shift of AD moves output down, but since the price level is inflexible downward, it does not change.

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e. The price level increases somewhat, with a relatively large change in output, which is similar to part c, but since the AD shift is dominant, the price level increases somewhat.

Question 5 Why does a reduction in aggregate demand tend to reduce real output, rather than the price level?

LO4 Answer A reduction in aggregate demand causes a decline in real output rather than the price level because prices are inflexible downward (―sticky‖). If we assume prices are completely inflexible downward, then a reduction in demand is essentially moving leftward and the aggregate supply curve is flat (horizontal), which means reduced output at a constant price. To say prices are completely inflexible downward may be an exaggeration, but prices don’t fall easily for several reasons: wage contracts, minimum wage laws, employee morale, fear of price wars, and the ―menu cost‖ notion.

Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at full strength. If price were flexible downward, the decrease in spending would lower prices, encouraging some individuals within the macro economy to spend more, dampening the multiplier effects.

Question 6 Explain: ―Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate supply.‖ In each case, specify the price-level outcomes. LO4 Answer The statement is true, although the magnitude of the effect on unemployment can vary considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply will unambiguously increase the price level and reduce real output. With the decrease in output we would expect unemployment to rise. If the economy is operating above its full-employment output, a decrease in aggregate demand will have more modest effects on unemployment, having its strongest impact on the price level (reducing it). If aggregate demand falls while the economy is operating to the left of full-employment output, the increases in unemployment will be more substantial, and the effects on the price level weaker.

Question 7 In early 2001 investment spending sharply declined in the United States. In the 2 months following the September 11, 2001, attacks on the United States, consumption also declined. Use AD-AS analysis to show the two impacts on real GDP. LO4 Answer Both events would be represented by a leftward shift in aggregate demand, and the initial declines in spending would be multiplied. (See figure below, shift from AD1 to AD3.) This would 1-206 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

cause real GDP to drop and, assuming flexible prices, a drop in the price level. To the extent the drop in investment spending affected productivity, it could have either shifted AS left (if productivity dropped) or slowed the rightward movement of AS that occurred through much of the 1990s and into the early 2000s.

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Question 8 Using the concept of the multiplier, explain why mass lay-offs by large companies such as Boeing or General Motors are a concern to the citizens and leaders where those firms are located.

LO4 Answer Mass layoffs would be represented by a decrease in aggregate demand as workers become unemployed, lose income, and begin spending less. Investment spending by large companies also falls, causing aggregate demand to fall by more due to the multiplier effect. If Boeing or GM were the only employer in a given town (a labor market monopsonist), the effect of mass layoffs would be detrimental as most of the town’s workers/citizens spend less due to the loss of income.

The decrease in consumer and investment spending is multiplied, causing a much larger decrease in GDP. PROBLEMS Problem 1 Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. Also assume that the economy’s multiplier is 4. If household wealth falls by 5 percent because of declining house values, and the real interest rate falls by 2 percentage points, in what direction and by how much will the aggregate demand curve initially shift at each price level? In what direction and by how much will it eventually shift? LO1 Answer If household wealth falls by 5 percent because of declining house values, the initial shift in aggregate demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) × $5 (consumer spending for every 1% change)). Note the positive relationship between wealth and consumer spending. If household wealth falls by 5 percent because of declining house values, the initial shift in aggregate demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) × $5 (consumer spending for every 1 percent change)).

Note the positive relationship between wealth and consumer spending.

Also, suppose that investment spending initially rises by $20 billion for every 1 percentage point fall in the real interest rate. If the real interest rate falls by two percentage points, the initial shift in aggregate demand will be to the right (increase in real GDP) by $40 billion ( = 2 (percentage point decline in interest rate) × $20 (investment spending for every 1 percentage point change)).

Note the inverse relationship between the interest rate and investment. The combined initial effect is a shift to the right of the aggregate demand curve by $15 billion. There is a decrease of $25 billion from consumer expenditure and an increase of $40 billion from investment expenditure; thus, the net effect is a positive $15 billion.

Given that the multiplier is 4, the aggregate demand curve will shift to the right by $60 billion after the multiplier process works its way through the economy ( = 4 (multiplier) × $15 billion (initial net impact on aggregate demand).

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Problem 2 Answer the following questions on the basis of the three sets of data for the country of North Vaudeville: LO2

a. Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville?

The short run? The long run? b. Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what will be the new levels of real GDP in the right column of A? Does the new data reflect an increase in aggregate supply or does it indicate a decrease in aggregate supply?

Answer a. The data in B represents AS in the immediate short run. The price level does not have time to adjust in the immediate short run. Only output can change.

The data in A represents AS in the short run. The price level only has time to partially adjust in the short run. Both the price level and output can change.

The data in C represents AS in the long run. The price level has time to completely adjust in the long run. Only price will change. b. To find the new level of output at each price level, multiply the original values by 1.1.

Price level 110: New output equals 302.5 (= 1.1 × 275).

Price level 100: New output equals 275 (= 1.1 × 250).

Price level 95: New output equals 247.5 (= 1.1 × 225).

Price level 90: New output equals 220 (= 1.1 × 200).

This is an increase in aggregate supply because output has increased at every price level.

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Problem 3 Suppose that the aggregate demand and aggregate supply schedules for a hypothetical economy are as shown in the table. LO3

a. Use the data above to graph the aggregate demand and aggregate supply curves. What is the equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the equilibrium real output also necessarily the full-employment real output? b. If the price level in this economy is 150, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? If the price level is 250, will quantity demanded equal, exceed, or fall short of quantity supplied? By what amount? c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level.

Sketch in the new aggregate demand curve as AD1. What is the new equilibrium price level and level of real output?

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Answer a. See the graph.

Equilibrium price level = 200, which occurs where aggregate supply equals aggregate demand.

Thus the equilibrium real output = $300 billion. No, the full-capacity level of GDP cannot be determined without more information. b. At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real GDP demanded of $400 billion. Thus, quantity demanded exceeds the quantity supplied by $200 billion. At a price level of 250, real GDP supplied is $400 billion, which is more than the real GDP demanded of $200 billion. Thus, quantity demanded falls short of the quantity supplied by $200 billion.

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c. See the graph from part a. Increases in consumer, investment, government, or net export spending might shift the AD curve rightward. The new values for the aggregate demand schedule are: Amount of Real GDP Price Level Amount of Real GDP Demanded, Billions (Price Index) Supplied, Billions $300 (= $100 + $200) 300 $450 $400 (= $200 + $200) 250 400 $500 (= $300 + $200) 200 300 $600 (= $400 + $200) 150 200 $700 (= $500 + $200) 100 100 The new equilibrium price level = 250, where aggregate supply equals aggregate demand. The new equilibrium GDP = $400 billion.

Problem 4 Suppose that the following table shows an economy’s relationship between real output and the inputs needed to produce that output: LO3

a. What is productivity in this economy? b. What is the per-unit cost of production if the price of each input unit is $2? c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity. What is the new per-unit cost of production? In what direction would the $1 increase in input price push the economy’s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output? d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100 percent. What would be the new per-unit cost of production? What effect would this change in per-unit production cost have on the economy’s aggregate supply curve? What effect would this shift of aggregate supply have on the price level and the level of real output?

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Answer a. Productivity is defined by how much output each unit of the input produces.

Productivity = Real GDP/Input quantity You can use any of the three combinations above.

Productivity = $400/150 = 2.6667 b. The per-unit cost is defined by how much each unit of output costs to produce. The total cost of production equals $300 (you can use any combination above) when real GDP is $400.

Per-unit cost = (Price of input unit × Input quantity)/Real GDP For the values above, per-unit cost = ($2 × 150)/$400 = $300/$400 = $0.75 c. The new per-unit cost = ($3 × 150)/$400 = $450/$400 = $1.125.

This would cause firms to raise prices at every level of output (higher input cost); thus the aggregate supply schedule would shift left. This would cause output to decrease and prices to rise in the short run. d. If productivity increases by 100 percent, this implies output will double at every input quantity. Real GDP will now be $800 at the input quantity of 150.

New productivity = 2 × 2.6667 (original productivity) = 5.3334 From this we can find the required level of real GDP. Productivity = Real GDP/Input quantity, or 5.3334 = Real GDP/150 Thus, real GDP = $800 = 150 × 5.3334 (rounding).

Once we have the new level of real GDP, we can find the per-unit cost.

Per-unit cost = (Price of input unit × Input quantity)/Real GDP Per-unit cost = ($2 × 150)/$800 = $0.375 This reduction in per-unit cost will increase the supply of goods at every price level; thus the aggregate supply schedule will shift to the right. This will cause prices to fall and output to increase in the short run.

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Problem 5 Refer to the data in the table that accompanies problem 2. Suppose that the present equilibrium price level and level of real GDP are 100 and $225, and that data set B represents the relevant aggregate supply schedule for the economy. a. What must be the current amount of real output demanded at the 100 price level? b. If the amount of output demanded declined by $25 at the 100 price levels shown in B, what would be the new equilibrium real GDP? In business cycle terminology, what would economists call this change in real GDP? LO4 Answer a. Given that the economy is in equilibrium when aggregate supply equals aggregate demand, real output demanded must also equal $225 (quantity supplied given in the text). b. If output demanded fell by $25, the new level of demand is $200. Since the price level does not change, the quantity supplied would also fall by $25.

The new equilibrium level of real GDP is $200. This decline in output is likely a recession.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 13 Fiscal Policy, Deficits, and Debt QUESTIONS Question 1 The federal government establishes its budget to decide what programs to provide and how to pay for them. How does fiscal policy differ from this ordinary fiscal activity of budgeting? LO1 Answer Fiscal policy is directed specifically at altering the level of macroeconomic activity in order to stimulate growth, reduce unemployment, and/or restrain inflation. Ordinary fiscal activities address a wider range of priorities, many of which are noneconomic in nature, at least on the surface, or that run contrary to traditional macroeconomic objectives.

Question 2 What are government’s fiscal policy options for moving the economy out of a recession?

Speculate on which of these fiscal options might be favored by (a) a person who wants to preserve the size of government and (b) a person who thinks the public sector is too large. How does the ―ratchet effect‖ affect anti-inflationary fiscal policy? LO1 Answer Options are to increase government spending, decrease taxes, or some combination of both. See the figure below. If the price level is flexible downward, it will fall. In the real world, the goal is 1-214 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward.

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Question 3 Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy’s built-in stability? LO2 Answer In a phrase, ―net tax revenues vary directly with GDP.‖ When GDP is rising, so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments such as unemployment compensation and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability.

A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or a regressive tax. The latter rate would rise more slowly than the rate of increase in GDP with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.

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Question 4 Define the cyclically adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its standardized adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure? LO3 Answer The cyclically adjusted budget measures what the federal deficit or surplus would be if the economy reached the full-employment level of GDP with existing tax and spending policies. If the cyclically adjusted budget is balanced, then the government is not engaging in either expansionary or contractionary policy, even if, for example, a deficit automatically results when GDP declines. The ―actual‖ budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full employment.

Looking at the figure, if full-employment GDP is GDP3, then the cyclically adjusted budget is contractionary since a surplus would exist. Even though the ―actual‖ budget has no deficit at GDP2, fiscal policy is contractionary. To move the economy to full employment, government should cut taxes or increase spending. You would raise the G line or lower the T line or a combination of each until they intersect at GDP3.

Question 5 Why did the budget surpluses of 2000 and 2001 give way to a series of budget deficits in 2002?

Why did those deficits increase substantially beginning in 2008? LO3 Answer The economy was sluggish through 2002, lowering revenues, and in June 2003 Congress again cut taxes. In addition there were the September 11, 2001 terrorist attacks, the subsequent ―war on terror‖ at home and abroad, the economic downturn of 2001, and the fiscal policy response of extended unemployment benefits and significant reductions in tax rates.

In 2008 Congress acted rapidly to pass an economic stimulus package to address the recession.

This law provided a total of $152 billion in stimulus, with some of it coming as tax breaks for businesses, but most of it delivered as checks of up to $600 each to taxpayers, veterans, and Social Security recipients.

Question 6 Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy.

Explain the idea of a political business cycle. How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out effect, and why might it be relevant to fiscal policy? LO4 1-217 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag), and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation.

A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise.

In this view, the political process creates economic instability.

A decrease in tax rates might be enacted to stimulate consumer spending. If households receive the tax cut but expect it to be reversed in the near future, they may hesitate to increase their spending. Believing that tax rates will rise again (and possibly concerned that they will rise to rates higher than before the tax cut), households may instead save their additional after-tax income in anticipation of needing to pay taxes in the future.

The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending, financed by borrowing.

The increase in G was designed to increase AD but the resulting increase in interest rates may decrease I. Thus, the impact of expansionary fiscal policy may be reduced.

Question 7 How do economists distinguish between the absolute and relative sizes of the public debt? Why is the distinction important? Distinguish between refinancing the debt and retiring the debt. How does an internally held public debt differ from an externally held public debt? Contrast the effects of retiring an internally held debt and retiring an externally held debt. LO5 Answer There are two ways of measuring the public debt: (1) measure its absolute dollar sizeand (2) measure its relative size as a percentage of GDP. The distinction is important because the absolute size doesn’t tell us about an economy’s capacity to repay the debt. The United States has the largest public debt of any country, but as a percentage of GDP has a smaller debt than some other nations. This means the United States has greater ability (more income) to service that debt than those countries whose debt is a higher percentage of GDP. Refinancing the public debt simply means rolling over outstanding debt—selling ―new‖ bonds to retire maturing bonds. Retiring the debt means purchasing bonds back from those who hold them or paying the bonds off at maturity.

An internally held debt is one in which the bondholders live in the nation having the debt; an externally held debt is one in which the bondholders are citizens of other nations.

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Paying off an internally held debt would involve buying back government bonds. This could present a problem of income distribution because holders of the government bonds generally have higher incomes than the average taxpayer. But paying off an internally held debt would not burden the economy as a whole—the money used to pay off the debt would stay within the domestic economy. In paying off an externally held debt, people abroad could use the proceeds of the bond sales to buy products or other assets from the U.S. However, the dollars gained could be simply exchanged for foreign currency and brought back to their home country. This reduces U.S. foreign reserves holdings and may lower the dollar exchange rate.

