Solution Manual For Microeconomic Principles and Problems A Pluralist Introduction 2nd Edition By G

Solution Manual For Microeconomic Principles and Problems A Pluralist Introduction 2e By Geoffrey Schneider Chapter 1, Answers to Questions for Review Chapter 1-24 1. What is austerity? Why do most economists think it is a bad economic policy to pursue in a recession?

Austerity is a set of policies that involve reducing government spending or increasing taxes when an economy is faced with a budget deficit. Most economists, especially Keynesians, believe this policy is inappropriate in a recession because reductions in spending and increases in taxes take money away from consumers and businesses, resulting in additional reductions in spending.

Thus, austerity policies tend to make recessions worse. Instead, governments need to spend more and tax less in recessions to stimulate economic growth.

2. Read about what is happening in the nation or around the globe in a reputable magazine or newspaper, such as the New York Times, Wall Street Journal, The Economist, The Financial Times, or The Guardian. Which events would be considered to be relevant to the study of economics, given the definitions of economics in this chapter? How are these events important to people and their communities? Explain briefly.

The chapter takes up topics such as government policies on spending and taxation (austerity), government regulations, the business cycle, the production and distribution of commodities (food, consumer goods), pollution, advertising, corporations, trade, power and influence, and economic growth. Any articles that refer to consumer behavior, producer behavior, changes in industries, or government policies would be appropriate. Students should be able to list an issue, explain why it is relevant to an economics class, and discuss why the issue is important to people.

3. What are the primary differences between mainstream economics and political economy (PPE and RPE)? Explain briefly in your own words.

Mainstream economics tries to discover the constant relationships between economic variables, trying to be as precise and scientific as possible. Establishing constant relationships allows mainstream economists to construct models, which they use to make forecasts about the future and recommend policies. Establishing relationships in a changing world requires making a number of restrictive assumptions, which can render economic models inaccurate at times.

Political economists study how economic institutions (organizations; patterns; culture) affect society as a whole and how these institutions change over time. They take a broader approach, incorporating a wider variety of variables, and they are less likely to make restrictive assumptions about human behavior.

4. Consider the description of economic man above, and the description of positive, scientific economics. Also consider how political economists (PPE and RPE) study human behavior. Then

reflect carefully on your own shopping habits. Do you usually make rational, calculated, fully informed purchases (like “economic man”), or do you tend to buy on impulse for a variety of reasons, or do you do both? Analyze how much of your purchasing behavior can be captured by “positive economics,” and when the methods used by political economists would better reflect your behavior. How much of your shopping behavior could be predicted scientifically?

How much of it would be hard to predict?

Mainstream economics assumes that people are self-interested, insatiable, predictable, rational, and calculating, and that they know all available information about quality and prices. This means we are not influenced by ads or store displays, we don’t buy on impulse, we don’t buy goods based on image or values, we don’t generally do things for the benefit of the community, etc.

According to political economists, this does not mesh with many consumers’ behavior nor with history. Political Economists study how economic institutions affect society as a whole. They see morality, ethics, and culture all interacting with and affecting the economy.

They prefer a more complex study of people featuring culture, values, information and advertising, instead of assuming (rational economic man) that all people have insatiable demands, that preferences are determined by non-economic factors, and that people are always rational and calculating.

Most people find that some of their purchases are rational and calculating and based on a reasonably good estimate of how good the quality of the product is. But they also acknowledge that many of their purchases are impulsive and based on very little information. Furthermore, rather than being independent, people’s purchases are deeply affected by cultural norms and trends.

5. Briefly explain the main differences between the economic systems of unregulated market capitalism, mixed market capitalism and democratic socialism. Using a recent issue of The Economist or another reputable publication with a lot of international economic news, find examples that show how two countries exhibit characteristics of one or more of these types of economic systems.

Unregulated Market Capitalism is an economic system in which the main productive resources of society—the labor, land, machinery, equipment, and natural resources—are owned by private individuals, who use those resources to produce goods and services that are bought and sold in markets for profits. Examples include the U.S. (to a certain degree), Hong Kong, Singapore, and Ireland.

Mixed Market Capitalism is an economic system in which private sector firms and individuals produce goods and services for markets for profits. The public sector established by the government regulates those markets and provides public goods such as schools, roads, airports, health care and other goods and services provided inadequately by private markets. Most modern economic systems are of this type, including Germany, France, Japan, etc.

Democratic Socialism, an economic system where the most important resources of society are controlled democratically by all citizens, including workers who usually have little say in how market capitalist economies are run. Examples include the Nordic countries (Sweden, Norway, Denmark). Some people consider Cuba and China to be socialist, although they are not very democratic.

6. Why do you think all modern economic systems involve variations of a mixed economy, with some utilization of markets and some intervention by government? Why might economies have moved away from unregulated capitalism and command communism?

Answers will vary, and there is no one correct answer to this question. As we will see later in the book, unregulated capitalism proved to be ruthlessly exploitative and increasingly unequal, even though it was very productive. Command communism proved to be very inefficient, providing insufficient incentives and fostering a large, stifling bureaucracy. In the modern world, economies like the U.S. are closest to laissez-faire, even though they have substantial government intervention to keep markets from being too exploitative and unequal. Command communist countries like China have moved toward greater use of markets to foster growth and dynamism, even as they have preserved large amounts of government intervention. Thus, all modern economies involve some degree of government intervention to prevent the worst aspects of markets. And, all modern economies utilize markets to some degree to foster innovation and to build the incentives of competition into the economy. However, the balance of government and markets varies significantly from one economy to the next.

7. Which of the 10 schools of economic thought listed in Figure 1.3 do you find most interesting?

Which do you find least interesting? What does this indicate about your own background and approach to economics at this point?

There is no right answer to this question. Students are basically identifying their own preconceptions regarding the study of economics.

Chapter 2, Answers to Questions for Review 1. Explain how each of the following events would affect scarcity. a. Consumers’ desire for goods and services decreases.

Scarcity is determined largely by wants. If wants decline, then there is less scarcity, and people are more satisfied with what they have. b. Resources become less plentiful.

Fewer goods would be produced with fewer resources, which would increase the level of scarcity. c. The government discovers a large amount of unused resources.

With additional resources, the amount of scarcity would decline because more goods could be produced.

2. Use the concept of opportunity cost to analyze the decision of whether or not you should study economics tonight.

You should attempt to determine what the next best use of your time would be. Would it be better for you to study a different subject, have fun with your friends, stream a movie, or to study economics. The key is to evaluate the benefits that you would get from studying economics, and compare that to the benefit you would get from other activities.

3. The graph in Figure 2.8 below displays a production possibilities curve for the World in choosing between allocating resources towards Food or Machinery.

Figure 2.8 PPC for Problem 3 a. What is the opportunity cost Machinery World PPC of moving from point B to point D? E D  40 1500 units of food (what is C given up). b. What is the opportunity cost of 1 unit of Machinery between point D and point C?

35



25

F 

0

1000

B B2

1500

A 

1800 2000

Foo d

From D to C, 5 units of Machinery are given up for 1000 units of Food. 5M=1000F. So, 1M=200F. In this region, each unit of machinery uses the same resources as 200 units of food.

c. Which points on the graph are considered to be efficient and feasible? Explain briefly.

All points on the PPC are considered to be efficient and feasible. Indeed, the PPC shows all combinations of two goods that can be produced given resources and technology. Thus, the PPC shows all combinations of goods that use all resources (efficient) and that can be achieved (feasible). d. The reason for the curved shape of the PPC above is that (choose the best answer): i. Resources are scarce. ii. Increasing food production causes a decrease in machinery production. iii. There are opportunity costs for producing more of either good. iv. Some inputs are better at producing food than machinery. v. None of the above.

The PPC is curved due to the specialization of resources. e. Scientists estimate that global climate change will destroy 10% of land that is current used to produce Food. Show on a graph how this will affect the PPC. The PPC shifts in along the Food axis by 10%, from a maximum of 2000 to a maximum of 1800. f.

Assuming that the world is at point B on the PPC, producing and consuming 1500 units of Food, and that the World will need to continue consuming the same amount of food after global climate change destroys 10% of land, how will the destruction of land affect the production of machinery? Will economic growth in the future be affected by these changes?

Why or why not?