Question 8 True or False. If false, explain why. LO5 a. The total public debt is more relevant to an economy than the public debt as a percentage of GDP. b. An internally held public debt is like a debt of the left hand owed to the right hand. c. The Federal Reserve and Federal government agencies hold more than three-fourths of the public debt. d. As a percentage of GDP, the total U.S. public debt is the highest such debt among the world's advanced industrial nations.

Answer a. False. There are two ways of measuring the public debt: (1) measure its absolute dollar size and (2) measure its relative size as a percentage of GDP. The distinction is important because the absolute size doesn’t tell us about an economy’s capacity to repay the debt. The United States has the largest public debt of any country, but as a percentage of GDP has a smaller debt than some other nations. This means the United States has a greater ability (more income) to service that debt than those countries whose debt is a higher percentage of GDP. b. True, but this does not mean a large debt is entirely problem free. c. False: The Federal Reserve and Federal government held only 37 percent of the public debt in 2018. d. False: There are a number of countries with a higher public debt as a percentage of GDP.

Question 9 Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP? LO5

Answer The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing was automatic, there would be no debt-load at all. But 1-219 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important and its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of the GDP is a measure of total national income or how much the government can raise in taxes to pay the interest.

Question 10 Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the stock of capital, and economic growth. How might investment in public capital and complementarities between public capital and private capital alter the outcome of the cause-effect chain? LO5 Answer Government borrowing to finance the debt competes with private borrowing and drives up the interest rate; the higher interest rate causes a decline in borrowing by private companies, thereby reducing the formation of private capital and economic growth slows.

However, if public investment complements private investment, private borrowers may be willing to pay higher rates for positive growth opportunities. Productivity and economic growth could rise.

Question 11 What do economists mean when they say Social Security and Medicare are "pay-as-you-go" plans? What are the Social Security and Medicare trust funds, and how long will they have money left in them? What is the key long-run problem of both Social Security and Medicare? To fix the problem, do you favor increasing taxes, or do you prefer reducing benefits? LO6 Answer Social Security and Medicare are largely annual ―pay-as-you-go‖ plans, meaning that most of the current revenues from the Social Security tax are paid to current Social Security retirees.

Social Security and Medicare trust funds are assets held by these programs to help pay for future projected tax revenue shortfalls. These trust funds hold special issue treasury bonds purchased using the revenue in excess of payouts in past years. The Social Security trust fund is projected to be depleted by 2033. The Medicare trust fund is expected to be depleted by 2024.

The key problem is that the United States' population is aging. That is, the fraction of the population over the age of 65 is increasing due to increased longevity and the retirement of the baby boom generation 1-220 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Student answers will vary for the following question: Do you favor increasing taxes, or do you prefer reducing benefits to fix the problem?

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PROBLEMS Problem 1 Refer back to the table in Figure 12.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percentage will the price level increase? Will this inflation be demand-pull inflation, or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? LO1 Answer Real Output Demanded (Original) $506 508 510 512 514

Real Output Demanded (New) $513 515 517 519 521

Price Level

Real Output Supplied

108 104 100 96 92

$513 512 510 507 502

After the increase in real output demanded by $7 billion at each price level, we see that the new equilibrium is $513 billion (quantity demanded equals quantity supplied) at the price level 108.

The price level increase is 8 percent (= (108 – 100)/100 = 0.08 (or 8 percent)).

Since this inflation is the result of an increase in aggregate demand, this is demand-pull inflation.

If potential real GDP (= full-employment GDP) is $510 billion, the size of the positive GDP gap after the change in aggregate demand is $3 billion (= $513 billion – $510 billion).

If government wants to use fiscal policy to counter this inflation without changing tax rates, it would decrease government spending.

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Problem 2 Refer to the accompanying table for Waxwania: LO2, LO3

a. What is the marginal tax rate in Waxwania? The average tax rate? Which of the following describes the tax system: proportional, progressive, regressive? b. Suppose Waxwania is producing $600 of real GDP, whereas the potential real GDP (or fullemployment real GDP) is $700. How large is its budget deficit? Its cyclically adjusted budget deficit? Its cyclically adjusted budget deficit as a percentage of potential real GDP? Is Waxwania’s fiscal policy expansionary or is it contractionary?

Answer a. The marginal tax rate is 20 percent: Marginal tax rate = Δ Tax revenue/Δ Real GDP We apply this to every change in real GDP and find that it is the same for each incremental change of $100 (in a more general setting, this does not need to be the case).

The average tax rate is also 20 percent.

Average tax rate = Tax revenue/Real GDP We apply this to every level of real GDP and find that it is the same for each level (in a more general setting, this does not need to be the case).

Since the average tax rate does not change as income (real GDP) increases, the tax system is proportional.

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b. If Waxwania is producing $600 of real GDP, the budget deficit equals $40 billion (= $160 (government spending at $600) – $120 (government revenue at $600)).

If potential real GDP (= full-employment real GDP) is $700, then the cyclically adjusted budget deficit is $20 billion (= $160 (government spending at $700) – $140 (government revenue at $700)).

Thus, the cyclically adjusted budget deficit as a percentage of potential real GDP equals 2.86 percent (= $20/$700 = 0.02857, or approximately 2.86 percent).

Since the government is running a cyclically adjusted budget deficit, this fiscal policy is expansionary.

Problem 3 Suppose that a country has no public debt in year 1 but experiences a budget deficit of $40 billion in year 2, a budget deficit of $20 billion in year 3, a budget surplus of $10 billion in year 3, and a budget deficit of $2 billion in year 4. What is the absolute size of its public debt in year 5? If its real GDP in year 5 is $104 billion, what is this country’s public debt as a percentage of real GDP in year 5? LO5 Answer Public debt is the sum of deficits and surpluses (negative deficits) over time. Since the country started year 1 with no public debt, the country’s debt at the end of year 5 is $52 billion (= $40 (deficit year 2) + $20 (deficit year 3) – $10 (surplus year 4, negative deficit) + $2 (deficit year 5)).

If real GDP in year 5 is $104 billion, this country’s public debt as a percentage of real GDP in year 5 is 50 percent =( $52 (debt)/$104 (GDP) = 0.5, or 50 percent).

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Problem 4 Suppose that the investment demand curve in a certain economy is such that investment declines by $100 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $150 billion at each real interest rate for every 1 percentage point increase in the expected rate of return from investment. If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, but also raises the expected rate of return on investment by 1 percentage point, how much investment, if any, will be crowded out? LO5 Answer If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, this will reduce investment by $200 billion. If stimulus spending (an expansionary fiscal policy) also raises the expected rate of return on investment by 1 percentage point, this increases investment by $150 billion. Combining these two effects results in $50 billion in investment spending being crowded out by the expansionary fiscal policy (= $200 (decrease from interest rate movement) – $150 (increase from the expected rate of return increase)).

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 14 Money, Banking, and Financial Institutions QUESTIONS Question 1 What are the three basic functions of money? Describe how rapid inflation can undermine money’s ability to perform each of the three functions. LO1 Answer Money is used as a medium of exchange for goods and services, as a unit of account for expressing price, and as a store of value.

People will only accept money in exchange for goods and services and for the work they perform if they can be reasonably certain that the medium of exchange—money—will retain its value until they are ready to spend it. In runaway inflations of the thousands or tens of thousands of percent a year, people revert to barter.

Again, drastic inflation greatly reduces money’s use as a measure of value (unit of account), for it is impossible to adjust instantaneously all prices strictly in line with their relative values. Thus, opportunities are afforded to speculators to profit at the expense of the less sophisticated who, eventually, will learn to distrust money’s usefulness as a measure of value.

Finally, and most obviously, money’s usefulness as a store of value is destroyed in a drastic inflation. The ―rule of 70‖ is instructive here. By dividing the absolute inflation rate into 70, one 1-225 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

can estimate how long it takes one’s dollar savings to lose half their purchasing power. At 7 percent inflation, the dollar will be worth half as much in 10 years.

Question 2 Which two of the following financial institutions offer checkable deposits included within the M1 money supply: mutual fund companies; insurance companies; commercial banks; securities firms; thrift institutions? Which of the following is not included in either M1 or M2: currency held by the public; checkable deposits; money market mutual fund balances; small-denominated (less than $100,000) time deposits; currency held by banks; savings deposits? LO2 Answer Commercial banks and thrift institutions offer checkable deposits.

Currency held by banks is not counted in either M1 or M2.

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Question 3 What are the components of the M1 money supply? What is the largest component? Which of the components of M1 is legal tender? Why is the face value of a coin greater than its intrinsic value? What near-monies are included in the M2 money supply? LO2 Answer M1 = currency (in circulation) + checkable deposits. The largest component of M1 is currency (51 percent), and it is the only part that is legal tender. If the face value of a coin were not greater than its intrinsic (metallic) value, people would remove coins from circulation and sell them for their metallic content. M2 = M1 + noncheckable savings deposits + money market deposit accounts + small time deposits + money market mutual fund balances.

Question 4 What ―backs‖ the money supply in the United States? What determines the value (domestic purchasing power) of money? How does the purchasing power of money relate to the price level? Who in the United States is responsible for maintaining money’s purchasing power? LO3 Answer There is no concrete backing to the money supply in the United States.

Paper money, which has no intrinsic value, has value only because people are willing to accept it in exchange for goods and services, including their labor services as employees.

And people are willing to accept paper as money because they know that everyone else is also willing to do so. If the monetary authorities were issued new banknotes at a rate far in excess of available output, the acceptability of paper money would diminish. People would start to worry about whether the banknotes would be worth much after they received them. Checks are part of the money supply and are not legal tender, but people accept them willingly from people believed trustworthy.

The purchasing power of money is inversely related to the price level.

The Board of Governors of the Federal Reserve System (the Fed) is responsible for managing the United States’ money supply so that money retains its purchasing power.

Question 5 How is the chairperson of the Federal Reserve System selected? Describe the relationship between the Board of Governors of the Federal Reserve System and the 12 Federal Reserve Banks. What is the purpose of the Federal Open Market Committee (FOMC)? What is its makeup? LO4 Answer 1-227 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

The members of the Board of Governors of the Federal Reserve are selected by the U.S. president and confirmed by the Senate. The seven board members have long terms—14 years—which are staggered so that one member is replaced every 2 years. The president selects the chairperson and vice-chairperson of the oard of Governors from among the members, and they serve 4-year terms. Several entities assist the Board of Governors in determining banking and monetary policy.

The Federal Open Market Committee is the most important, voting on the Fed’s monetary policy and directing the purchase or sale of government securities. Five of the presidents of the Federal Reserve Banks have voting rights on the FOMC each year, rotating the membership among the 12 banks, except for the president of the New York Federal Reserve Bank Fed who has a permanent voting seat.

Question 6 What do economists mean when they say that the Federal Reserve Banks are central banks, quasi-public banks, and bankers’ banks? LO5 Answer The 12 Federal Reserve Banks are ―central‖ banks whose policies are coordinated by the Board of Governors. They are quasi-public banks, meaning that they are a blend of private ownership and public control. They are also bankers’ banks in that they perform essentially the same functions for banks and thrifts as those institutions perform for the public.

Question 7 Identify three functions of the Federal Reserve , other than its main role of controlling the supply of money. LO5 Answer The Federal Reserve performs 7 basic functions: 1. The Fed issues Federal Reserve Notes, the paper currency used in the U.S. monetary system.

2. The Fed sets reserve requirements and holds the mandated reserves that are not held as vault cash.

3. The Fed lends money to banks and thrifts.

4. The Fed provides for check collection.

5. The Fed acts as fiscal agent for the Federal government.

6. The Fed supervises the operation of banks.

7. Finally, and most importantly, the Fed has responsibility for regulating the supply of money, and this in turn enables it to affect interest rates.

Any three of the first six are appropriate answers.

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Question 8 How does each of the following relate to the financial crisis of 2007–2008: declines in real estate values, subprime mortgage loans, mortgage-backed securities? LO6 Answer Prior to the 2007-2008 financial crisis the banking institutions issued a large number of loans to borrowers that were relatively more 'risky' in the sense that these borrowers were more likely to default on their loans. This was referred to as the sub-prime market. This resulted in a rapid increase in home prices (along with housing market speculation) that was unsustainable (sometimes referred to as a 'bubble'). This problem was also exacerbated by the issuance of mortgage backed securities, which bundled riskier mortgages together, and sold them to investors. In theory, this reduced the risk exposure that banks faced after issuing these loans. This apparent reduction in risk increased the amount of sub-prime loans made by the banks. However, this reduction in risk was an accounting illusion since the banks also made loans to the groups purchasing the mortgage backed securities.

When housing prices started to decline and individuals started to default on their mortgages (initially sub-prime borrowers), this reduced, or completely eliminated, the value of these mortgage backed securities. This caused the financial investors who held these securities to default on their loans to the banks that originally offered the mortgage backed securities (basically the banks issued loans to the individuals who were buying the assets they were selling). Thus, there was a major 'credit crunch' as banks wrote-off the bad loans.

Question 9 What is TARP and how was it funded? What is meant by the term ―lender of last resort‖ and how does it relate to the financial crisis of 2007-2008? LO6 Answer In late 2008 Congress passed the Troubled Asset Relief Program (TARP), which allocated $700 billion—yes, billion—to the U.S. Treasury to make emergency loans to critical financial and other U.S. firms. This was financed with general tax revenue and the issuance of government debt.

One of the roles of the Federal Reserve is to serve as the lender of last resort to financial institutions in times of financial emergencies. That is, the Federal Reserve stands ready to lend funds to the banking sector to keep credit flowing. The Fed performed this vital role during the Financial Crisis of 2007-2008. Under Fed Chair Ben Bernanke, the Fed designed and implemented several highly creative new lender-of-last-resort facilities to 1-229 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

pump liquidity into the financial system. These facilities, procedures, and capabilities were in addition to both the TARP efforts by the U.S. Treasury and the Fed’s use of standard tools of monetary policy (the subject of Chapter 36) designed to reduce interest rates.

Question 10 How did the Wall Street Reform and Consumer Protection Act of 2010 try to address some of the problems that helped cause the financial crisis of 2007-2008? LO6 Answer The Wall Street Reform and Consumer Protection Act of 2010 eliminated the Office of Thrift Supervision. It was the single largest policy response to the crisis that: (1) Gave broader authority to the Federal Reserve to regulate all large financial institutions.

(2) Created a Financial Stability Oversight, Council to watch for risks to the financial institutions.

(3) Established a process for the federal government to liquidate (sell off) the assets of failing nonbank financial institutions, much as the FDIC does with failing banks.

(4) Required mortgage-backed securities and other derivatives to be federally regulated and traded on public exchanges.

(5) Required companies selling asset-backed securities to retain a portion of those securities so that they would always share some part of the default risk.

(6) Established a stronger consumer financial protection role for the Fed through creation of the Bureau of Consumer Financial Protection.

Question 11 What is the difference between an asset and a liability on a bank’s balance sheet? How does net worth relate to each? Why must a balance sheet always balance? What are the major assets and claims on a commercial bank’s balance sheet? LO7 Answer An asset of a commercial bank is something owned by the bank or owed to the bank (cash, securities, loans, etc...). A liability of the bank is a claim against the bank by nonowners (checkable deposits, etc...) and the owners of the bank. This last liability is the net worth of the bank. The balance sheet must balance by definition. That is, the sum of assets must equal the sum of liabilities plus net worth for the bank to ensure appropriate accounting of transactions.

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The major assets of a bank are reserves, securities, loans, and vault cash (this last one is relatively small when compared to the others). The major claim on the bank is checkable deposits.

Question 12 Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves? LO7 Answer Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy.

Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Bank. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes;In other words, these reserves are claims that commercial banks have against the Fed. Actual reserves minus required reserves equal excess reserves. Excess reserves determine the amount of money that banks can loan and is a crucial concept in how the banking system creates money.

Question 13 ―Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced.‖ Do you agree? Explain why or why not. LO7 Answer Students should not agree. The M1 money supply consists of currency outside of the banks (cash in the hands of the public) and checking account deposits of the public in the commercial banks. The deposit of currency into a checking account in a bank has changed the form of the money supply but not the amount.

PROBLEMS Problem 1 Assume that the following asset values (in millions of dollars) exist in Ironmania: Federal Reserve Notes in circulation = $700; Money market mutual funds (MMMFs) held by individuals 1-231 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

= $400; Corporate bonds = $300; Iron ore deposits = $50; Currency in commercial banks = $100; Savings deposits, including money market deposit accounts (MMDAs) = $140; Checkable deposits = $1500; Small-denominated (less than $100,000) time deposits = $100; Coins in circulation = $40. LO2 a. What is M1 in Ironmania? b. What is M2 in Ironmania?

Answer a. M1 equals Federal Reserve Notes in circulation plus checkable deposits plus coins in circulation.

M1 = $700 + $1,500 +$40 = $2,240 b. M2 equals M1 plus savings deposits, including money market deposit accounts (MMDAs) plus small-denominated (less than $100,000) time deposits plus money market mutual funds (MMMFs) held by individuals.

M2 = $2,240 + $140 + $100 + $400 = $2,880

Problem 2 Assume that Jimmy Cash has $2000 in his checking account at Folsom Bank and uses his checking account card to withdraw $200 of cash from the bank’s ATM machine. By what dollar amount did the M1 money supply change as a result of this single, isolated transaction? LO2 Answer The answer is zero. Jimmy withdrew $200 from his checking account, so his checkable deposits are now $1,800. This results in a decrease in M1 by the amount of the withdrawal. amount.

However, Jimmy now has $200 in cash, which increases M1 by $200.

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Problem 3 Suppose the price level and value of the U.S. dollar in year 1 are 1 and $1, respectively. If the price level rises to 1.25 in year 2, what is the new value of the dollar? If, instead, the price level falls to .50, what is the value of the dollar? LO2 Answer The amount a dollar will buy varies inversely with the price level; that is, a reciprocal relationship exists between the general price level and the purchasing power of the dollar. That is, to find the value of the dollar $V, divide 1 by the price level P expressed as an index number (in hundredths).

In equation form, the relationship looks like this: $V = 1/P. This implies that when the price level rises to 1.25 in year 2, the new value of the dollar is $V = 1/1.25 = $0.8.

This also implies that when the price level falls to 0.5, the new value of the dollar is $V = 1/0.5 = $2.

Problem 4 Suppose that Lady Gaga goes to Las Vegas to play poker and at the last minute her record company says it will reimburse her for 50 percent of any gambling losses that she incurs. Will Lady Gaga wager more or less as a result of the reimbursement offer? What economic concept does your answer illustrate? LO6 Answer More; moral hazard.

Feedback: Since Lady Gaga will get reimbursed for part of her losses she will ot bear the full cost of her decisions. Thus, she will gamble more.The economic concept illustrated by this example is moral hazard.

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Problem 5 Assume that securitization combined with borrowing and irrational exuberance in Hyperville have driven up the value of existing financial securities at a geometric rate, specifically from $2 to $4 to $8 to $16 to $32 to $64 over a six-year time period. Over the same period, the value of the assets underlying the securities rose at an arithmetic rate from $2 to $3 to $4 to $5 to $6 to $7. If these patterns hold for decreases as well as for increases, by how much would the value of the financial securities decline if the value of the underlying asset suddenly and unexpectedly fell by $5? LO6 Answer Since we are assuming the same ratios (or the structure of the growth rates remains the same), a decline in underlying asset value by $5 results in a new value of $2 (falls from $7, the current value, to the new value of $2).

This implies that the value of existing financial securities, which grew at a geometric rate, falls back to $2. This was the existing asset value associated with the underlying asset value five years ago (the underlying asset value was $2 five years ago).

Thus, the value of the financial securities would fall by $62. (= $64 (value of the securities at the end of the sixth year) − $2 (beginning value)).

Problem 6 Suppose the assets of the Silver Lode Bank are $100,000 higher than on the previous day and its net worth is up $20,000. By how much and in what direction must its liabilities have changed from the day before? LO7 Answer By definition (balance sheet approach), the total amount of assets must equal liabilities plus net worth.

Assets = Liabilities + Net worth We can extend this logic to changes. That is, the change in assets must equal the change in liabilities plus the change in net worth. Δ Assets = Δ Liabilities + Δ Net worth Substituting the values above, we have: $100,000 = Δ Liabilities + $20,000 This implies that Δ Liabilities = $80,000, which is obviously an increase in liabilities.

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Problem 7 Suppose that Serendipity Bank has excess reserves of $8,000 and checkable deposits of $150,000. If the reserve ratio is 20 percent, how much does the bank hold in actual reserves?

LO7 Answer The first step is to calculate the required reserves for the bank, which equals the product of the required reserve ratio (decimal form) and checkable deposits.

Required reserves = 0.20 × $150,000 = $30,000 The second step is to calculate actual reserves, which is the sum of required reserves and excess reserves.

Actual reserves = Required reserves + Excess reserves = $30,000 + $8,000 = $38,000

Problem 8 Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5000 in currency into a checking account at the bank, and that currency is added to reserves. What amount of excess reserves does the bank now have?

LO7 Answer The first step is to calculate checkable deposits. This equals the original checkable deposits plus the new deposit, $105,000 (= $100,000 + $5,000).

The second step is to calculate required reserves for the deposits, which equals the product of the required reserve ratio (decimal from) and checkable deposits.

Required reserves = 0.20 × $105,000 = $21,000 The third step is to calculate excess reserves, which equals actual reserves minus required reserves. Since the $5,000 deposit was added to the original reserves of $20,000, the new (actual) reserves equal $25,000.

Excess reserves = Actual reserves – Required reserves = $25,000 – $21,000 = $4,000

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Problem 9 The balance sheet below is for Big Bucks Bank. The reserve ratio is 20 percent. LO7

a. What is the maximum amount of new loans that Big Bucks Bank can make? Show in columns 1 and 1' how the bank’s balance sheet will appear after the bank has loaned this additional amount. b. By how much has the supply of money changed? c. How will the bank’s balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against the bank? Show the new balance sheet in columns 2 and 2'. d. Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent.

Answer a. The first step is to calculate required reserves, which equals the product of the required reserve ratio (decimal form) and checkable deposits.

Required reserves = 0.20 × $100,000 = $20,000 The second step is to calculate excess reserves, which equals actual reserves minus required reserves.

Excess reserves = Actual reserves – Required reserves = $22,000 – $20,000 = $2,000

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After making a loan of $2,000 (excess reserves), loans will increase by $2,000. There is no change in reserves initially (checks have not been drawn against the loan yet) or securities. Once the bank makes the loan it will also credit the borrower’s account (checkable deposits) equal to the value of the loan. Thus, checkable deposits will increase by $2,000.

Assets (1)

Liabilities and net worth (1' ) (2' )

(2)

Reserves $22,000

$22,000 ------------------

Securities 38,000 Loans 40,000

38,000 -----------------42,000 ------------------

Checkable $100,000 $102,000 ---------------deposits

b. The immediate effect is an increase in the money supply by $2,000. Checkable deposits have increased by $2,000 (note that we have not worked through the monetary multiplier yet; this is the immediate effect of the transaction.) c. After checks are drawn against the loan, checkable deposits will fall by $2,000 (the amount of the loan) and reserves will fall by $2,000 (the amount of the loan) after the checks clear.

Assets (1)

Liabilities and net worth (1' ) (2' )

(2)

Reserves $22,000

$22,000

$20,000

Securities 38,000 Loans 40,000

38,000 42,000

38,000 42,000

Checkable deposits $100,000 $102,000

$100,000

d. a. The first step is to calculate required reserves, which equals the product of the required reserve ratio (decimal form) and checkable deposits. Required reserves = 0.15 × $100,000 = $15,000. The second step is to calculate excess reserves, which equals actual reserves minus required reserves. Excess reserves = Actual reserves – Required reserves = $22,000 – $15,000 = $7,000. After making a loan of $7,000 (excess reserves), loans will increase by $7,000. There is no change in reserves initially (checks have not been drawn against the loan yet) or securities.

Once the bank makes the loan, it will also credit the borrower’s account (checkable deposits) equal to the value of the loan. Thus, checkable deposits will increase by $7,000.

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Assets (1)

Liabilities and net worth (1' ) (2' )

(2)

Reserves $22,000

$22,000 ------------------

Securities 38,000 Loans 40,000

38,000 47,000

Checkable deposits $100,000 $107,000 ----------------

-----------------------------------

b. The immediate effect is an increase in the money supply by $7,000. Checkable deposits have increased by $7,000 (note that we have not worked through the monetary multiplier yet; this is the immediate effect of the transaction).

c. After checks are drawn against the loan, checkable deposits will fall by $7,000 (the amount of the loan) and reserves will fall by $7,000 (the amount of the loan) after the checks clear.

Assets (1)

Liabilities and net worth (1' ) (2' )

(2)

Reserves $22,000

$22,000

$15,000

Securities 38,000 Loans 40,000

38,000 47,000

38,000 47,000

Checkable deposits $100,000 $107,000

$100,000

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Problem 10 Suppose the following simplified consolidated balance sheet is for the entire commercial banking system and that all figures are in billions of dollars. The reserve ratio is 25 percent. LO7

a. What is the amount of excess reserves in this commercial banking system? What is the maximum amount the banking system might lend? Show in columns 1 and 1′ how the consolidated balance sheet would look after this amount has been loaned. What is the size of the monetary multiplier? b. Answer the questions in part a assuming the reserve ratio is 20 percent. What is the resulting difference in the amount that the commercial banking system can loan?

Answer a. $2 billion; $8 billion; Column (1) Reserves = $52, Securities = $48, Loans = $108, Checkable deposits = $208; Money multiplier = 4 b. $12 billion; $60 billion; Column (1) Reserves = $52, Securities = $48, Loans = $160, Checkable deposits = $260; Money multiplier = 5 Feedback: a. The first step is to calculate required reserves, which equals the product of the required reserve ratio (decimal from) and checkable deposits.

Required Reserves = 0.25 × $200 billion = $50 billion The second step is to calculate excess reserves, which equals actual reserves minus required reserves.

Excess Reserves = Actual Reserves – Required Reserves = $52 billion – $50 billion = $2 billion The third step is to calculate the maximum amount the banking system (not a single bank as in problem 5) might lend. This is found by taking product of the monetary multiplier and the amount of excess reserves.

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The monetary multiplier = 1/required reserve ratio = 1/0.25 = 4 Maximum amount of loans = 4 × $2 billion = $8 billion Assets

Liabilities and Net Worth (2)

(1) Reserves Securities Loans

$ 52 48 100

$52 48 108

Checkable deposits

$200

$208

Two things to note here: (1) The banking system does not lose reserves (2) checkable deposits increase by the amount of the loans (money creation through the fractional reserve banking system). b. We follow the same steps, but with a required reserve ratio of 20 percent.

The first step is to calculate required reserves, which equals the product of the required reserve ratio (decimal from) and checkable deposits.

Required Reserves = 0.20 × $200 billion = $40 billion The second step is to calculate excess reserves, which equals actual reserves minus required reserves: Excess Reserves = Actual Reserves - Required Reserves = $52 billion – $40 billion = $12 billion The third step is to calculate the maximum amount the banking system (not a single bank as in problem 5) might lend. This is found by taking product of the monetary multiplier and the amount of excess reserves.

The monetary multiplier = 1/required reserve ratio = 1/0.2 = 5 Maximum amount of loans = 5 × $12 billion = $60 billion

Assets

Liabilities and Net Worth (2)

(1) Reserves Securities Loans

$ 52 48 100

$52 48 160

Checkable deposits

$200

$260

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With the required reserve ratio of 20% (rather than 25%) the banking system can lend $52 billion more (= $60 billion – $8 billion).