The economy will be forced to move from point B to point B2, which means that less machinery must be produced. This will reduce economic growth in the future, because machinery is a capital good, which is one of the key ingredients in economic growth. g. How would political economists broaden the analysis in parts e and f of this question? What institutions would they think are most relevant to the issues being raised?

The tradeoff between food and machinery is much more complex to political economists than is implied by the model.

Figure 2.9 PPC for Problem 4 Transportation

4. The graph in Figure 2.9 displays a production possibilities curve for the US in choosing between allocating resources towards Transportation or Beer. a. What is the opportunity cost of 1 unit of beer between point A and point B?

D 80

25B=50T; 1B=2T;

0

7 0 50

PPC for the US   F 

50

E

C B

75

A  100

Bee r

2 units of Transportation b. What is the opportunity cost of moving from point A to point C?

50 units of beer. c. Show what would happen to the graph if states like Pennsylvania fail to maintain their transportation infrastructure.

The PPC shifts in on the Transportation axis (see the graph). d. The President of the US recently proposed that the U.S. should dramatically increase its transportation spending. Assume that the economy is currently at point B in the graph above. If we follow the President’s plan and increase Transportation Spending dramatically, what would be the immediate, short term effect?

Increasing transportation spending would move the economy from point B to a point such as point C, where there is more transportation being produced but less beer. e. Economic data indicate that transportation spending by the government improves businesses’ productivity. Using the PPC model above, analyze what the President’s proposal to increase transportation spending will do in the long run to the US economy.

Increases in productivity allow the economy to produce more goods with its existing resources.

The entire PPC would shift out along both axes. f.

How would political economists respond to the analysis in parts d and e?

Political economists find the analysis in the PPC model to be too simplistic. Politically, it may be difficult to get people to sacrifice beer and other goods to pay for more transportation. And, it would be important not to ignore the impact on the well-being of the population from any reduction in consumer goods production. This too could impact productivity. Also, some types of infrastructure may increase productivity much more than others over the long term.

5. Given the factors that mainstream economists believe contribute to economic growth, what would happen to economic growth and to the Production Possibilities Curve for the US if it halts all immigration into the economy and the US population actually declines?

Economic growth is driven by changes in the quantities of productive resources (labor and capital) and improvements in productivity. Thus, a decline in the amount of labor would reduce the size of the PPC and reduce economic growth.

6. Scientists are convinced that the burning of fossil fuels is contributing to global climate change, which will harm future economic growth. a. Construct a PPC showing the tradeoff between fossil fuels and renewable energy.

Explain how different points on the PPC will affect future growth in the PPC.

Possible PPC Answer for Problem 6a Fossil Fuels

Machiner

100 D 90 70 5

0



E

C  F 

B

50

70

A  Renewable

100 0

Energy

Fossil fuels harm future growth, while renewable energy, as a capital good, should improve economic growth. Thus, the closer the economy moves to point D, the less economic growth will result in the future. The closer the economy moves to point A, the more economic growth will occur in the future. b. Undertake an analysis from a political economy perspective on the choice of whether or not to devote resources to renewable energy. Why do you think the US devotes fewer resources to renewable energy than many other developed countries?

To political economists, economic choices are usually a product of the power structures in a society, along with cultural factors. In the U.S., large fossil fuel corporations such as Exxon Mobil have immense power, which allows them to disproportionately affect political decisions.

In addition, the U.S. culture of individualism seems to put less emphasis on preserving resources for future generations, providing another reason why so many Americans are little concerned with climate change.

Chapter 03, Answers to Questions for Review 1. What factors determined who did what job (how labor was allocated) in (a) traditional, huntergatherer societies, (b) slave-based empires such as Rome, (c) Feudalism and (d) Mercantilism?

In traditional societies, tradition and authority determined who did what. Men were traditionally hunters and women gatherers. Chiefs also had some authority over how tasks were allocated.

In slave-based empires, decisions were made based on authority (power), which was determined by class status. The emperor and the patricians dictated what was done by the slaves. Freeborn plebeians had some independence, by tradition, but still had to answer to the emperor and patricians.

Feudalism similarly featured tradition and authority, with the lords having the most power but serfs having traditional rights to protection, the use of the common lands, and 50% of their produce. Religious officials held significant power by tradition.

Under Mercantilism, kings and powerful merchants controlled most of the economy and dictated most jobs, once again showing the power of authority in most pre-capitalist economic systems.

2. Why do political economists think that human beings are inherently social beings with strong levels of group identity? Is there evidence from economic history to support this view? Why or why not?

In Hunter-gatherer societies (traditional communities) cooperation was essential for survival, therefore human beings evolved as social beings with a strong group identity. Sharing food so that the entire community could survive and thrive was an essential feature of such communities, which were largely egalitarian except for small differences based on gender roles and tribal leaders.

3. Describe the role played by (a) tradition, (b) authority and (c) markets in traditional, slave, feudal, and mercantilist economic systems.

(a) Tradition: in traditional societies, much behavior was dictated by tradition. Children would be taught traditional ways of doing things by their elders, and gender roles and other traditions would dictate who did what tasks. Tradition also dictated who took on leadership roles. In slave systems, traditions such as birth rights and religious beliefs and rites played an important role. In

feudal systems, sons and daughters followed in the traditional roles of their parents and assumed the same social status. Lords and religious officials were accorded high status and a high standard of living based on traditional beliefs and the existing hierarchy. Mercantilism began to erode the traditional norms of feudalism, with economic power becoming more important. (b) Authority: In traditional societies, there was very little authority, although the chief usually had slightly more authority than other members of the community. Under slave-based empires such as the Roman empire, authority was probably the most important factor in making economic decisions such as the allocation of resources. The authority of the emperor, lord, or merchant over his subjects and slaves, and women, was nearly absolute. Similarly, under feudalism the authority of the lord was paramount in dictating the activities of the peasants and serfs. The authority of the church and the guilds also had significant power. Under Mercantilism, the authority of the king and of the merchants who were given control over vast markets was also very important. However, the monetization of the economy meant that at times, labor was allocated to the highest bidder and not to those with authority. This trend was even more prominent under capitalism: in a competitive market system, resources were allocated based on monetary concerns rather than tradition or authority. However, in non-competitive markets, firms with monopoly power still had considerable authority. (c) Markets: Traditional economies had very little in the way of markets. Goods were produced and allocated within small communities.

The development of agriculture and the generation of greater surplus meant that slave economies did engage in some trade. However, most goods were allocated by tradition and authority, and markets were reserved for trade in luxury goods or goods requiring specialized skills (e.g., blacksmithing).

Under Feudalism, towns had markets and there were some traveling merchants. However, as in slave economies, most goods were allocated by tradition and authority. Markets featured mostly luxury items and goods produced by skilled tradespeople.

Under mercantilism, markets became extremely important, and merchants came to dominate the economy. Markets were expanded internally as the power of lords decreased, and externally via exploration and colonialism.

4. How did the role and status of women change as economic systems evolved from traditional economies to Mercantilism?

In traditional societies, women were on relatively equal footing with men, although they were usually not allowed to be chiefs and they tended to be gatherers rather than hunters. Women’s status declined in empires, where men often used their power to subjugate and enslave women.

In feudalism, women were only allowed to do traditional work in the household and were often abused by lords. Women were largely excluded from formal employment and positions of power under mercantilism.

5. Why is the specialization of labor important to understanding historical economic development?

Specialization of labor tends to enhance productivity and spur innovation, which increases productivity and the availability of surplus. In traditional societies, extra food would allow people to specialize in hunting large game, which could be a huge windfall. With the invention of agriculture, fewer people were needed to grow food, which allowed people to specialize in being soldiers, skilled craftspeople, or priests, something that occurred in empires, feudal

societies, and mercantilist societies. In general, specialization tends to increase productivity and innovation.

6. How is the generation and utilization of the surplus product important to understanding economic development?

Surplus product can generate growth if it is invested, but if it is wasted by the elites, then growth will not happen. Surplus food also makes possible urbanization and specialization, and specialization is often associated with innovation and manufacturing. However, the allocation of surplus is often associated with conflict and exploitation (slavery, serfdom), as groups in society struggle to gain a larger share.