Problem 11 If the required reserve ratio is 10 percent, what is the monetary multiplier? If the monetary multiplier is 4, what is the required reserve ratio? LO7 Answer The monetary multiplier equals one divided by the required reserve ratio.

Required reserve ratio = 10 percent: Monetary multiplier = 1/Required reserve ratio = 1/.10 = 10 Monetary multiplier = 4: Required reserve ratio = 1/Monetary multiplier = 1/4 = .25, or 25 percent.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 15 Interest Rates and Monetary Policy QUESTIONS Question 1 What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how these two demands can be combined graphically to determine total money demand. How is the equilibrium interest rate in the money market determined? LO1 Answer (a) The level of nominal GDP. The higher this level, the greater the amount of money demanded for transactions. (b) The interest rate. The higher the interest rate, the smaller the amount of money demanded as an asset.

On a graph measuring the interest rate vertically and the amount of money demanded horizontally, the two demands for the money curves can be summed horizontally to get the total demand for money. This total demand shows the total amount of money demanded at each interest rate. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve.

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Question 2 What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy? LO4 Answer The basic objective of monetary policy is to assist the economy in achieving a full-employment, noninflationary level of total output.

Monetary policy affects the economy through a complex cause-effect chain: (a) Policy decisions affect commercial bank reserves; (b) changes in reserves affect the money supply; (c) changes in the money supply alter the interest rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; and (f) changes in aggregate demand affect the equilibrium real GDP and the price level.

The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, that the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s.

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Monetary policy is formed by the seven members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress, plus the president. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.

Question 3 What is the impact of each of the following transactions on commercial bank reserves? LO2 a. The New York Federal Reserve Bank purchases government securities from private businesses and consumers. b. Commercial banks borrow from Federal Reserve Banks at the discount rate. c. The Fed reduces the reserve ratio. d. The Fed increases the interest rate on excess reserves.

Answer a. If private businesses and consumers deposit the proceeds from their sale of government securities to the Fed, commercial bank reserves will rise. If they hold the proceeds as cash, no change in reserves will occur. b. Reserves will rise if commercial banks borrow from the Fed. c. Reducing the reserve ratio will not directly change the reserves of commercial banks. It will, however, change some of the bank reserves from required to excess reserves. To the extent that it also encourages greater lending, the increase in the money supply will generate more reserves. d. If the Fed increases the interest rate paid on reserves, it will become more attractive for commercial banks to hold reserves, the amount of excess reserves in the system will increase.

Question 4 What are the two parts of the Fed’s dual mandate? How does the dual mandate relate to the bullseye chart? Which quadrants of the bullseye chart give conflicting signals to the Fed and what is the source of the confusion in each case? LO3 Answer The Fed's dual mandate, given to it by Congress in 1977, states that the Fed’s two highest objectives should be full employment and stable prices.

The bullseye chart was developed by the Federal Reserve Bank of Chicago. It is a visual comparison of the current state of the economy with the Fed's dual mandate of full employment and stable prices. The chart shows the inflation rate on the vertical axis and the unemployment rate on the horizontal axis and has crosshairs where the two targets meet. The current rates of unemployment and inflation are also plotted on the chart. The southwest (lower left) and northeast (upper right) quadrants send conflicting messages about which monetary policy is appropriate. If the point showing the actual rates of unemployment and inflation lies southwest of the center of the bullseye, the Fed will be 1-243 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

in a policy predicament. The fact that the actual unemployment rate is below the fullemployment rate of unemployment will suggest that the Fed should be inclined toward a restrictive monetary policy. But the fact that the inflation rate is below 2 percent suggests that a stimulatory policy is in order.

If the point showing the actual rates of unemployment and inflation lies northeast of the center of the bullseye, the opposite problem exists. There, the unemployment rate will be suggesting an expansionary monetary policy (to reduce the unemployment rate down to the 4.3 percent target) while the inflation rate will be suggesting a contractionary monetary policy (to reduce the inflation rate down to 2 percent).

Question 5 Suppose that you are a member of the Board of Governors of the Federal Reserve System and the economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend, and (d) the interest rate on excess reserves? Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand. LO3 Answer To reduce inflation, the reserve ratio and the discount rate, should be increased. A higher reserve ratio will decrease reserves, thereby decreasing the money supply, raising the interest rate, and decreasing investment, consumption, and aggregate demand. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

Question 6 What do economists mean when they say that monetary policy can exhibit cyclical asymmetry?

How does the idea of a liquidity trap relate to cyclical asymmetry? Why is the possibility of a liquidity trap significant to policymakers? LO4 Answer Cyclical asymmetry refers to the condition that a restrictive monetary policy is relatively potent at contracting economic activity, while an expansionary monetary policy is relatively weak at stimulating an economy. The weakness in expansionary monetary policy results when, even though the Fed increases liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of uncertainty over general weakness in the economy). This is often referred to as a liquidity trap.

Cyclical asymmetry, and the potential for a liquidity trap, is important to policymakers because it suggests that while monetary policy can effectively fight inflation, it may not be as successful in bringing an economy out of a recession. As Japan learned in the 1990s, expansionary monetary policy may be inadequate, and an expansionary fiscal policy may be necessary to stimulate recovery.

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Question 7 How did the Fed use the main tools of monetary policy to respond to the financial crisis that began in 2007? What additional programs did the Fed create and implement to facilitate its role as lender of last resort? What was the primary purpose of these new programs?

LO5 Answer The financial crisis of 2007–2008 presented a financial emergency. Under Fed Chair Ben Bernanke, the Fed designed and implemented several highly creative new lender-of-last-resort facilities to pump liquidity into the financial system. In undertaking its lender-of-last-resort functions, the Fed bought securities from financial institutions. The purpose was to increase liquidity in the financial system by exchanging illiquid bonds (that the firms could not easily sell during the crisis) for cash, the most liquid of all assets.

The following list of current and former Fed credit facilities underscores the extraordinary extent of the Fed’s lender-of-last-resort response to the crisis.

• Term Auction Facility (TAF) provided short-term loans of reserves to commercial banks through a secret bidding process.

• Primary Dealer Credit Facility (PDCF) provided securities from the Fed through participating in competitive single-bid auctions.

• Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility provided loans to U.S. banks and thrifts to finance their purchases of commercial paper from money market mutual funds. Commercial paper consists of asset-backed, short term IOUs that are mainly issued by corporations. These short-term loans are vital for financing the day-to-day operations of businesses.

• Commercial Paper Funding Facility (CPFF) purchased commercial paper to support the commercial paper market and therefore the short term credit needs of businesses.

• Money Market Investor Funding Facility (MMIFF) provided funding support to a privatesector initiative designed to ensure the liquidity of U S. money market mutual funds. Many Americans rely on money market mutual funds as low-risk investments.

• Term Asset-Backed Securities Loan Facility (TALF) helped households and business with their credit needs by providing funding support for asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).

• Interest Payments on Reserves bolsters the profitability of banks by paying interest on the reserves they hold in their vaults or in the Federal Reserve Banks.

These extraordinary efforts, like those of the Treasury, helped prevent total disarray in the credit markets.

PROBLEMS Problem 1 1-245 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Assume that the following data characterize the hypothetical economy of Trance: money supply = $200 billion; quantity of money demanded for transactions = $150 billion; quantity of money demanded as an asset = $10 billion at 12 percent interest, increasing by $10 billion for each 2percentage-point fall in the interest rate. a. What is the equilibrium interest rate in Trance? b. At the equilibrium interest rate, what are the quantity of money supplied, the total quantity of money demanded, the amount of money demanded for transactions, and the amount of money demanded as an asset in Trance? LO1 Answer a. To answer this part of the question, we use the table below. The first column is the interest rate and the second column is the quantity of money demanded as an asset at each rate. The third column is the quantity of money demanded for transactions, which is independent of the interest rate. The fourth column is actual (total) quantity of money demanded at each interest rate, which is the sum of columns 2 and 3. The fifth column is the quantity of money supplied at each interest rate.

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Interest Rate

Asset Demand for Money

Transactions Demand

12% 10% 8% 6% 4% 2%

10 20 30 40 50 60

150 150 150 150 150 150

Combined Demand for Money 160 170 180 190 200 210

Money Supply

200 200 200 200 200 200

We find the equilibrium interest rate by equating the quantity supplied with the quantity demanded, which occurs at the interest rate of 4 percent. b. It also follows from the answer above that the equilibrium quantity of money supplied is $200 and the equilibrium quantity demanded is $200. We can decompose the quantity demanded into its separate components, where the amount of money demanded for transactions is $150 and the amount of money demanded as an asset is $50.

Problem 2 Refer to Table 15.2 and assume that the Fed’s reserve ratio is 10 percent and the economy is in a severe recession. Also suppose that the commercial banks are hoarding all excess reserves (not lending them out) because of their fear of loan defaults. Finally, suppose that the Fed is highly concerned that the banks will suddenly lend out these excess reserves and possibly contribute to inflation once the economy begins to recover and confidence returns. By how many percentage points would the Fed need to increase the reserve ratio to eliminate one-third of the excess reserves? What would be the size of the monetary multiplier before and after the change in the reserve ratio? By how much would the lending potential of the banks decline as a result of the increase in the reserve ratio? LO2

Answer 5 percentage points; 10 before, 6.67 after; $16,660.

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Feedback: At the 10% reserve ratio the amount of excess reserves is $3,000. If the Fed wants to reduce a third of these excess reserves (eliminate $1,000 of excess reserves,) it should raise the reserve ratio to 15%. This will result in excess reserves of $2,000 (between $3,000 and $1,000). Thus, the Fed should raise the reserve ratio by 5 percentage points The monetary multiplier before the change is 10 (= 1/0.1).

The monetary multiplier after the change is 6.67 (= 1/0.15).

Before the change the banks' lending potential was $30,000 [= 10 (monetary multiplier) × $3,000 (excess reserves)].

After the change the banks' lending potential was $13,340 [= 6.67 (monetary multiplier) × $2,000 (excess reserves)].

Thus, the decline in lending potential is $16,660.

Problem 3 Refer to the table for Moola below to answer the following questions. What is the equilibrium interest rate in Moola? What is the level of investment at the equilibrium interest rate? Is there either a recessionary output gap (negative GDP gap) or an inflationary output gap (positive GDP gap) at the equilibrium interest rate and, if either, what is the amount? Given money demand, by how much would the Moola central bank need to change the money supply to close the output gap? What is the expenditure multiplier in Moola? LO4

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Answer The equilibrium interest rate occurs at the interest rate where the quantity of money supplied equals the quantity of money demanded. Thus, the equilibrium interest rate is 5 percent.

Investment at this interest rate is $20.

At the interest rate of 5 percent, potential GDP is $350 and actual GDP is $330. Since actual GDP is less than potential GDP, there is a recessionary (negative) GDP gap. The gap is the difference, so the amount of the recessionary gap is $20.

To eliminate the recessionary gap, that is, move actual GDP to $350 so that it equals potential GDP, the Fed will need to increase the money supply to $600. This is an increase of $100.

To find the expenditure multiplier, we can divide the change in actual GDP by the change in investment.

Multiplier = ($350 – $330)/($30 – $20) = $20/$10 = 2 Brue, McConnell, Flynn Essentials of Economics 5e Chapter 16

International Trade and Exchange Rates

QUESTIONS

Question 1 Quantitatively, how important is international trade to the United States relative to the importance of trade to other nations? What country is the United States’ most important trading partner, quantitatively? With what country does the United States have the largest trade deficit? LO1

Answer Our exports of goods and services are about 12 percent of GDP. That percentage is much lower than the percentage in many other nations, including Belgium, the Netherlands, Germany, Canada, and the United Kingdom.

Canada is the United States’ most important trading partner as measured by volume of trade. In 2018, 1-249 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

about 15 percent of U.S. exported goods were sold to Canadians, who in turn provided 12 percent of the U.S. imports of goods.

The United States has a sizable trade deficit with China (largest trade deficit for the United States). In 2018, it was $419 billion.

Question 2 Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries? LO2

Answer To answer this question, we find the opportunity cost of the two goods. The opportunity cost of good X (in terms of good Y) in Big Country is 3/4 (= 60/80) unit of Y for each unit of X. That is, Big Country needs to give up 3/4 unit of Y to produce 1 more unit of X. Note that this is the slope of Big Country's production possibilities curve with Y on the vertical axis. The opportunity cost of good X (in terms of good Y) in Small Nation is 1 (= 60/60) unit of Y for each unit of X. That is, Small Nation needs to give up 1 unit of Y to produce 1 more unit of X. Note that this is the slope of Small Natio's production possibilities curve with Y on the vertical axis. Given these opportunity costs, Big Country should produce good X (only needs to give up 3/4 unit of Y for 1 X) and Small Nation should produce good Y (needs to give up 1 unit of X for 1 unit of Y). That is, Big Country has a comparative advantage in producing good X because it has to give up less Y to produce X per unit.

The limits of the terms of trade depend on the opportunity costs. For example, Big Country will never pay more than 4/3 units of good X for a unit of good Y. Big Country can always produce a unit of Y itself by giving up 4/3 a unit of good X. Small Nation will never accept less than 1 unit of good X for a unit of good Y because it can always produce a unit of X for a unit of good Y. The terms of trade will be between 1 unit of good X for a unit of good Y and 4/3 a unit of X for a unit of good Y.

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Question 3 Explain why the U.S. demand for Mexican pesos slopes downward and the supply of pesos to Americans is slopes upward. Indicate whether each of the following would cause the Mexican peso to appreciate or depreciate, other things equal: LO a. The United States unilaterally reduces tariffs on Mexican products. b. Mexico encounters severe inflation. c. Deteriorating political relations reduce American tourism in Mexico. d. The U.S. economy moves into a severe recession. e. The United States engages in a high-interest-rate monetary policy. f. Mexican products become more fashionable to U.S. consumers. g. The Mexican government encourages U.S. firms to invest in Mexican oil fields. h. The rate of productivity growth in the United States diminishes sharply.

Answer The U.S. demand for pesos is downward-sloping: When the peso depreciates in value (relative to the dollar), the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping: As the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos. a. The peso will appreciate. Mexican goods will become cheaper, so U.S. demand for pesos will increase. b. The peso will depreciate. The high rate of inflation in Mexico (relative to the United States) will cause the price of Mexican goods and services to increase (relative to the United States). The U.S. demand for pesos will fall. The supply of pesos will also increase because U.S. goods are relatively cheaper. This will reinforce the depreciation of the peso. c. The peso will depreciate. The reduction in U.S. tourism in Mexico reduces the demand for pesos.

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d. The peso will depreciate. The recession in the U.S. economy will reduce imports from Mexico. This, in turn, will decrease the demand for the peso. e. The peso will depreciate. The high interest rate in the United States will attract investors from Mexico.

This will increase the demand for U.S. dollars or the supply of pesos. f. The peso will appreciate. U.S. consumers purchase more goods from Mexico. This increases the demand for the peso. g. The peso will appreciate. The U.S. firms must purchase pesos to invest in Mexico. This increases the demand for pesos.

h. The peso appreciates. The sharp decline in U.S. productivity reduces investment in the U.S. by firms in Mexico. This decreases the supply of pesos.

Question 4 Explain why you agree or disagree with the following statements. Assume other things equal: LO3 a. A country that grows faster than its major trading partners can expect the international value of its currency to depreciate. b. A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate. c. A country’s currency will appreciate if its inflation rate is less than that of the rest of the world.

Answer a. This statement is true. If high rates of economic growth mean that the real incomes of a country’s citizens are rising more rapidly than in other countries, its imports will rise more than its exports. The demand for foreign currency by its citizens will increase more than the supply of foreign currency, causing the value of the domestic currency to decline. b. This statement is true. If domestic real interest rates are increasing more quickly than those in other countries, foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency and therefore an appreciation of the country’s currency. c. This statement is true. If a country’s inflation rate is lower than rates in other countries, the foreign 1-252 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

prices of its products will decline relative to foreign-made products, increasing exports and the supply of foreign currency. And the domestic prices of foreign imports will increase relative to domestically made goods, decreasing the demand for foreign currency. Both factors will cause the country’s currency to appreciate.

Question 5 Suppose that a Swiss watchmaker imports watch components from Sweden and exports watches to the United States. Also suppose the dollar depreciates, and the Swedish krona appreciates, relative to the Swiss franc. Speculate as to how each would hurt the Swiss watchmaker. LO3

Answer

If the dollar depreciated relative to the franc, this means that it would take more dollars to get the francs necessary to buy a watch. In other words, the watch would become more expensive in dollar terms which would cause a decline in imported watches purchased in the United States. Second, if the krona appreciated relative to the Swiss franc, this is the same thing as saying that the franc depreciated relative to the krona. In other words, it would took more Swiss francs to buy parts in Sweden than it did previously. As a result, the imported components for the watches would became more expensive to the Swiss company. The Swiss watchmaker would rise hurt twice. Its costs rose while its export sales would declined.

Question 6 What measures do governments take to promote exports and restrict imports? Who benefits and who loses from protectionist policies? What is the net outcome for society? LO4

Answer Governments promote exports by providing subsidies to export producers, which effectively lowers their costs and enables them to sell their products at lower prices on world markets. Subsidies enable export firms or industries to compete against other nations, but the fact the subsidy was necessary for this competition means that the most efficient use of resources is not taking place.

Restriction of imports can be accomplished by tariffs, by import quotas, and by nontariff barriers such as licensing requirements, unreasonable quality standards, and unnecessary import procedures.

The benefits of protectionist policies accrue to the industry that has to compete on world markets either 1-253 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

with its exports or against imports. Even this may be a short-run benefit because industries that are protected may become so inefficient and outmoded that they are unable to stay afloat even with the protection in the long run. There may also be some political benefits as those protected groups have a strong self-interest in this protection and are vocal opponents of free trade for their industries, whereas the benefits of free trade are more diffuse and the benefits to any single group of voters is less noticeable.

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The costs of protectionist policies are more widespread. The costs of protectionist policies arise because resources are not being used as efficiently as they might be under free trade. This raises the cost of production and raises prices, and means the total quantity of world output produced and consumed is not as great as it could be without such barriers. Consumers lose since they must pay higher prices, but worldwide producers also lose because productivity is not as high as it could be.

The net outcome to society is negative. Costs outweigh the benefits for the reasons stated above.

Question 7

In 2018, manufacturing workers in the United States earned average compensation of $21.86 per hour.

That same year, manufacturing workers in Mexico earned average compensation of $3.20 per hour. How can U.S. manufacturers possibly compete? Why isn't all manufacturing done in Mexico and other lowwage countries?

Explanation: The United States can compete if its workers are more productive, that is, if the productivity level for U.S. workers is higher. If this is the case, then some manufacturing will take place in the United States (with productivity-adjusted wages equalized). Other reasons that all manufacturing doesn't take place in the low-wage countries may be due to trade barriers or other issues such as significant transportation costs or political instability.

Question 8 What is offshoring of white-collar service jobs and how does that practice relate to international trade?

Why has offshoring increased over the past few decades? Give an example (other than that in the textbook) of how offshoring can eliminate some U.S. jobs while creating other U.S. jobs. LO2 1-255 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Answer The offshoring of white-collar service jobs refers to jobs relating to data entry, book composition, and software coding. This reflects a growing specialization and international trade in services. These types of jobs are moving to countries with an educated labor force such as India. Offshoring may increase the demand for complementary jobs in the United States.

Question 9 Identify and state the significance of each of the following trade-related entities: (a) the WTO; (b) the EU; (c) the eurozone; and (d) NAFTA. LO5

Answer

a. The WTO oversees trade agreements reached by member nations and arbitrates trade disputes among them. b. The European Union (EU) is a trading bloc of 28 European countries who have agreed to abolish tariffs and import quotas on most products and have liberalized the movement of labor and capital within the EU. c. The euro is the common currency that is used by 19 of the European Union (EU) countries (known as the eurozone). A common currency facilitates trade between the countries of the eurozone. d. North American Free Trade Agreement (NAFTA) is a trade bloc made up of the United States, Canada, and Mexico whose purpose is to reduce tariffs and other trade barriers among the three countries.

PROBLEMS

Problem 1 Assume that the comparative-cost ratios of two products—baby formula and tuna fish—are as follows in the nations of Canswicki and Tunata: Canswicki: 1 can baby formula ≡ 2 cans tuna fish Tunata: 1 can baby formula ≡ 4 cans tuna fish 1-256 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

In what product should each nation specialize? Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula ≡ 2 ½ cans tuna fish; (b) 1 can baby formula ≡ 1 can tuna fish; (c) 1 can baby formula ≡ 5 cans tuna fish? LO2

Answer Since the opportunity cost of producing baby formula is lower in Canswicki, this implies Canswicki should produce baby formula. This also implies that Tunata should specialize in producing tuna.

We can also look at the opportunity cost of producing cans of tuna fish (in terms of forgone cans of baby formula). The opportunity cost of producing 1 can of tuna fish in Canswicki is 1/2 a can of baby formula.

The opportunity cost of producing 1 can of tuna fish in Tunata is 1/4 a can of baby formula.

Since the opportunity cost of producing tuna fish is lower in Tunata, this implies Tunata should produce tuna fish. This also implies that Canswicki should specialize in producing baby formula.

a. These terms of trade are acceptable. The best Canswicki can do without trade is produce 2 cans of tuna fish for each can of baby formula. If they trade 1 can of baby formula for 2.5 cans of tuna fish, they will be better off. Tunata will also trade because they only need to give up 2.5 cans of tuna fish for each can of baby formula. If Tunata produced baby formula themselves, they would need to give up 4 cans of tuna fish for each can of baby formula.

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b. These terms of trade would not be acceptable. Canswicki would not be willing to trade 1 can of baby formula for 1 can of tuna fish. They can do better themselves by producing 2 cans of tuna fish for each can of baby formula. c. These terms of trade would not be acceptable. Tunata would not be willing to trade (give up) 5 cans of tuna fish for 1 can of baby formula. They could do better themselves by producing a can of baby formula and giving up 4 cans of tuna fish.

Problem 2 The accompanying hypothetical production possibilities tables are for New Zealand and Spain. Each country can produce apples and plums. Plot the production possibilities data for each of the two countries separately. Referring to your graphs, answer the following: LO2

a. What is each country’s cost ratio of producing plums and apples? b. Which nation should specialize in which product?

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c. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples.

(Plot these lines on your graph.) d. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade?

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Answer a. The opportunity cost of producing 1 apple in New Zealand is 0.25 plums. That is, for each apple produced in New Zealand, the country must give up 0.25 plums.

The opportunity cost of producing 1 apple in Spain is 1 plum. That is, for each apple produced in Spain, the country must give up 1 plum.

We can also look at the opportunity cost of producing plums.

The opportunity cost of producing 1 plum in New Zealand is 4 apples. That is, for each plum produced in New Zealand, the country must give up 4 apples.

The opportunity cost of producing 1 plum in Spain is 1 apple. That is, for each plum produced in Spain, the country must give up 1 apple. b. The opportunity cost of producing apples in New Zealand is lower than Spain's opportunity cost of producing apples. Therefore, New Zealand should produce apples and Spain should produce plums. c. The graphs below show each country’s production possibilities schedules with and without trade.

Apples are on the vertical axis and plums are on the horizontal axis.

New Zealand has a vertical intercept of 60 apples (produce only apples) and a horizontal intercept of 15 plums (produce only plums). The slope of production possibilities schedule equals –4 (negative 4). This slope is the opportunity cost of producing plums. That is, for each plum produced by New Zealand they must give up 4 apples.

However, after trade, New Zealand’s horizontal intercept will be 30 apples. Since the terms of trade are 1 plum for 2 apples, New Zealand could specialize in apple production and trade 2 apples for each plum (produce 60 apples and receive 30 plums). The slope of the after-trade production possibilities schedule is –2 (negative 2). New Zealand must now only give up 2 apples for each additional plum consumed (trade 2 apples for additional plum).

The same logic applies to Spain. Before trade the vertical intercept is 60 apples and the horizontal intercept 60 plums. The slope of the production possibilities schedule is –1, which is the opportunity cost of 1 more plum in terms of apples.

After trade Spain’s vertical intercept is now 120 apples and the horizontal intercept remains at 60 plums.

Spain will produce only plums and can trade now 1 plum for 2 apples (terms of trade). If they trade all 60 1-260 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

plums for apples, they will receive 120 apples. The new slope of the production possibilities schedule is – 2, which is the opportunity cost of consuming (not trading) 1 more plum.

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(NOTE: The intercepts above reflect possibilities not actual equilibrium consumption bundles. For example, if Spain produced only plums and traded these for apples, they should be able to consume 120 apples (vertical intercept after trade). The problem is that New Zealand is only producing 60 apples (the most it possibly can). This is not a flaw in the logic of the problem because we are only considering the construction of the production possibilities schedules. The next step would be to allow terms of trade to adjust in response to shortages and surpluses of goods based on country preferences. We do not do this step here.)

d. The first step is to determine total production before any trade takes place.

New Zealand’s optimal product mix before trade is alternative B (given in the text): Apples = 20 Plums = 10 Spain’s optimal product mix before trade is alternative S (given in the text): Apples = 20 Plums = 40 Combined, the optimal mix before trade is: Before-trade total apples = 40 (20 New Zealand plus 20 Spain) Before-trade total plums = 50 (10 New Zealand plus 40 Spain) The next step is to determine total production after specialization. Recall that New Zealand will specialize in apple production (produce only apples) and Spain will specialize in plum production (produce only plums).

After-trade total apples = 60 (New Zealand alternative D) After-trade total plums = 60 (Spain alternative R) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

Total gain apples = 20 (= 60 – 40) 1-263 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

Total gain plums = 10 (= 60 –50)

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Problem 3 The following hypothetical production possibilities tables are for China and the United States. Assume that before specialization and trade, the optimal product mix for China is alternative B and for the United States is alternative U. LO2

a. Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce? b. What is the total gain in apparel and chemical output that would result from such specialization? c. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1 ½ units of chemicals and that 4 units of apparel are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation?

Answer a. Yes, the two areas should specialize. The opportunity cost of producing 1,000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1,000 units of apparel is 2 tons of chemicals in the United States. Thus, the opportunity cost for apparel is lower in China. This implies China should 1-265 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

produce apparel and the United States should produce chemicals.

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b. The first step is to determine total production before any trade takes place.

China’s optimal product mix before trade is alternative B (given in the text) Apparel = 24,000 Chemicals = 6 The United States’ optimal product mix before trade is alternative U (given in the text): Apparel = 4,000 Chemicals = 12 Combined, the optimal mix before trade is: Before-trade total apparel = 28,000 (24,000 China plus 4,000 United States) Before-trade total chemicals = 18 (6 China plus 12 United States) The next step is to determine total production after specialization. Recall China will specialize in apparel production (produce only apparel) and the United States will specialize in chemical production (produce only chemicals).

After-trade total apparel = 30,000 (China alternative A) After-trade total chemicals = 20 (U.S. alternative W) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade.

Total gain apparel = 2,000 (= 30,000 – 28,000) Total gain chemicals = 2 (= 20 – 18)

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c. To determine the limits of the terms of trade, we look at opportunity cost. The opportunity cost of producing 1,000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1,000 units of apparel is 2 tons of chemicals in the United States.

The most China will trade (give up) is 1,000 units of apparel for 1 ton of chemicals. If the United States required more, China could do better producing the chemicals themselves.

The most the United States is willing to trade (give up) is 2 tons of chemicals for 1,000 units of apparel. If China required more, the United States could do better producing the apparel.

This implies the range, or limits, of the terms of trade: 1,000 units of apparel will be exchanged for somewhere between 1 and 2 tons of chemicals.