Under traditional economies, slave economies and feudalism there was very little surplus, so there were limits to how much investment, growth and development occurred. What surplus that was generated was usually spent on luxury goods for the elites and churches and palaces.

Under mercantilism, however, significantly more surplus existed due to increases in agricultural productivity. This fueled trade, urbanization, market development, and investment in manufacturing, generating economic growth.

7. Construct an argument agreeing or disagreeing with the following statement: All human societies involve a large degree of cooperation, redistribution and reciprocity. Use specific examples to support your argument.

Traditional societies certainly involved a large degree of cooperation, redistribution and reciprocity: the entire system was based on these principles. During the age of empires, groups would still cooperate to dominate other groups, and there was some redistribution and reciprocity to those within one’s group, but there was much less than in traditional societies. Under Feudalism, lords and serfs cooperated and experienced reciprocal relations, trading protection for produce, but there was little redistribution. Mercantilism featured reciprocity, which is a primary component of a trading relationship, and groups cooperated within firms, but redistribution and reciprocity were less prominent. In every human society, groups cooperated to achieve goals and to protect themselves from others. Reciprocity has also been present to a degree in all human societies, forming the basis of many human relationships. Redistribution was featured prominently in some societies but not others.

8. List the main social classes in each of the following economic systems: (a) Traditional (huntergatherer), (b) The Roman Empire, (c) Feudalism, and (d) Mercantilism.

Traditional economies had almost no class distinctions and can be described as primitive communism. (There were often tribal elders who had more power in the system, and men tended to have power over women, but most resources were shared so there were few class distinctions.)

In the Roman Empire, the emperor and the patricians made up the highest class. Freeborn plebeians were next (farmers, merchants, priests, craftsmen). Slaves made up the lowest class.

Lords and high-ranking religious officials formed the top class in feudalism. There was a very small middle class of independent craftsmen. At the bottom were serfs, who were bound to the lord’s land but who had some limited rights.

In Mercantilist systems, the highest social class was occupied by the king and the merchants.

Business owners (capitalists) and the aristocracy formed the next tier. Below them were independent craftsmen, then workers, and then slaves.

9. Describe how social classes evolved from traditional economies through mercantilism. How did the determination of status (which people were held in highest esteem) change?

There were no social classes in traditional economies. Status was determined by productivity. In empires, the emperor sat on top, controlling resources and labor, followed by priests and nobles, and then merchants and craftspeople. Slaves were at the bottom of society. Status was determined by birth. In feudalism, lords and priests sat atop the system, with knights and artisans in the middle, and serfs as the bottom. Status was determined by birth. Under mercantilism, merchants and kings controlled society’s resources, followed by lords and nobility, then small businesses, with peasants, indentured servants and slaves at the bottom. Status was determined by connections to the king and merchants, and by birth.

10. How has the role of private property changed as economic systems evolved?

There was no private property in traditional societies. Emperors controlled both property and people during the age of empires. Lords controlled property and people during feudalism. And Merchants and kings controlled property and people during Mercantilism.

11. How did attitudes toward greed change as economic systems evolved?

Greed was not a feature of traditional societies, and it was discouraged under feudalism.

Empires, however, often featured greedy despots, and merchants and kings were also known to be greedy during the Mercantilist era. Thus, attitudes toward greed changed based on social conditions and how heavily concentrated wealth was.

12. List and analyze the major forces that eroded each economic system and paved the way for the next economic system.

Traditional, hunter-gatherer societies were eroded by the invention of new technologies like agriculture and food storage that gave advantages to farming societies which could feed large armies. Empires were eroded by uprisings from those excluded from power and resources, such as neighboring societies or slaves. Feudalism was eroded by changes in technology (increased surplus from crop rotation which allowed for larger cities and armies and greater specialization and urbanization) and class conflicts (between merchants and kings who fought against feudal lords). Mercantilism was eroded by the increasing power of capitalists, who wanted to open markets for trade. In most cases, class conflicts and technological changes (affecting the surplus available) were the driving forces for change.

13. Construct an argument for which 2 factors were most important in eroding Feudalism and paving the way for Mercantilism. Use specific examples to support your argument.

The factors that eroded feudalism were: 1. An Increase in the Surplus from Improvements in Agricultural Technology 2. Urbanization and Specialization 3. Long Distance Trade and Traveling Merchants 4. The Crusades and the Opening of Europe 5. The Rise of the Nation-State and Commercial Interests 6. Exploration and Colonization by Nation-States 7. The Rise of Protestantism, Individualism and Greed 8. The Putting-Out System and the Beginnings of Capitalist Factories

9. The Monetization of the Economy and the Decline of the Manor 10. The Enclosure Movement and the Establishment of Private Property Rights You could select any 2 of those as long as you have a compelling argument. (Answers may vary significantly on this question.)

Most economists argue that the rising surplus (from improvements in agricultural technology) and the establishment of private property rights via the enclosure movements were the most important factors, because they directly undermined the feudal system and provided the foundation for capitalism. Trade and merchants, as the drivers of many of these changes, could also be seen as a key factor, along with the rise of nations and commercial interests. Trade and national economies were central in the new economic system of mercantilism.

Chapter 04 Adam Smith Answers to Questions for Review 1. What were the major institutional factors that spurred the development of capitalism in England? Which of these factors do you think was most important? Why? The major factors were the following: (1) Protestant ideology, where wealth was seen as a sign of godliness, which promoted greed and self-interest and investment in new material ventures. (2) Interest in science and engineering, which promoted scientific inventions and the development of new products.

(3) A secure system of property rights, which facilitated investment in one’s land. (4) The most comprehensive enclosure movement secured private property and displaced peasants from their land, creating a mass of landless laborers who would work for wages. (5) Wealth in England meant a large potential market for products. (6) Cheap inputs such as domestic coal and iron and raw materials from the British empire made costs of production low, making it easier for early firms to earn profits.

Mainstream economists often seize on property rights as the key to capitalism’s development, because this is a necessary condition for investment and development of manufacturing. However, there is no one right answer to which factor is most important.

2. Given the institutional factors that provided the foundation for capitalism in England, do you think capitalism would work as effectively in other countries with different institutions? Why or why not?

The absence of any of the factors present in England could cause capitalism to work very poorly. In countries with insecure property rights, people are not willing to start businesses or invest in business which can be seized. Communal values make self-interest problematic, and cause countries to lean towards more socialistic systems. Lack of scientific background limits innovation. An insufficient work force makes it hard for businesses to expand when they need to. The lack of a large market for products makes investing in new ventures extremely risky. And, expensive inputs or shortages of inputs can make production unprofitable.

3. Why was Adam Smith critical of Mercantilism? Why did he think Capitalism was preferable to Mercantilism?

Smith was opposed to Mercantilism because he saw it as a system in which the kings and merchants structured the economy for their benefit. Smith thought government was too often allied with large commercial interests to the detriment of small firms and society as a whole. Smith was particularly critically of Mercantilist policies which guaranteed firms a monopoly in goods markets. This allowed them to charge high prices, stop innovating, and create a monopsony in labor markets to exploit workers/ Capitalism, Smith hoped, would be much better for the typical person. Competition in goods markets would keep prices low and foster innovation, and competition for workers would improve their wages and working conditions. Limited government, laws preventing oppression, and moral sentiments would result in improved conditions for workers.

4. Smith argued that unregulated (laissez-faire) capitalism would lead to substantial increases in income for all, and especially for workers. Carefully explain how Smith thought this would come about. Critically evaluate his analysis.

Specialization and the division of labor increase efficiency and productivity. Trade allows firms to specialize further, generating additional efficiency gains. Competition in goods markets keeps prices low and even regulates incomes (high incomes in one industry cause competitors to enter, which then reduces above-normal profits). Competition in labor markets insures that laborers get a decent wage.

(Note: industries must be very competitive and have easy entry for this condition to hold.) Competition also forces firms to innovate and imitate to keep up with or go ahead of competitors. Moral sentiments prevent anyone from behaving too badly under the system, providing a check on unethical behavior by producers. And, the government provides a justice system that prevents oppression. Thus, the standard of living should increase over time as productivity increases, and competition should insure that everyone, even the poor, see improvements in their standard of living.