Now assuming the actual terms are 1,000 units of apparel for 1.5 tons of chemicals and that the ACTUAL amount traded (exchanged) is 4,000 units of apparel for 6 tons of chemicals, we can find the new consumption levels for each country.

The United States produces all 20 tons of chemicals. They trade 6 tons of chemicals for 4,000 units of apparel. So, after trade the United States consumes 14 tons of chemicals and 4,000 units of apparel.

China produces all 30,000 units of apparel. They trade 4,000 units of apparel for 6 tons of chemicals. So, after trade China consumes 6 tons of chemicals and 26,000 units of apparel.

The gain to China comes in apparel. Before trade they consumed 24,000 units of apparel and after trade they consume 26,000. This is a gain of 2,000 units of apparel.

The gain to the United States comes in chemicals. Before trade they consumed 12 tons of chemicals and after trade they consume 14 tons of chemicals. This is a gain of 2 tons of chemicals.

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Problem 4 Refer to the following table, in which Qd is the quantity of loonies demanded, P is the dollar price of loonies, Qs is the quantity of loonies supplied in year 1, and Q's is the quantity of loonies supplied in year 2. All quantities are in billions and the dollar-loonies exchange rate is fully flexible. LO3

a. What is the equilibrium dollar price of loonies in year 1? b. What is the equilibrium dollar price of loonies in year 2? c. Did the loonies appreciate or did it depreciate relative to the dollar between years 1 and 2? d. Did the dollar appreciate or did it depreciate relative to the loonies between years 1 and 2? e. Which one of the following could have caused the change in relative values of the dollar (used in the United States) and the loonie (used in Canada) between years 1 and 2: (1) more rapid inflation in the United States than in Canada, (2) an increase in the real interest rate in the United States but not in Canada, or (3) faster income growth in the United States than in Canada.

Answer a. The equilibrium is 115, where Qd equals Qs (Qd = Qs =20). b. The equilibrium is 120, where Qd equals Q's (Qd = Q's =15). c. Since the price of the loonies increased (more dollars must now be given up to purchase one more loonies), the loonies appreciated. d. Since the price of the loonies increased (more dollars must now be given up to purchase one more loonies), the dollar depreciated.

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e. Which one of the following could have caused the change in relative values of the dollar (used in the United States) and the loonie (used in Canada) between years 1 and 2: (1) more rapid inflation in the United States than in Canada, (2) an increase in the real interest rate in the United States but not in Canada, or (3) faster income growth in the United States than in Canada.

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Problem 5 Suppose that the current Canadian dollar (CAD) to U.S. dollar exchange rate is $0.85 CAD = $1 US and that the U.S. dollar price of an iPhone is $300. What is the Canadian dollar price of an iPhone? Next, suppose that the CAD to U.S. dollar exchange rate moves to $0.96 CAD = $1 US. What is the new Canadian dollar price of an iPhone? Other things equal, would you expect Canada to import more or fewer iPhones at the new exchange rate? Explain. LO3

Answer The exchange rate is $0.85 Canadian dollar for $1 U.S. dollar. As a simple example, assume a candy bar costs $1 in the United States. An individual with $0.85 Canadian could use this to purchase a U.S. dollar and buy the candy bar. Thus, the candy bar only costs $0.85 in Canadian dollars (= 0.85 × $1).

We apply the same logic to the iPhone. The iPhone costs $300 U.S. dollars, which implies it costs $255 Canadian dollars (= 0.85 × $300).

If the CAD to U.S. dollar exchange rate moves to $.96 CAD = $1 US, the price of the iPhone increases for Canadians (or individuals with Canadian currency) to $288 Canadian dollars (= 0.96 × $300).

Since the price of the iPhone increases for Canadians (the Canadian currency has depreciated), they will likely buy fewer (less) iPhones.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 17 Wage Determination QUESTIONS Question 1 Explain the meaning and significance of the fact that the demand for labor is a derived demand.

Why do labor demand curves slope downward? LO1 Answer Factors of production are not hired or bought because their employer or buyer desires them for themselves. The demand for resources, like labor, is entirely derived from what the firm believes the resources can produce. If there were no demand for output, there would be no demand for input.

The demand for a resource depends, then, on how productive it is in producing output and on the 1-271 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

price of the output. The demand for a resource is downward sloping because of the diminishing marginal product of the resource (because of the law of diminishing returns) and, in imperfectly competitive markets, also because the greater the output, the lower its price.

Question 2 Complete the following labor demand table for a firm that is hiring labor competitively and selling its product in a competitive market. LO2

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a. How many workers will the firm hire if the market wage rate is $27.95? $19.95? Explain why the firm will not hire a larger or smaller number of units of labor at each of these wage rates. b. Show this firm’s labor demand curve in schedule form and graphically. b.

Answer

Units of labor

Total product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal product

Product price

Total revenue

Marginal revenue product

17 14 12 10 7 5

$2 2 2 2 2 2 2

$0 34 62 86 106 120 130

$34 28 24 20 14 10

a. The firm will hire Two workers at $27.95 because the MRP of the first worker is $34 and the MRP of the second worker is $28, both exceeding the $27.95 wage. Four workers will be hired at $19.95 because workers 1 through 4 have MRPs exceeding the $19.95 wage. The fifth worker’s MRP is only $14 so he or she will not be hired.

The marginal revenue product curve for any resource is the demand curve for that resource because the firm equates resource price and MRP in determining its profit-maximizing level of resource employment. Thus each point on the MRP curve indicates how many resource units the firm will hire at a specific resource price. b. The demand schedule consists of the first and last columns of the table: a. nits of Labor Total Product Marginal Product Product Price Total Revenue Marginal Revenue Product −

$2

$0

—

0

0

1

17

(17 − 0)/(1 − 0) = 17

2

(17 × 2) = 34

(34 − 0)/(1 − 0) = $34

2

31

(31 − 17)/(2 − 1) = 14

2

(31 × 2) = 62

(62 − 34)/(2 − 1) = 28

3

43

12

2

86

24

4

53

10

2

106

20

5

60

7

2

120

14

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nits of Labor Total Product Marginal Product Product Price Total Revenue Marginal Revenue Product 6

65

5

2

130

10

b.

Units of Labor

Total Product

Marginal Product

Product Price

Total Revenue

Marginal Revenue Product

0

0

−

$2

$0

—

17

(17 − 0)/(1 − 0) = 17

2

(17 × 2) = 34

(34 − 0)/(1 − 0) = $34

2

31

(31 − 17)/(2 − 1) = 14

2

(31 × 2) = 62

(62 − 34)/(2 − 1) = 28

3

43

12

2

86

4

53

10

2

10 6

0

5

60

7

2

12 0

4

6

65

5

2

13 0

1

2 4 2

1

1 0

c. Unlike before, the price drops by $0.05 with each unit of labor used (from the same starting point of $2.20 when using 1 unit of labor). The total revenue earned is less than before (when labor is greater than 1), but the formula to find total revenue (TR = P × Q) is still the same. The marginal revenue product is also found the same way as before ((change in total revenue)/(change in labor)), although the numbers are again different.

Units of Labor

Total Product

Marginal Product

Product Price

Total Revenue

0

0

—

$ 2.25

$0

Marginal Revenue Product

—

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2.2

(17 × 2.20) = 37.40

(37.40 − 0)/(1 − 0) = $37.40 (66.65 − 37.40)/(2 − 1) = 29.25

17

(17 − 0)/(1 − 0) = 17

2

31

(31 − 17)/(2 − 1) = 14

2.15

(31 × 2.15) = 66.65

3

43

12

2.1

90.

3

23.65

4

53

10

2.05

10 8.65

18.35

5

60

7

2

12 0

11.35

6

65

5

1.95

12 6.75

6.75

1

The new labor demand is less elastic. Here, MRP falls because of diminishing returns and because product price declines as output increases. A decrease in the wage rate will produce less of an increase in the quantity of labor demanded because the output from the added labor will reduce product price and thus MRP.

Question 3 1-275 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

In 2018, General Motors (GM) announced that it would reduce employment by 14,000 workers.

What does this decision reveal about how GM viewed its marginal revenue product (MRP) and marginal resource cost (MRC)? Why didn’t GM reduce employment by more than 14,000 workers or by fewer than 14,000 workers? LO2 Answer GM’s decision suggests that the MRC of those 14,000 workers was greater than the MRP. GM didn’t reduce employment further because the MRP of the remaining workers exceeded the MRC. Reducing employment by less than 14,000 workers would have left GM with some employees for whom the MRC exceeded the MRP, reducing the company’s profits.

Question 4 What factors determine the elasticity of resource demand? What effect will each of the following have on the elasticity or the location of the demand for resource C, which is being used to produce commodity X? Where there is any uncertainty as to the outcome, specify the causes of that uncertainty. LO2, LO3 a. An increase in the demand for product X. b. An increase in the price of substitute resource D. c. An increase in the number of resources substitutable for C in producing X. d. A technological improvement in the capital equipment with which resource C is combined. e. A fall in the price of complementary resource E. f. A decline in the elasticity of demand for product X due to a decline in the competitiveness of product market X. Answer Elasticity of demand for a resource is determined by: (1) ease of resource substitutability, (2) elasticity of product demand, and (3) ratio of resource costs to total costs. a. An increase in the demand for good X means more of resource C will be needed for production. This is an increase in the demand for resource C. b. Uncertainty relative to the change in demand for resource C; answer depends on which is larger—the substitution effect or the output effect. c. An increase in the elasticity of resource C. This is because as other substitutes become available, a price increase in C (for example) means the quantity changes more as the producer switches inputs. d. An increase in the demand for resource C. This is because producers can now use C more efficiently, lowering the marginal cost of production. This implies producers will increase production, and thus increase their demand for inputs (like C).

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e. An increase in the demand for resource C. Because the complementary input's price has fallen, demand for that complement will go up. This means more of resource C also makes the production more efficient (due to the nature of complements). f. A decrease in the elasticity of resource C. A drop in the competitiveness in the market for good X means that the elasticity of demand for product X will drop, which correlates directly with the elasticity of its inputs, including resource C. The change in elasticity for the output is essentially "passed through" the production function to its inputs.

Question 5 Florida citrus growers say that the recent crackdown on illegal immigration is increasing the market wage rates necessary to get their oranges picked. Some are turning to $100,000 to $300,000 mechanical harvesters known as ―trunk, shake, and catch‖ pickers, which vigorously shake oranges from the trees. If widely adopted, what will be the effect on the demand for human orange pickers? What does that imply about the relative strengths of the substitution and output effects? LO2 Answer The effect of the adoption of the mechanical pickers will be to decrease the demand for human pickers. If this occurs, the substitution effect will have been greater than the output effect.

Question 6 Why is a firm in a purely competitive labor market a wage taker? What would happen if it decided to pay less than the going market wage rate? LO4 Answer A firm in a purely competitive labor market is a wage taker because there are a large number of firms wanting to buy the labor services of the workers in that market and a large number of workers with identical skills wanting to sell their labor services. As a result, the individual firm has no control over the price of labor. If a firm attempted to pay a wage below the going wage, no workers would offer their services to that firm.

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Question 7 Contrast the methods used by inclusive unions and exclusive unions to raise union wage rates.

LO5 Answer Inclusive (or industrial) unions try to organize all workers so as to gain monopoly power in the selling of labor. A successful inclusive union would be able to secure a wage rate for its members higher than the equilibrium wage (and similar to a minimum wage—see Figure A.5).

Exclusive (or craft) unions attempt to restrict membership and reduce the supply of labor.

Successfully restricting labor supply will result in higher wages for union members (see Figure A.4). Exclusive unions restrict supply by limiting (through numbers, fees, or credentials) the number of workers available for hire in a particular profession. They also tend to support immigration restrictions, reduced child labor, mandatory retirements, and a shorter workweek.

Question 8 Have you ever worked for the minimum wage? If so, for how long? Would you favor increasing the minimum wage by a dollar? By two dollars? By five dollars? Explain your reasoning. LO5 Answer Student answers will vary. Those students that have worked for minimum wage probably didn’t stay at that job for long, and would probably describe their performance and that of their coworkers as relatively unproductive (an absence of efficiency wages). Support for an increase will depend on factors such as their perception of how much employment would be lost versus the income gains of those retaining employment.

Question 9 ―Many of the lowest‐paid people in society—for example, short‐order cooks— also have relatively poor working conditions. Hence, the notion of compensating wage differentials is disproved.‖ Do you agree? Explain. LO6 Answer Short-order cooks generally need few specific skills, i.e., practically anyone is thought to be capable of flipping burgers. Since the supply of unskilled workers is high relative to the demand for them, their wages are low. In this case, the concept of compensating wage differentials is swamped by the excess supply of low-wage workers. Compensating wage differentials must be paid to compensate for nonmonetary differences in various jobs. Jobs with high risk of injury or death pay more than comparable, safer jobs. Jobs lacking employer-paid health insurance, pensions plans, and vacation time pay more than comparable jobs that provide these ―fringe benefits

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Question 10 What is meant by investment in human capital? Use this concept to explain (a) wage differentials and (b) the long‐run rise of real-wage rates in the United States. LO6 Answer Investment in human capital is educational activity that improves individual productivity (a) The concept of human capital investment explains wage differentials to some extent. There is a strong positive correlation between time spent acquiring formal education and lifetime earnings. Investments in human capital, such as education and training, enable a worker to build specialized skills that have additional wage value in the labor market. Of course, it can be said that the brain surgeon who spent over twenty years in training, starting in grade 1, had the qualities to succeed in the labor market without spending over twenty years in school. Though this counter-argument has some merit, the point still is that this highly-skilled individual would never have become a brain surgeon without the over twenty years in school and might not have achieved the particular high income that goes with being a medical specialist. (b) The long-run rise in real wage rates in the United States is positively correlated to investment in human capital. Without the increase in education and training of the American labor force that has occurred over the years, productivity (output per person per hour) would still have risen because of the investment in real capital, improved technology, and our abundant natural resource base. But the real wage would undoubtedly now be very much lower, because an unskilled labor force could not possibly have made efficient use of the material resources and advancing technology of the economy.