In your evaluation of this theory, you need to consider (a) if markets are sufficiently competitive to keep prices low and firms innovating, (b) if competition for workers is sufficient to keep their wages high and working conditions adequate, (c) if firms have sufficient moral sentiments to prevent them from engaging in unethical behavior, and (d) if the government adequately safeguards people against oppression. Opinions on each of those issues can vary substantially.

The vast increases in productivity and the rapid transformation of capitalist economies into industrial powerhouses indicate that early capitalism certainly did foster competition, innovation and growth. However, the regular revolts against capitalism by workers, and the movement to regulate capitalist markets (Polanyi’s double movement) provide strong evidence that capitalism did not work exactly as Smith hoped it would.

5. Smith believed that laissez-faire capitalism would be almost completely self-regulating via the invisible hand, as long as moral sentiments and an effective legal system were in place. Evaluate his argument, and use examples from current events in the newspaper to support your analysis.

Answers will vary. In general, we see some modern trends that support Smith, such as the consistent invention of new products and generation of economic growth. This provides jobs and income for people. In countries where growth is rapid, workers tend to experience rising wages and to be treated well. However, in countries with stagnant growth, workers do not do well and are treated poorly. And, many countries experience stagnant growth despite adopting a laissez-faire capitalist economic system.

Similarly, firms often behave well and provide good products for consumers without significant

regulation. But each year companies are caught producing unsafe products or exploiting workers, so moral sentiments have not proven to be a sufficient check on the worst excesses of business behavior.

6. Smith was an opponent of Mercantilist governments. What role (if any) does Adam Smith envision for government in a Capitalist economy?

Smith advocated Limited Laissez-Faire. To Smith, the government should do the following: (1) Maintain order and defense. (2) Protect every member of society from injustice and oppression, by establishing a system of justice. (3) Provide public goods, including roads, harbors, education which all contribute to commerce.

7. Why did Malthus (and others) oppose the poor laws such as the Speenhamland system? What parts of their arguments were valid and what parts would modern economists consider invalid?

The Speenhamland system subsidized workers’ wages and guaranteed them a minimum income at a living wage. However, this undermined incentives. Workers could exert minimal effort and still receive the same income as if they worked hard. Employers had an incentive to pay wages below a living wage because the government would make up the difference. In addition to the disincentives, Malthus worried that higher incomes would cause the poor to have more children, which would increase the population and eventually lead to a famine. These arguments led Malthus and politicians to slash support for the poor.

However, we now know that higher incomes for the poor actually reduce population growth. Families have fewer children when they have a secure income and many economic opportunities. Thus, the problem with the Speenhamland was its poorly structured incentives, rather than the idea that supporting the poor would lead to rampant population growth.

8. Describe Say’s Law and why it is important. Also explain the major criticism of Say’s Law. Say’s Law states, “Supply creates its own demand.” This implies that there will always be enough demand for products, and the economy can never enter a recession for a prolonged period of time. The major criticism of Say’s Law is that there is not always enough demand for products, especially when consumers and investors become pessimistic about the future. This can lead to a glut of products, and a recession as businesses cut back on production and lay off workers.

9. Apply Say’s Law to the modern economy. Has the economy recently experienced a shortfall in demand, or has the economy operated smoothly without such a problem in recent decades?

The global economy experienced a major recession in 2008-2010 when a real estate bubble burst and caused widespread bank failures. It also experienced a recession in 2000 when the dot.com stock bubble burst. And, it experienced a recession in 2020 when the COVID-19 pandemic shut down much of the global economy. Thus, the modern global economy experiences regular recessions, rather than operating smoothly.

10. Why did Smith and Ricardo advocate unregulated trade? What problems might occur when a country moves to unregulated trade? Do we see any such problems in the modern world?

Smith and Ricardo objected to the use of tariffs to protect domestic industries because they reduced competition, thereby interfering with the efficient functioning of the market system. Unregulated trade, they thought, would increase the size of the market, increasing specialization, productivity and efficiency in the process, and thereby improving the standard of living.

However, reducing tariffs can cause previously protected industries to fail when confronted with lower cost foreign competition. This happened in numerous industries in the U.S., including steel, clothing, and shoes.

11. Define Karl Polanyi’s concept of the double movement, and apply this concept to the modern world. Do we see businesses pushing for fewer regulations and access to more markets today?

Is there opposition to these business initiatives from people and communities? Give specific examples.

The double movement refers to the fact that the push to develop and expand markets was met by a movement from workers and communities to regulate markets to protect people and communities from markets’ excesses. Businesses in the modern U.S. are constantly lobbying for reduced regulations and for the ability to expand into new markets in emerging markets such as China and India. Consumers, workers and communities often oppose deregulations that threat health and welfare, and market openings that might lead to the exporting of jobs abroad and the decline of communities in the U.S.

Chapter 5 Marx, Answers to Questions for review Questions for Review 1. Explain in your own words the concept of an infant industry promotion strategy. Do you think such strategies could work in the modern world? Why or why not?

In most cases, a new firm cannot compete with established firms in an industry that are larger and more established. Established firms have lower costs from economies of scale and a global supply chain, greater access to global markets due to their connections, the best technology, and other advantages.

The only way a new firm can compete is if they are protected from competition until they can grow large and efficient enough to compete. These strategies have been used successfully in a number of modern cases, including China’s and India’s protection of steel, South Korea’s protection of the car industry, and many more.

2. Given the experiences of workers under laissez-faire capitalism, analyze Smith’s argument that laissez-faire capitalism would benefit workers. Which of Smith’s ideas hold up and which do not?

Smith believed that competition between firms would lead to widespread benefits for workers. First, competition prods firms to be innovative, and innovations result in new industries and an increase in economic growth, which has the effect of increasing the demand for labor. Second, competition between firms for workers means that they will get paid and treated well, or they can switch to a different job where they are better off. The fact that workers often experienced exploitative conditions under laissez-faire capitalism indicate that economic growth rates were never high enough and competition for workers was rarely sufficient for them to experience the rosy conditions Smith anticipated.

3. What are the key components of Marx’s method, historical materialism? Explain briefly. Use historical materialism to explain the transition from one specific economic system to another.

Historical materialism involves the study of how the economy evolves. It uses the dialectical method, focusing on the forces behind how economic systems change. Economic systems involve two key elements, the forces of production (technological systems) and the relations of production (class relations in the production process. These elements determine who owns the means of production, society’s productive resources, and who does what job). Class conflict and technological change are major causes of the evolution of economic systems.

For example, under mercantilism, there were class conflicts between the powerful merchant trading companies and the nascent capitalist class. The merchants wanted monopolistic trading regimes to generate the maximum profits for their companies. But early capitalists wanted large, unregulated markets to provide low cost materials, and new opportunities for sales, innovations and profits.

Ultimately, the wealth generated by capitalist businesses, and especially the rapid pace of technological advancement, eventually helped them displace the mercantilists. As they grew in power capitalists pressured for a more laissez-faire, capitalist economic system. Out of the conflict between merchants and capitalists, there arose a new economic system, capitalism. And, the class system changed as a result, from one of merchants and lords, peasants, and small business owners, to one featuring primarily capitalists and wage laborers.

Under capitalism, conflicts between capitalists and workers resulted in the mixed market economies (some government some market) in the West, and the Soviet Union in Russia. So a similar process unfolded under capitalism.

4. Describe what you see as the major contradictions, technological changes and class conflicts in our current society. What factors do you think are most likely to provoke a crisis? What type of economic system might evolve out of the crisis to resolve the existing contradictions?

Contradictions exist when economic processes undermine the existing basis of the economic system.

Some of the major contractions in modern society include the following: Increased economic growth leads to increased environmental devastation and resource depletion, which undermines the ability of the economy to continue growing. Global capitalism has reduced incomes of the poor and the middle class in developed countries, while increasing incomes of the rich, fostering inequality. This has slowed economic growth and led to outbursts of political populism and class conflict as those at the bottom seek alternatives to the status quo. Meanwhile, in terms of technology the rise of robotics and artificial intelligence threatens to replace vast numbers of jobs, which could undermine incomes and lead to widespread poverty and economic crises. Any of these contradictions could cause an economic crisis which could reshape the economic system in a way that would try to solve the contradiction. An environmental crisis might cause a rapid move to a more sustainable economic system, or a devolution to an authoritarian state where those with power seize scare resources. Class conflict or the end of employment for millions due to technology could result in a socialist system to redistribute society’s resources or a fascist system whereby those in power hold onto the most resources.

5. List all of the factors that would increase the surplus value going to an employer.

1) Increasing the length of the work day 2) Reducing the amount of time necessary to pay for a laborer’s wage by a. reducing wages,

b. replacing workers with more cost-effective machinery, or c. increasing the productivity of workers by speeding up the pace of work or other measures that target productivity.

6. Find 3 examples from a reputable news source that illustrate the drive by modern employers for greater surplus value.

Answers will vary. Examples might include those that demonstrate laborers working longer hours or working at home, actions that reduce wages or benefits, technological changes that replace workers, and efforts to speed up work or increase productivity at work through monitoring.

7. Would it be possible for an employer to pay and treat workers well and still increase the amount of surplus value they take in? Why or why not?

Increases in wages can result in increases in surplus value if productivity increases enough to offset higher wages. We see this often in white collar occupations, where paying workers well and treating them well increases productivity so much that the firms are even more profitable after such efforts.

8. Do you or most people you know find work to be alienating? Explain and give specific examples.

Answers will vary. Most people in skilled occupations or who have control over their work lives tend to find work fulfilling much of the time. Less skilled workers with little control over their lives are much more likely to be alienated, doing boring, repetitive, uninteresting jobs while being treated poorly.

9. Find 3 examples of commodification that you see around you. Choose different examples from those given in this chapter.

Answers will vary. Commodification is the process by which the capitalist system, in relentlessly searching for new profitable opportunities, tends to turn most things of value into a commodity.

Examples could include the commodification of various holidays, love, national parks, labor, aspects of childhood, etc. Your examples may vary. Some recent examples of commodification include:  Adultery (Ashley Madison web service)  Star Wars Movie (toys, mugs, shirts, etc.)  Attempt to create new holidays (Grandparents day, boss’s day)  Shopping services, where people are paid to shop for others  Food delivery services where even high end restaurants have their food delivered by Uber Eats and other services so diners can have the restaurant experience in their home  Social media ads that look like regular content but are disguised advertisement, 10. Contrast Marx’s view of competition with that of Adam Smith. Analyze which aspects of their views of competition you think are most accurate, and support your answer with specific examples.

To Smith, competition kept firms innovative, prices low, and wages high (as firms competed to hire laborers). Marx, on the other hand, talked about competition as a race to the bottom, in which firms competed to make the most profit, but this often meant slashing wages and terrible working conditions.

Thus, Smith sees competition as constructive whereas Marx sees it as primarily destructive. Also, Smith though markets would always stay competitive, whereas Marx saw markets becoming increasingly monopolistic.

Your views on which economist has the best take on competition will depend on which elements you see most prevalent in the world around you. For example, you might site the relentless innovations of capitalism, falling prices of many goods (TVs, cell phones) and the improvements in the standard of living as evidence that Smith was correct. However, you could point to the concentration of many industries and the prevalence of sweatshop labor and abusive working conditions in many countries as examples supporting Marx’s view.

11. Explain why Marx thought capitalism would eventually lead to a workers’ revolt. Assess the strengths and weaknesses of Marx’s argument regarding the inevitable fall of laissez-faire capitalism.

When Marx wrote in the mid-1800s, capitalism was becoming increasingly unequal, and labor strife was increasing. The trends Marx saw—globalization, commodification, increasing monopoly power of the largest firms, the lack of political power of workers, and more—seemed to indicate more and more crises and, eventually, a workers’ revolt. Interestingly, recurrent crises did occur, and labor protests steadily gained in strength, culminating in the Great Depression. This crisis was so bad, and workers so adamant about the need for change, that laissez faire capitalism did fall and the economic system did change. In most developed countries, the change was to mixed market capitalism not to socialism.

However, Russia and some other countries to move to socialism or communism. Therefore, it appears that Marx was right to predict the downfall of laissez-faire capitalism, but wrong to think that only socialism could fix the problems with a capitalist system.

Veblen and Monopoly Capitalism Answers to Questions For Review 1. How was the era of Monopoly Capitalism different from the competitive capitalism of Adam Smith’s era? Does Smith’s argument that unregulated capitalism will tend to benefit the workers hold up under monopoly capitalism?

During the robber baron era in the U.S., huge, monopolistic firms run by rapacious capitalists dominated entire industries, as epitomized by Standard Oil, which monopolized the oil industry using brutal tactics. The robber barons were so powerful that they controlled government officials and operated with virtual impunity. Smith hoped that competition and moral sentiments would end up benefiting the working class under unregulated capitalism. Competition would insure that prices were low, innovations occurred to lower costs and create new products, and the demand for labor would increase as industry expanded, benefitting workers significantly in the process. Moral sentiments would prevent exploitation. Unfortunately, the robber barons often made their money via destructive means, bombing or buying out competitors, buying off politicians, demanding that the government shoot striking workers, and so on. Monopoly capitalism, despite being largely unregulated, did not work as Smith hoped.

2. How do race and gender interact with social class to affect opportunities?

In the early history of the US, African Americans and women were forced into the lowest social classes. Native Americans were excluded from white society. Today, African Americans and women (especially single parents) are still disproportionately in the lower classes of the US, and many Native Americans are still excluded. This shows us how historical disadvantages tend to last for a very long time. This is most likely because of discrimination and the ability of the top social classes to pass on advantages (social and cultural capital) to their children.

3. How did the Age of Imperialism restructure the global economic system?

From 1415 to the mid-1800s, European powers gained control of the Americas, India and coastal Southeast Asia. From 1870-1914, European powers seized almost all of Africa, Japan pushed into China and Korea, and the U.S. seized the Philippines and Cuba and began efforts to dominate Latin America and the Caribbean. Imperial countries structured colonies or territories to serve their interests by providing cheap raw materials and requiring that they buy the imperial power’s manufactured products. This had the effect of stunting the economic development of colonies, something we still see today in the impoverished status of many former colonies.

4. Describe how Veblen’s “evolutionary” approach to economics differs from the approaches of Smith, Marx and neoclassical economics.

Veblen believed that since the economy is constantly evolving, it is fruitless to try and establish economic laws. Thus, Veblen’s methodology involves studying the institutions that make up society and how they evolve in order to grasp the economy's path. This approach has been labeled "evolutionary economics" to focus on the dynamic nature of the economy and the idea that you cannot established fixed laws of economic behavior. Both Smith and Marx were more inclined to see certain types of behaviors as consistent enough to be characterized by “laws” of economic behavior.

5. Describe the role of the leisure class, conspicuous consumption, and pecuniary emulation in the economy. Apply the concepts of conspicuous consumption and pecuniary emulation to the modern world, including examples from your community or university.

The leisure class is made up of members of society who are exempt from menial labor and who work in honorable employments. “The modern leisure class consists of those whose ownership of wealth and whose control of the means of production permits them to engage in the same kind of relentless competition and predatory activity carried out by their barbarian forefathers, and more importantly, to be exempt from the menial jobs performed by ordinary workers.” The leisure class competes for status by engaging in industrial sabotage and conspicuous consumption.

Conspicuous consumption refers to the consumption of particular brands or types of products that are consumed specifically to be visible or conspicuous to others, with the intent of showing the consumer’s status. Your answers may vary, but in general there should be some recognition of the extent to which many of the items we buy have a useful component, but also a conspicuous component. A shirt is purchased because it is useful and necessary, but a brand name shirt usually is purchased because of its display value (conspicuous consumption).

Consumers pick different items to display their social status conspicuously in different places (watches in New York, clothes in Dallas).

Pecuniary emulation refers to the tendency of human societies to emulate those at the top and their peer group. We develop tastes and preferences based on our peer reference group, but our desire for status also means that we desire a higher level of consumption if we can manage it.

Given the homogenization of tastes at Bucknell, it certainly appears that pecuniary emulation is a major force here, and there does seem to be a coveting of nicer items.

6. Define what Veblen means by conspicuous consumption. Make a list of at least 3 items that people in your community or university seem to purchase more for the purposes of conspicuous consumption than for the usefulness of the item. Briefly explain why you chose these particular items. Do not use examples already given in this book.