PROBLEMS Problem 1 Suppose that marginal product tripled while product price fell by one-half in the table accompanying Figure 17.1. What would be the new MRP values in the table? What would be the net impact on the location of the resource demand curve in Figure 17.1? LO2 Answer Units of Resource

Total Product (Output)

0 1 2 3

0 21 39 54

Marginal Product (MP)

Product Price

Total Revenue

Marginal Revenue Product (MRP)

21 18 15

$1 $1 $1 $1

0 $21 $39 $54

$21 $18 $15

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4 5 6 7

66 75 81 84

12 9 6 3

$1 $1 $1 $1

$66 $75 $81 $84

$12 $9 $6 $3

Relative to the original resource demand schedule, the new demand schedule will lie to the right.

That is, the scenario above will cause the resource demand schedule to shift to the right because the marginal revenue product is higher for each unit of the resource.

Problem 2 Complete the following labor supply table for a firm hiring labor competitively: LO4

a. Show graphically the labor supply and marginal resource (labor) cost curves for this firm. Are the curves the same or different? If they are different, which one is higher? b. Plot the labor demand data of review question 2 in Chapter 16 on the graph used in part a above. What are the equilibrium wage rate and level of employment?

Answer (a) The supply curve and the MRC are the same.

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Units of labor

Wage Rate

0 1 2 3 4 5 6

$14 14 14 14 14 14 14

Total labor cost $0 14 28 42 56 70 84

Marginal resource (labor) cost $14 14 14 14 14 14

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Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor.

Feedback: a. The labor supply curve and MRC curve coincide as a single horizontal line at the market wage rate of $14. The firm can employ as much labor as it wants, each unit costing $14; wage rate = MRC because the wage rate is constant to the firm.

Units of labor

Wage Rate

0 1 2 3 4 5 6

$14 14 14 14 14 14 14

Total labor cost $0 14 28 42 56 70 84

Marginal resource (labor) cost $14 14 14 14 14 14

b. Graph: Equilibrium is at the intersection of the MRP and MRC curves. Equilibrium wage rate = $14; equilibrium level of employment = 5 units of labor. From the tables: MRP exceeds MRC for each of the first four units of labor MRP = MRC for the fifth unit; but MRP is less than MRC for the sixth unit.

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Problem 3 Assume a firm is a monopsonist that can hire its first worker for $6 but must increase the wage rate by $3 to attract each successive worker (so that the second worker must be paid $9, the third $12, and so on). LO4 a. Draw the firm’s labor supply and marginal resource cost curves. Are the curves the same or different? If they are different, which one is higher? b. On the same graph, plot the labor demand data of question 2. What are the equilibrium wage rate and level of employment? c. Compare these answers with those you found in problem 2 above. By how much does the monopsonist reduce wages below the competitive wage? By how much does the monopsonist reduce employment below the competitive level?

Answer a. Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)): MRC monopsony $

MRP = $24 MRC = $18

Supply monopsony

competitive wage = $14

MRC=Supply competitive

monopsony wage = $12 MRP

$6

1

3

5

units of labor

The curves are different; the MRC curve is higher than the labor supply curve. b. The firm will employ three workers in this situation. Here the MRP = $24 is greater than the MRC = $18. For the fourth worker the MRP = $20 and the MRC = $24. c. The monopsonist reduces the wage by $2 (from $14 to $12) and reduces employment by two workers (from 5 to 3).

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Feedback: a and b.

Table for part a and table for part b (from review question 2 in Chapter 14 and problem 2 above).

Units of labor

Wage Rate

Total labor cost (wage bill)

Marginal resource (labor) cost

0 1 2 3 4 5 6

$NA 6 9 12 15 18 21

$0 6 18 36 60 90 126

$6 12 18 24 30 36

Units of labor

Total product

0 1 2 3 4 5 6

0 17 31 43 53 60 65

Marginal product

Product price

Total revenue

17 14 12 10 7 5

$2 2 2 2 2 2 2

$0 34 62 86 106 120 130

Marginal revenue product $34 28 24 20 14 10

Graph: (approximate shape below. Also note that the discreet nature of the problem requires that the marginal revenue product (MRP) be greater than or equal to the marginal resource cost (MRC)).

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MRC monopsony

MRP = $24 MRC = $18

Supply monopsony

competitive wage = $14

MRC=Supply competitive

monopsony wage = $12 MRP

$6

1

3

5

units of labor

The MRC schedule lies above the labor supply schedule because employing the next worker requires a higher wage in this market and you must pay all workers this higher wage.

The firm will employ three workers in this situation. To see this look at the MRP and MRC columns in the table above. The first worker will generate a MRP = $34 and will have a MRC = $6, thus the firm will employ this worker (the marginal revenue product for this worker is greater than his or her marginal cost). For the second worker we have MRP = $28 and MRC = $12, so we employ this worker. For the third worker we have MRP = $24 is greater than the MRC = $18, so we employ this worker as well. For the fourth worker we have MRP = $20 and the MRC = $24. In this case the marginal cost of this worker is greater than the worker's marginal revenue product, so we do not employ this worker. c. The monopsonist decreases employment by 2 units and the equilibrium wage rate is $2 less than the competitive wage.

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e. At what value would the minimum wage have to be set so that the firm would make zero economic profit from employing an additional low-skilled worker to clear woodland?

Answer a.

Units of Labor Wage Rate Total Labor Cost Marginal Resource (Labor) Cost Marginal Revenue Product 0

—

$0

—

—

1

$6

(1 × 6) = 6

(6 − 0)/(1 − 0) = $6

$ 30

2

9

(2 × 9) = 18

(18 − 6)/(2 − 1) = 12

24

3

12

36

18

18

4

15

60

24

15

5

18

90

30

12

6

21

126

36

10

The MRC schedule lies above the labor supply schedule because employing the next worker requires a higher wage in this market, and you must pay all workers this higher wage.

b. The competitive equilibrium occurs where MRP equals the labor supply, at a quantity of 4.

The corresponding wage at that point is $15 per unit of labor. c. The firm will employ three workers in this situation. To see this, look at the MRP and MRC columns in the table above. The first worker will generate an MRP = $30 and will have an MRC = $6. Thus, the firm will employ this worker (the marginal revenue product for this worker is greater than his or her marginal cost). For the second worker, we have MRP = $24 and MRC = $12, so we employ this worker. For the third worker, we have MRP = $18 and MRC = $18, so we employ this worker as well. For the fourth worker, we have MRP = $15 and MRC = $24. In this case, the marginal cost of this worker is greater than the worker's marginal revenue product, so we do not employ this worker. The monopsonist decreases employment by 1 unit and the equilibrium wage rate is $3 less than the competitive wage.

Problem 4 Suppose that low-skilled workers employed in clearing woodland can each clear one acre per month if they are each equipped with a shovel, a machete, and a chainsaw. Clearing one acre brings in $1000 in revenue. Each worker’s equipment costs the worker’s employer $150 per month to rent and each worker toils 40 hours per week for four weeks each month. LO5 1-286 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

a. What is the marginal revenue product of hiring one low-skilled worker to clear woodland for one month? b. How much revenue per hour does each worker bring in? c. If the minimum wage is $11.20, would the revenue per hour in part b exceed the minimum wage? If so, by how much per hour? d. Now consider the employer’s total costs. These include the equipment costs as well as a normal profit of $50 per acre. If the firm pays workers the minimum wage of $11.20 per hour, what will the firm’s economic profit or loss per acre?

Explanation: a. The marginal revenue is $1,000. This is the revenue each worker can generate for the firm by clearing one acre. b. Since the worker generates $1,000 per month and works a total of 160 hours (40 hours per week for 4 weeks), revenue per hour equals $6.25 (= $1,000/160). c. If the minimum wage is $11.20, revenue per hour in part b is less than the minimum wage by $4.95 per hour (= $6.25 − $11.20). d. Now consider the employer’s total costs. These include the equipment costs as well as a normal profit of $50 per acre. The total equipment cost for the firm per acre equals $150. Thus, the economic profit per worker at the minimum wage equals $1,000 (revenue) − $150 − $50 (normal profit) − (160 × $11.20) (hours of labor multiplied by the minimum wage = $1,792) = − $992. The firm suffers a loss per acre of $992. e. To determine the minimum wage necessary for the firm to earn zero economic profit, we first calculate the revenue left over for labor after accounting for a normal profit and equipment cost.

The revenue left over after these components have been removed is $800 (= $1,000 − $150 − $50). This leaves $800 left to pay each unit of labor for the month (clears one acre). Since each worker works 160 hours a month, the highest the break-even wage can be is $5 (= $800/160).

This is the highest the minimum wage can be set in the industry without exit.

Brue, McConnell, Flynn Essentials of Economics 5e Chapter 18 Income Inequality and Poverty QUESTIONS Question 1 Use quintiles to briefly summarize the degree of income inequality in the United States. How and to what extent does government reduce income inequality?

Answer The income share received by the highest 20 percent was 50 percent in 2008, which is more than 10 times the 3.4 percent received by the lowest 20 percent. The middle three quintiles receive under 50 percent of the total before-tax income. The top two quintiles receive twice as much as the bottom three quintiles combined; in fact, the top 20 percent receives as much as the bottom 1-287 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.

80 percent.

The effect of government on the distribution of income occurs through both taxes and transfer payments. The total effect of federal, state, and local taxes on income distribution is mildly progressive in that high-income households pay a somewhat higher proportion of their incomes in taxes than low-income families. But about 80 percent of government’s contribution to income equality takes place through transfer programs. This contribution is particularly significant for those in the lowest quintile, for whom government transfer payments comprise over 75 percent of total income.

These statistics do not necessarily mean that the contribution of government in furthering equality is entirely positive. To the extent that transfer programs aimed at lower-income households decrease the incentive to work, the earned incomes of these households will be less than otherwise. Also, some transfer programs go to the nonpoor. For example, most farm subsidies go to the wealthiest farmers, and higher education funding tends to benefit middle- to high-income students.

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Question 2 Assume that Al, Beth, Carol, David, and Ed receive incomes of $500, $250, $125, $75, and $50, respectively. Construct and interpret a Lorenz curve for this five-person economy. What percentages of total income are received by the richest quintile and by the poorest quintile?

Answer In this simple economy each person represents a complete income quintile—20 percent of the total population. The richest quintile (Al) receives 50 percent of total income; the poorest quintile (Ed) receives 5 percent.

This follows from the calculations below.

Total income equals $1,000 (= $500 + $250 + $125 + $75 + $50).

The lowest quintile (Ed) is 5 percent of total income (= $50/$1,000).

The second quintile (David) is 7.5 percent of total income (= $75/$1,000).

The third quintile (Carol) is 12.5 percent of total income (= $125/$1,000).

The fourth quintile (Beth) is 25 percent of total income (= $250/$1,000).

The upper quintile (Al) is 50 percent of total income (= $500/$1,000).

Question 3 How does the Gini ratio relate to the Lorenz curve? Why can’t the Gini ratio exceed 1? What is implied about the direction of income inequality if the Gini ratio declines from 0.42 to 0.35?

How would one show that change of inequality in the Lorenz diagram?

Answer The Gini ratio is the numerical measurement of the inequality depicted by the Lorenz curve. It is calculated by dividing the area between the curve and the diagonal by the total area below the diagonal.

The Gini ratio can’t exceed 1 because if the Lorenz curve is as far as possible from the diagonal (line of equality), the area between the curve and the diagonal will equal the total area below the diagonal. The equality will result in a Gini ratio of 1.

A decline in the Gini ratio implies less income inequality; and it would be graphically depicted by moving the Lorenz curve closer to the diagonal.

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Question 4 Why is the lifetime distribution of income more equal than the distribution in any specific year?

Answer The disparity of incomes in a single year reflects the income distribution at a point in time. The very young and very old will receive lower incomes, while the middle-aged tend to receive higher incomes, giving a picture of great inequality. However, if we view these same groups over time, there is considerable income mobility both up and down the income quintile groups, suggesting that income is more equally distributed over a 5-, 10-, or 20-year period for these same households.

Question 5 Briefly discuss the major causes of income inequality. With respect to income inequality, is there any difference between inheriting property and inheriting a high IQ? Explain.

The reasons for income inequality are differences in abilities and talents among individuals, differences in the amount of education and training an individual obtains, labor market discrimination, differences in tastes and preferences toward work and job attributes, inequality in the distribution of wealth, the ability to use market power to transfer income to oneself, luck, connections, and misfortune.

A high IQ normally does not lead to high income unless it is combined with personal initiative and favorable social circumstances. Inherited property—as long as it is competently managed— provides income irrespective of one's character and personal attributes. Both factors are largely a matter of the luck of being born into a family with good ability genes and/or wealth. What one does with the genes or wealth is up to the recipient.

Question 6 What factors have contributed to increased income inequality since 1980?

Answer Several factors have contributed to the increase in income inequality since 1970. The overriding factor is the structural changes that have occurred in the U.S. economy. There has been an increase in the demand for high-skill and well-educated workers relative to lesser-skilled workers. During the 1970s and 1980s less-experienced, younger people entered the labor force in large numbers, thus reducing their incomes. There also was a rise in the number of single mothers with children, but few labor market skills. More recently, there has been a tendency for well-educated men and women to marry, thus placing these families in the highest quintile and increasing the income of those in that quintile. Increased divorce rates have tended to push female-headed households into poverty. Other structure changes include more import competition resulting in a reduction in the demand for and employment of less-skilled workers who used to command high-paying, often union, jobs in manufacturing and an increase in the immigration of unskilled workers.

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Question 6 Should a nation’s income be distributed to its member according to their contributions to the production of that total income or according to the members’ needs? Should society attempt to equalize income or economic opportunities? Are the issues of equity and equality in the distribution of income synonymous? To what degree, if any, is income inequality equitable?