Conspicuous consumption refers to the consumption of particular brands or types of products that are consumed specifically to be visible or conspicuous to others, with the intent of showing the consumer’s status. Your answers may vary, but in general there should be some recognition of the extent to which many of the items we buy have a useful component, but also a conspicuous component. Examples might include brands of clothing, watches, purses or bags, backpacks, computers, and cars.

7. Why does Veblen distinguish between making money (via industrial sabotage) vs. making goods? Explain briefly.

To Veblen, firms can make a profit by producing a good product and selling it for a good price (making goods). Or, they can make a profit via industrial sabotage, which could involve monopolizing an industry, milking an industry for short term profits while neglecting investment in the future of the company (GM producing profitable SUVs without considering a future of high gas prices), advertising to convince consumers they need something that they do not have (or need!), and so on. Veblen classifies predatory and wasteful behavior as industrial sabotage.

An economy focused on making goods is preferable to an economy focused on industrial sabotage.

8. Why does Veblen think that culture is important in understanding human behavior? Explain.

Veblen’s studies of human societies throughout history indicated that culture is one of the most important factors in shaping economic behavior. People strive to fit into their culture to survive and thrive, internalizing its values. Under difficult conditions, cultures tend to value productive work, sharing and cooperation, which are crucial to survival. A hierarchical society often values things that display one’s play in the hierarchy, including jewelry, fine clothes, fancy vehicles, and large houses. One cannot understand the behavior and motivation of a society’s citizens without understanding culture.

9. How did the “roaring 1920s” set the stage for the Great Depression? How did the Great Depression create the conditions for the Keynesian Revolution in economics?

The rapid economic growth created a fragile economic bubble in financial markets which eventually burst, causing the Great Depression. Consumer debt doubled during the 1920s, and investors bought stock with borrowed money (buying on the margin). As stocks increased, this caused ever-riskier spending and investing. The bubble finally burst in late 1929, the stock market crashed and numerous banks failed. Despite the assurances of most economists, the economy did not recover. After 3 years of devastating unemployment and business closures,

voters elected Franklin Delano Roosevelt on a platform emphasizing Keynesian economics. This platform involved the U.S. of government spending and regulations to end the Great Depression and stimulate economic growth. Keynesian economics would dominate the profession for the next 40 years.

10. Veblen focused on institutions and how those institutions tend to persist over time, largely due to the forces of culture and the power of the vested interests to resist change. But, these institutions also evolve. Using Veblen’s approach, analyze the persistence and evolution of one of the following factors over time: (a) racial inequality, (b) gender inequality, (c) class inequality, (d) domination of the economy by large corporations, or (e) domination of the global economy by the former imperial powers.

Your answers will vary. Here are some suggestion for topics to take up related to the factors listed above. (a) Racial inequality: White workers and employers resist efforts by black workers to join unions, get good jobs, and get higher wages. This keeps profits high for employers and keeps white workers at the top of the hierarchy in the labor market. But, the civil rights movement and other efforts gradually begin to give workers of color more rights and more access to employment, government resources, unions, and housing. (b) Gender inequality: Men resist the advancement of women into skilled professions to preserve their status and salaries. But, the women’s movement, along with the civil rights movement pushes through Affirmative Action laws which mandate that women and people of color be considered for jobs on an equal footing with men. In cases where women candidates are equal to men in terms of qualifications, the edge should be given to the person from the historically under-represented group. This gradually opens up white-male-dominated professions to women and people of color. (c) Class inequality: During the monopoly capitalism / robber baron era, huge corporations dominated the economy, and this resulted in vast inequality. The labor movement and the reform movement, which culminated in the New Deal of the Great Depression, gave workers more rights and reduced inequality. (d) Domination of the economy by large corporations: During the monopoly capitalism / robber baron era, huge corporations dominated the economy. The progressive movement and the labor movement, as embodied in the New Deal of the Great Depression, reigned in some of the power of corporations. This gave workers more rights and, for a time, reduced the power of large corporations. (e) Domination of the global economy by the former imperial powers: The imperial powers dominated the World until after World War II. But, independence movements in India, Ghana and elsewhere after World War II led to independence of former colonies. In the modern world, the wealthiest countries continue to be the former imperial powers (the U.S., Europe, Japan).

However, in recent years former colonies such as China, India and Brazil have been among the most rapidly growing economies. There seems to be a shift from the former imperial powers to certain emerging markets.

Chapter 07, Keynes Answers to Questions for Review 1. Explain how the neoclassical concepts (a) Marginal Productivity Theory of Distribution, (b) Markets Always Clear, and (c) Say’s Law combine to result in a conclusion that no government intervention is necessary in a capitalist market system. (a) The Marginal Productivity Theory of Distribution is the neoclassical theory that people are paid exactly what they are worth based on their marginal productivity under a competitive, capitalist economic system. This theory assumes that there are no power imbalances so no exploitative relationships exist. This means people are paid exactly what they are worth, and if they want to earn money they just need to work harder or find another job (the theory assumes that markets are competitive so there are many employers bidding for government services). Governments do not need to intervene in labor markets to put people to work, protect unions or to establish minimum wages under such conditions. (b) The idea that Markets Always Clear is the neoclassical theory that supply always equals demand in all markets, so the Invisible Hand of the market always allocates resources efficiently. This means there can never be involuntary unemployment or gluts with surpluses of goods. Thus, governments need not intervene to create jobs, provide unemployment insurance, or engage in stabilization policy. (c) Says Law is the theory that supply creates its own demand, and savings is always equal to investment. Say’s Law posits that in the act of supplying products firms generate income. Since every penny a firm earns in revenue is income for someone—either the workers, suppliers, or owners—there is always enough income generated to purchase all of the goods produced.

Governments to not need to intervene to counteract declines in investment and increases in savings—the market will automatically increase investment in such cases, preventing recessions from occurring.

2. Describe the nature of the Keynesian “revolution” in economics. How did Keynes reshape the way economists thought about the economy? How did he address the major flaws in the neoclassical economics of his time?

Before Keynes, most neoclassical economists ignored macroeconomics, and believed that a laissez-faire approach to economic policy was best. Keynes demonstrated that such views were based on fundamental misunderstandings of the macroeconomics of markets.

First, Say’s Law did not hold in recessions due to the Volatility of Investment. Declines in consumption and the corresponding increases in savings were not met with increased investment, as Say’s Law predicted. Instead, businesses focused on the decline in spending as a sign of bad times to come, which meant they did NOT increase investment when savings increased. The result was that the economy could get stuck in a recession for a long period of time.

Second, the labor market does not clear quickly due to sticky wages and prices. Workers and unions resist wage cuts, so it can take several years of recessionary conditions before wages fall.

This means that the economy will not experience a cut in wages that might eliminate unemployment in a recession for quite some time.

Third, even if wages and prices do fall, this will not help the economy recover from a recession.

Declining wages undermines consumer demand, and declining prices undermines business profitability. Thus, deflation is ruinous for the economy, keeping the economy in a recession instead of stimulating business expansion.

Fourth, Keynes pointed out that, because of the multiplier, small shifts in the economy could become huge changes. When a firm lays off workers and incomes decline, those workers spend less, which reduces sales at the businesses they usually patronize. When these businesses lose revenues, they lay off workers. Thos workers then spend less, which lowers incomes more, which lowers spending at businesses more, and so on. Thus, initial changes that seem minor can spark a full recession.

The key part of the Keynesian revolution was that the government can intervene to correct these failures in the market via stabilization policy. And, such interventions have helped to stabilize economies and foster growth, resulting in the modern mixed economies we see today.

3. Why do many economists see the Volatility of Investment along with the Multiplier as the key to understanding the business cycle (the cycle of booms and busts that characterize our economic system)?

The volatility of investment stems from the fact that investment is an inherently risky act, and investors can get spooked easily. If investors suddenly become pessimistic, they will not undertake a risky investment and will stop investing their profits. However, if there is a sudden drop in investment from a large number of firms, industries that manufacture investment goods take a hit. Companies will sell less concrete, computers and technology goods, steel, and other investment goods when investment falls. These firms will lay off workers, which will reduce in decreases in income and spending.

This is where the multiplier kicks in. When workers’ spending falls, they businesses they patronize—restaurants, car dealers, grocery stores, etc.—experience declines in sales. They have to cut costs to survive, so they lay off workers. But now another set of layoffs mean another set of declines in income and spending, which impacts yet another set of businesses. This spirals through the economy until a recession results.

4. How do sticky wages and prices prevent the economy from adjusting in a recession?

The labor market does not clear quickly due to sticky wages and prices. Workers and unions resist wage cuts, so it can take several years of recessionary conditions before wages fall. This means that the economy will not experience a cut in wages that might eliminate unemployment in a recession for quite some time.

However, even if wages and prices do fall, this will not help the economy recover from a recession. Declining wages undermines consumer demand, and declining prices undermines business profitability. Thus, deflation is ruinous for the economy, keeping the economy in a recession instead of stimulating business expansion.

5. In what areas of the economy do we tend to see the market fail to work well? What government programs have been designed to address those market failures?

In each of the following areas the market often fails and requires government regulation or intervention.

(1) Banking, financial markets and the money supply: Banks and financial markets invest too much in risky securities, which can lead to bankruptcies and a rapid decrease in the money supply. To reduce this problem, the government regulates banks, limiting how risky their portfolios can be, and intervenes to increase the money supply when banks fail and the economy hits a recession.

(2) Labor markets (poverty, inequality and unemployment): Markets often work poorly for the poor, the elderly and the unemployed. To reduce this problem, governments establish a safety net so those who fall on hard times can continue to spend (supporting the economy) and maintain a decent standard of living. Unemployment is a particularly thorny problem in recessions, so the government offers job search assistance and often directly creates jobs.

(3) Agricultural markets: Agricultural markets are prone to gluts and price crashes, which can undermine agriculture production and threaten food security. Governments utilize systems of price supports and subsidies to insure an adequate level of agricultural production.

(4) Environmental and resource issues: Markets tend to spoil the environment and use up scarce resources. Governments create agencies to regulate and mitigate environmental destruction.

6. How would you explain to someone with no economics background why deflation can be a major macroeconomic problem?

When a business produces a good, it has to pay laborers for their work and suppliers for their inputs at a certain cost. For example, suppose that it costs a car company $30,000 to make a car.

The car company spends $30,000 to make a car because it plans to sell the car for more than the cost of making it—perhaps $35,000. However, suppose that deflation happens, and the price at which car companies can sell cars falls by $10,000. If the car company can only sell the car for $25,000, they lose money. If companies lose money on the goods they produce, they go out of business. If enough businesses go out of business, the economy crashes.

7. How do Keynes’ ideas relate to those of Smith and Marx?

Instead of depending on an unstable market system, Keynes wanted to use government intervention to make the capitalist system better (more efficient, more stable, and more equitable). The fact that he wanted to preserve capitalism indicates an agreement with Adam Smith that capitalism is a good economic system with many positive qualities. The fact that he thought we must intervene to fix major problems, including the cyclical nature of the economy and the poor conditions that laborers faced, indicates an acknowledgement of the problems produced by capitalism, as described by Marx.

8. Which of Keynes’ ideas do you find most compelling in capturing the realities of the modern world? Explain and give examples.

There is no right answer to this question. Some possible answers include the following:  

The economy continues to experience a cycle of booms and busts that require government intervention for stabilization.

The deregulation of financial markets in the 1980s and 1990s created a speculative bubble of risky real estate investments in the 2000s, resulting in a devastating financial crisis. Keynes’ point that the financial system requires prudent regulation is compelling.

 

Mixed market economies dominate the global economy, so Keynes’ argument that government regulation can assist economic development is strong.

Economies with strong safety nets and government stabilization policy tend to fare better than economies without those things.

9. Which of Hayek’s ideas do you find most compelling? Which are least compelling? Support your answer with examples and analysis.

Hayek believed that competitive, unregulated markets were the best system possible for the gathering and dispersion of information. He saw knowledge as the key to growth, and the thought a capitalist system would generate the greatest rate of economic growth. Centrally planned economies could not hope to duplicate the complexities of the market because they could not generate or process the vast array of information that markets do on a daily basis.

Hayek also noted the institutional foundations of capitalism, including private property and social norms, which were required for it to work properly. Hayek disagreed with Keynes in that he thought government intervention would harm rather than help an economy, even in recessions. He agreed with Keynes that the government should intervene to fix some market failures, but he saw recessions as a necessary correction in the economy that did not need to be avoid. Keynes, and most economists since his time, instead have seen recessions as fundamentally damaging to the economy and to people, and therefore as something to be avoided. Hayek’s arguments about the importance of knowledge and information, and the inability of centrally planned economies to do well in these areas, was prescient. His argument that the government should not intervene in recessions is dismissed by most economists, and economies following this approach have fared poorly (e.g., the Euro region and the financial crisis of 2008-2010).

10. Compare and contrast Keynes’ ideas with those of Hayek.

Instead of depending on an unstable market system, Keynes wanted to use government intervention to make the capitalist system better (more efficient, more stable, and more equitable). The fact that he wanted to preserve capitalism indicates an agreement with Adam Smith that capitalism is a good economic system with many positive qualities. The fact that he thought we must intervene to fix major problems, including the cyclical nature of the economy and the poor conditions that laborers faced, indicates an acknowledgement of the problems produced by capitalism, as described by Marx. Keynes was a firm believer that sound economic policy, especially stabilization policy and the creation of a safety net, would improve the functioning of the market economy, fostering stability and growth.

In contrast, Hayek believed that competitive, unregulated markets were the best system possible for the gathering and dispersion of information. In this area, he had much in common with Smith. And, since he saw knowledge as the key to growth, such a system would generate the greatest rate of economic growth. Centrally planned economies could not hope to duplicate the complexities of the market because they could not generate or process the vast array of information that markets do on a daily basis. Hayek also noted the institutional foundations of capitalism, including private property and social norms, which were required for it to work properly. Hayek disagreed with Keynes in that he thought government intervention would harm rather than help an economy, even in recessions. He agreed with Keynes that the government should intervene to fix some market failures, but he saw recessions as a necessary correction in

the economy that did not need to be avoid. Keynes, and most economists since his time, instead have seen recessions as fundamentally damaging to the economy and to people, and therefore as something to be avoided.

11. Explain the concept of Creative Destruction, and give examples from the world around us.

Creative Destruction is the process by which businesses are forced to invent constantly to stay one step ahead of the competition, and where creative, new industries inevitably destroy and replace older ones. Recent examples include Amazon and e-commerce destroying retail industries, smart phones and tablets displacing laptop and desktop computers, digital photography replacing print photography, and music streaming replacing compact discs.

12. Describe the evolution of the U.S. economic system from 1920 to the present. How has our approach to regulating the economy shifted over time?

The “Roaring” 1920s were an era of mostly laissez-faire economic policy. The US economy experienced a manufacturing boom, but much of it was based on easy credit. Also, inequality reached extreme levels. With huge profits accruing to owners, there were vast amounts of profit to invest, leading to investments in speculative ventures. The result was the crash of 1929 and the Great Depression that followed.

Beginning in 1932, President Roosevelt ushered in the era of mixed capitalism, using government policy to stabilize the economy and to fix the worst aspects of market failures. This included regulation of banking and financial markets, the creation of a safety net for the poor, unemployment insurance, social security, and an agricultural price support system.

The triumph of the U.S. and its allies in World War II ushered in the golden age of US capitalism from 1945-1973. US manufacturing boomed, and the US produced 80% of the world’s manufacturing output in the 1950s. This era featured a Capital-Labor Accord, with workers and management in the US both benefitting from the post-war boom. However, minorities and women were largely excluded from the gains, necessitating civil rights movements.

After the oil price shock in 1973 the U.S. experienced stagflation, which prompted businesses to pressure government to reduce taxes and regulations to restore business profitability. President Reagan was elected in 1980 on a platform of reducing the size of government, ushering in the era of neoliberalism. Taxes on the wealthy and corporations were cut, and government programs were scaled back. Unregulated trade policies were pursued. The government did continue to use stabilization policies in recessions, but in other areas government intervention was scaled back.

Deregulation and tax cuts fueled speculative bubbles in tech stocks (late 1990s) and real estate (mid-2000s), the latter of which resulted in the Great Recession of 2008-9. President Obama restored some regulations during his presidency, although many of his initiatives were reversed

by President Trump.

In summary, the US economy changed from being laissez-faire before the depression, to a mixed economy from the Depression through the 1970s, to a more laissez-faire mixed economy after 1980.