Answer The answer to this question is inextricably tied to value judgments, but most of us probably favor a combination of the two types of income distribution. A purely capitalist system, in which incomes are determined exclusively by the market mechanism, would mean that those who, for whatever reason, are unable to contribute to production would have to depend exclusively on private charity for their livelihood. A (hypothetical) communist state also leads to a seemingly intractable problem—if income is to be distributed purely on the basis of need, why would anyone engage in production? Most modern societies attempt to seek a compromise of one sort or another between these two extremes. The compromise that is actually found often differs markedly from what prevailing political rhetoric in that society might suggest. Socialist economies, which historically have had large differences in income distribution, also have widerranging government transfer programs than most capitalist economies.

Conservatives contend that because of the trade-off between equality and efficiency, society should content itself with attempting to ensure equality of opportunity. Liberals argue that income redistribution is essential since equality of economic opportunity is impossible in an economy with wide differences in income, especially when these differences are related to the inheritance of property.

Income equity refers to how fairly income is distributed. One can argue that some inequality of income is not only necessary for reasons of efficiency but is fairer than an equal distribution of income, since those who produce more deserve to be rewarded for their efforts. But unequal incomes are not necessarily related to differences in individual ability or effort. It is difficult to defend the inequalities that result from market power and discrimination as being equitable. The justness of inherited wealth is also questionable. Liberals argue that by creating inequality of opportunity, property inheritance is inherently unjust. Conservatives contend that allowing individuals to pass on wealth to whom they wish is much fairer than having wealth appropriated by the government.

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Question 7 Comment on or explain: a. Endowing everyone with equal income will make for very unequal enjoyment and satisfaction. b. Equality is a ―superior good‖; the richer we become, the more of it we can afford. c. The mob goes in search of bread, and the means it employs is generally to wreck the bakeries. d. Some freedoms may be more important in the long run than freedom from want on the part of every individual. e. Capitalism and democracy are really a most improbable mixture. Maybe that is why they need each other—to put some rationality into equality and some humanity into efficiency. f. The incentives created by the attempt to bring about a more equal distribution of income are in conflict with the incentives needed to generate increased income.

Answer a. No distribution of income can ensure equal enjoyment. Using marginal utility theory, it can be argued that by equalizing incomes in an economy, there is the probability of maximizing total utility for all individuals. This assumes that everyone has identical diminishing-marginal-utilityof-money schedules. b. The lessening of poverty provides a host of indirect benefits to affluent members of society— social peace, physical security, and perhaps the intangible satisfaction of living in a more equitable society. The better off the affluent become, the more they are willing to spend in order to purchase these benefits. c. Mobs commonly exhibit a marked preference for present over future consumption. Many conservatives contend that the income redistribution schemes resulting from democratic decision making suffer from a similar failing by decreasing the incentive to accumulate capital in order to provide present consumption to the poor. Is this view valid? Perhaps. Does this mean that such redistribution schemes are misguided? Not necessarily. d. This is a common conservative view, that civil and political liberties are more important than the universal eradication of poverty. Liberals are likely to contend that ensuring universal freedom from want does not necessarily detract from these fundamental freedoms. e. The principles underlying the two systems can be summarized as follows: Each dollar has a vote in the marketplace, and each person has a vote at the ballot box. These principles are similar enough that the presence of one often leads to the other. They are dissimilar enough so that the type of society that arises from a combination of the two represents a workable social compromise.

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f. Incentives created in the attempt to bring about more equal distribution of income may cause a trade-off in decreased economic efficiency. Higher marginal taxes may reduce the efforts of those at the top to work harder and produce more. Greater benefits to those at the bottom may reduce their incentive to do the same as they receive benefits without the productive effort.

Insofar as this trade-off occurs, there will be a reduction in economic growth and, therefore, damage to incentives leading to increased incomes.

Question 8 How could the poverty rate fall while the number of people in poverty rises? Which group in each of the following pairs has the higher poverty rate: (a) children or people age 65 or over? (b) African Americans or foreign-born non-citizens? (c) Asians or Hispanics?

Answer The poverty rate is a ratio of (persons in poverty / total persons) so this ratio could fall if the number of persons in poverty increases so long as the number of persons in total increases more.

Children have a higher poverty rate than people age 65 or over.

African Americans have a higher poverty rate than foreign-born noncitizens.

Hispanics have a higher poverty rate than Asians.

Question 9 What are the essential differences between social insurance and public assistance programs?

Why is Medicare a social insurance program whereas Medicaid is a public assistance program?

Why is the earned-income tax credit considered to be a public assistance program?

Answer Social insurance programs provide aid to those who are retired or suffering from temporary distress. They are usually financed through payroll levies and are viewed to be earned rights because they are paid for by recipients. Public assistance programs provide benefits for those who are unable to earn income because of permanent disabilities or who have no or very low income and have dependent children. To receive assistance, an individual must pass a ―means‖ test. The cash payments are paid for out of general tax revenues. Most of these revenues come from individuals other than the recipients.

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The Medicare program is a part of the Social Security program and is financed with a 2.9 percent tax on wage and salary earnings. Those who have reached 65 years of age are eligible to participate in the program. Medicaid is a program for individuals who are participating in the SSI and TANF programs. It is financed from general tax revenues and is available only to qualified individuals.

The earned-income tax credit is considered a public assistance program because it is targeted at low-income families.

Question 10 Prior to the implementation of welfare reforms through the Temporary Assistance for Needy Families (TANF) program, the old system (AFDC) was believed to be creating dependency, robbing individuals and family members of motivation and dignity. How did this reform (TANF) try to address those criticisms? Do you agree with the general thrust of the reform and with its emphasis on work requirements and time limits on welfare benefits? Has the reform reduced U.S. welfare rolls or increased them?

Answer The major criticisms of the old welfare system (AFDC) were that it was not ending poverty although billions of dollars were being spent, that the number of people in poverty was increasing, and that it was creating a dependency on the government by those participating in the program.

The new program (TANF) sets a five-year lifetime limit on the participants and requires ablebodied adults to work after receiving assistance for two years. It ended food-stamp eligibility for able-bodied persons aged 18 to 50 years (with no dependents) who are not working or engaged in a job-training program. It tightened the definition of ―disabled children‖ relative to eligibility for SSI assistance. And, finally, it established a five-year waiting period for new immigrants who are not citizens to receive assistance.

Economic security and self-sufficiency are two goals that are best for individuals as well as for the economy as a whole. The new TANF will help to achieve both of these goals, hopefully without causing undue hardship particularly for children.

The reform, along with strong labor demand and low unemployment, reduced the number of welfare recipients from 12.6 million in 1996 to 4.5 million by the middle of 2007.

Question 11 What are the main arguments for and against UBI? What is your personal opinion on the probable effects of UBI?

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Explanation: The basic idea of universal basic income, or UBI, is simple: the government would guarantee a minimum monthly income to every citizen, with the money arriving by automatic deposits into recipients' bank accounts.

Advocates assert a wide variety of benefits, including a reduction in poverty, a reduction in income inequality, and a reduction in income insecurity, or the negative feelings that come with having to worry about the possibility of becoming unable to support oneself financially.

Advocates also argue that it would be much less costly for the government to administer a single monthly UBI payment than it is to administer the large and sometimes confusing array of payment and reimbursement systems that we currently use to deliver welfare and public assistance. Instead of tax credits, food stamps, disability payments, housing subsidies, unemployment benefits, and cash payments made through EBT cards, the government would only have to administer a single monthly UBI payment.

Detractors have cited high costs, unfairness, and unintended consequences as reasons for opposition. With respect to costs, they point out that sending every American a check for $1,000 each month would cost $3.96 trillion, or substantially more than the $3.4 trillion that the federal government currently collects each year in taxes. Thus, they argue that UBI is politically impossible because voters would not accept the massive tax increase that would be necessary to fund UBI. Opponents point out that most people are employed so why should they get a government welfare check each month. They go on to argue that giving everybody a guaranteed $1,000 per month would reduce the incentive to work.

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PROBLEMS Problem 1 In 2019, Forbes magazine listedJeff Bezos, the founder of Amazon, as the richest person in the United States. His personal wealth was estimated to be $131 billion. Given that there were about 328 million people living in the United States that year, how much could each person have received if Bezos’s wealth had been divided equally among the population of the United States?

(Hint: A billion is a 1 followed by 9 zeros, while a million is a 1 followed by six zeros.)

Answer Simply divide Jeff Bezos's wealth, $131 billion, by the number of people in the United States, 328 million. The answer is $399.39 (= $131,000,000,000/32,000,000).

Problem 2 Imagine an economy with only two people. Larry earns $20,000 per year, while Roger earns $80,000 per year. As shown in the following figure, the Lorenz curve for this two-person economy consists of two line segments. The first runs from the origin to point a, while the second runs from point a to point b.

a. Calculate the Gini ratio for this two-person economy using the geometric formulas for the area of a triangle (= ½ × base × height) and the area of a rectangle ( = base × height). (Hint: The area under the line segment from point a to point b can be thought of as the sum of the area of a particular triangle and the area of a particular rectangle.) b. What would the Gini ratio be if the government taxed $20,000 away from Roger and gave it to Larry? (Hint: The figure will change.)

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c. Start again with Larry earning $20,000 per year and Roger earning $80,000 per year. What would the Gini ratio be if both their incomes doubled? How much has the Gini ratio changed from before the doubling in incomes to after the doubling in incomes?

Answer a. The Gini ratio is the area between the perfect equality line and the Lorenz curve divided by the area under the perfect equality line.

First, we find the area under the equality line. Using our formula for the area of a right triangle, we have an area of 5,000 (= ½ × 100 (base or x-axis) × 100 (height or y-axis).

Second, we find the area between the two curves. To do this we start by finding the area UNDER the Lorenz curve (we have easy-to-use formulas for triangles and rectangles). See the graph below.

The area of triangle A is 500 (= ½ × 50 (base) × 20 (height)). The base of the triangle is 50 (at 50 percent) because there are only two people in the economy. The height of the triangle is 20 (at 20 percent) because the lowest income is $20,000, which is 20 percent of the total income earned in society (= ($20,000/$100,000) × 100).

The area of rectangle B is 1,000 (= 50 (base) × 20 (height)).

The area of triangle C is 2,000 (= ½ × 50 (base) × 80 (height).

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The total area under the Lorenz curve is 3,500. We can now find the area between the two curves, which is 1,500 (= 5,000 (the area under the equality curve) – 3,500 (the area under the Lorenz curve)).

The final step of this procedure is to take the ratio of the area between the two curves and the area under the equality curve, which gives us the Gini ratio. The Gini ratio for this example is 0.3 (= 1,500/5,000). b. After the tax and redistribution program, Larry’s new income is $40,000 and Roger’s new income is $60,000. This implies that Larry (50 percent of the population) now controls 40 percent of society’s income rather than the 20 percent before the program.

To calculate the new Gini ratio we use the same procedure as above. However, we use 40 percent rather than the 20 percent shown in the diagram.

With this new value we have: The area of triangle A is 1,000 (= ½ × 50 (base) × 40 (height)). The area of rectangle B is 2,000 (= 50 (base) × 40 (height)). The area of triangle C is 1,500 (= ½ × 50 (base) × 60 (height). The total area under the Lorenz curve is 4,500. We can now find the area between the two curves, which is 500 (= 5,000 (the area under the equality curve, note this does not change) – 4,500 (the area under the Lorenz curve)). The Gini ratio for this income distribution is 0.1 (= 500/5,000). c. If incomes double, Larry earns $40,000 and Roger earns $160,000. The total income in society is now $200,000. Larry still only controls 20 percent of the society’s income (= ($40,000/$200,000) × 100). Since the doubling of incomes does not change the percentage of income controlled by Larry (or Roger), the Gini ratio will not change. The answer will be the same as in part a.

Problem 3 In 2018, many unskilled workers in the United States earned the federal minimum wage of $7.25 per hour. By contrast, average earnings in 2018 were about $27 per hour, and certain highly skilled professionals, such as doctors and lawyers, earned $100 or more per hour. a. If we assume that wage differences are caused solely by differences in productivity, how many times more productive was the average worker than a worker being paid the federal minimum wage? How many times more productive was a $100-per-hour lawyer compared to a worker earning minimum wage? b. Assume that there are 20 minimum-wage workers in the economy for each $100-per-hour lawyer. Also assume that both lawyers and minimum-wage workers work the same number of hours per week. If everyone works 40 hours per week, how much does a $100-per-hour lawyer earn a week? How much does a minimum-wage worker earn a week?

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c. Suppose that the government pairs each $100-per-hour lawyer with 20 nearby minimumwage workers. If the government taxes 25 percent of each lawyer’s income each week and distributes it equally among the 20 minimum-wage workers with whom each lawyer is paired, how much will each of those minimum-wage workers receive each week? If we divide by the number of hours worked each week, how much does each minimum-wage worker’s weekly transfer amount to on an hourly basis? d. What if instead the government taxed each lawyer 100 percent before dividing the money equally among the 20 minimum-wage workers with whom each lawyer is paired—how much per week will each minimum-wage worker receive? And how much is that on an hourly basis?

Answer a. Since wage differences are solely due to differences in productivity in the current example, we can determine how many times more productive one group is relative to another by taking the ratio of wages.

This implies that an average worker is 3.72 times more productive than a minimum-wage worker (= $27 / $7.25).

The high-wage worker is 13.79 times more productive than the minimum-wage worker (= $100 / $7.25). b. The lawyer earns $4000 per week (= $100 (hourly wage) x 40 (hours worked per week)).

The minimum-wage worker earns $290 (= $7.25 x 40). c. First, calculate government revenue from the tax on lawyers. At the tax rate of 25% on the $4,000 earnings per week, government revenue is $1000 (= 0.25 x $4000). This $1000 is then distributed to 20 minimum-wage workers; thus each worker receives $50 per week from the government. Finally, converting this transfer to an hourly basis by dividing the weekly transfer by the hours worked per week, we have a transfer of $1.25 per hour (= $50 / 40).

d. For this case government revenue will equal $4000, assuming the lawyer continues to work.

Dividing this by the 20 workers implies a weekly transfer of $200 (= $4000 / 20). The hourly transfer is $5 (= $200 / 40).

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