Chapter 8, Modern Economic Systems, by Geoffrey Schneider Answers to Questions for Review

1. Explain the key differences between Market Dominated Economies, Social Market Economies and State Dominated Economies. Use specific examples to support your answer.

Market Dominated Economies (MDEs) are economic systems in which the primary economic decisions are made by private actors (corporations, individuals) in the market. Governments and social values play a secondary role. Private actors therefore determine how society’s resources are allocated.

The government’s primary role is in an MDE is to support the market system by providing infrastructure and a judicial system to enforce contracts, and to fix the worst market failures. The main market failures include macroeconomic instability, poverty and inequality, the exploitation of laborers and the environment, and the lack of privately provided health and education. The U.S. in particular features a business-friendly legal system with few regulations. Low taxes on corporations and the wealthy, coupled with strong higher education and patent systems, foster numerous revolutionary innovations. However, the small welfare state and lack of a national health care system mean that the U.S. is the most unequal developed country in the world.

Social Market Economies (SMEs) are economic systems in which social values take a leading role in directing the economy, usually through the actions of a government which manages the economy in accordance with social values. Many services are provided to all citizens as human rights, including health care, child care, dental care, housing, education, and employment. Citizens receive much more generous vacations and family leaves. The government also plays a primary role in stimulating industrial development in strategic sectors of the economy to promote growth and employment. Norway’s government runs the oil industry and uses the proceeds to benefit all citizens. Workers have a generous safety net, and flexicurity programs insure that workers who lose jobs will receive a stipend and training to get them a new job. The safety net is instrumental in fostering entrepreneurship, since there are few risks associated with starting a business—if the business fails, the government will provide you with training and a stipend. SMEs generally have much lower levels of poverty and inequality.

In State Dominated Economies (SDEs) are economic systems in which the government is the main economic actor in most major industries or economic decisions, owning or controlling most of the economy. The government makes most of the important economic decisions. The government guides investment decisions, many goods are produced by state owned enterprises. For example, China attracted foreign investment by offering low wages and taxes, few regulations and a devalued current to make it extremely profitable to produce goods in China. But, in exchange for these attractive conditions and access to the huge Chinese market, they insisted that investors work with local partners and share technology. This gave Chinese firms experience in production and access to cutting edge technology which allowed them to become globally competitive. Thus, government control of foreign investment led to the development of Chinese industry.

2. What are the key elements of the US MDE? What factors do you think are essential contributors to US economic success? What are the major problems with the US MDE? The U.S. features a business-friendly legal system with few regulations. Low taxes on corporations and the wealthy, coupled with strong higher education and patent systems, foster numerous revolutionary innovations. However, the small welfare state and lack of a national health care system mean that the U.S. is the most unequal developed country in the world.

3. What are the key elements of the Nordic SME? What factors do you think are essential contributors to its economic success? What problems do you see with the SME approach?

Nordic value equality and human rights. Most services are provided to all citizens, including health care, child care, dental care, housing, education, and employment. Citizens receive much more generous vacations and family leaves. The government also plays a primary role in stimulating industrial development in strategic sectors of the economy to promote growth and employment. Norway’s government runs the oil industry and uses the proceeds to benefit all citizens. Workers have a generous safety net, and flexicurity programs insure that workers who lose jobs will receive a stipend and training to get them a new job. The safety net is instrumental in fostering entrepreneurship, since there are few risks associated with starting a business—if the business fails, the government will provide you with training and a stipend. SMEs generally have much lower levels of poverty and inequality. The government plays a central role in the economy, which could become problematic if the government was corrupt or inefficient.

4. How do socialism and communism differ from capitalism?

A socialist economic system is one in which the means of production and distribution are either owned or regulated by society. In most SMEs, only 40-60% of the economy is controlled or regulated by the state, whereas a fully socialist system would mean control or regulation of almost all industries.

A communist economic system is one in which the means of production and distribution are publicly owned and each person works according to their abilities and is paid according to their needs. Usually, communist systems are state dominated (SDEs), with the state dictating how industry works, who does what job, etc.

In a capitalist system, private owners of productive resources make most of the economic decisions based on the goal of making economic profit for themselves. Therefore, in theory, the main difference between socialism and communism vs. capitalism is the emphasis on socially or communally owned and controlled resources, versus privately owned and controlled resources. This has implications for who benefits from the operation of the economy.

5. What are the strengths and weaknesses of a market capitalist approach (US), a guided market approach (Nordic Model) and a central planning approach (USSR) to economic development?

Market capitalist systems like the U.S. are very innovative and dynamic, with lots of new inventions and industries as long as markets are sufficiently competitive. However, MDEs tend to feature a lot of inequality, poverty and environmental devastation. When industries become very powerful, such systems can lose their dynamic character.

Guided market economies tend to have the highest human development outcomes, with all citizens receiving high quality education and health, and an excellent safety net. If these SMEs are wellstructured, they can be quite innovative as well if the government policies promote innovative activities.

However, SMEs can acquire an inefficient bureaucracy which can give the economy a rigid character (e.g., France).

Centrally planned economies can mobilize vast resources to begin the process of economic development, and they are good at providing basic necessities to all citizens. However, the centralization of power in such systems can lead to dictatorship and human rights abuses.

6. The most successful countries in the last 50 years have used the government extensively in economic development efforts. However, many developing countries in sub-Saharan Africa,

Latin America and Southeast Asia have adopted similar approaches with little success. Why might a government-centered approach to development have such an uneven track record?

A government-centered approach to development is only as effective as the government that implements it. An efficient government run by the country’s best and brightest can be incredibly efficient and dynamic, outperforming MDEs. An inefficient and corrupt government can derail economic development, however, resulting in dismal economic performance.

7. What are the key ingredients in China’s economic success? Why was China’s transition from a centrally planned system to a market-oriented system more successful than the transition in Russia?

In Russia, little attention was paid to the need to develop legal and institutional structures to support markets. Thus, the economy was unable to work well within a market framework. They also developed a corrupt and inefficient bureaucracy that resisted change.

China gradually incorporated incentives and special economic zones into their communist system so that farmers and businesses gradually gained experience with markets. In particular, Chinese farms and businesses had to produce some goods for the state, but they could sell any surplus in statesanctioned markets. This preserved the state system while incentivizing increased production, resulting in rapid growth. China then attracted foreign investment by offering low wages and taxes, few regulations and a devalued current to make it extremely profitable to produce goods in China. But, in exchange for these attractive conditions and access to the huge Chinese market, they insisted that investors work with local partners and share technology. This gave Chinese firms experience in production and access to cutting edge technology which allowed them to become globally competitive.

The Chinese government also insisted that government officials prioritize economic growth above all other goals, which led to their entire system focusing on growth.

8. Innovation is a key ingredient in economic success over time. What are the lessons regarding innovation that emerge from the experiences of the countries described in this chapter?

Innovation is a product of a variety of factors, including incentives, safety nets, education, infrastructure and training, and market access. A chance at very high rewards can stimulate someone to invest in a risky new venture (US model). But the lack of a decent safety net increases risks and makes it less likely people will try out risky new ventures (SMEs offer safety nets and support to facilitate entrepreneurship). Education helps to develop ideas which can lead to the formation of new ventures, especially if some of that education emphasizes how to develop and implement new ventures. It is much easier to set up a new venture in a location with good infrastructure and well-trained workers. And, access to a large and growing market (e.g., China) can stimulate new venture development.

9. Write an essay in which you compare and contrast the US economic system with the Nordic Model. In your essay, take up the following issues: (a) What role does government play in each economy? (b) How does each economy reflect the ideas of Adam Smith, Karl Marx, Thorstein Veblen, John Maynard Keynes and Friedrich Hayek? (c) What are the strengths and weaknesses of each economic system?

(a) Market Dominated Economies (MDEs) are economic systems in which the primary economic decisions are made by private actors (corporations, individuals) in the market. Governments and social values play a secondary role. Private actors determine how society’s resources are allocated.

The government’s primary role is in an MDE is to support the market system by providing infrastructure and a judicial system to enforce contracts, and by fixing the worst market failures such as macroeconomic instability, poverty and inequality, the exploitation of laborers and the environment, and the lack of privately provided health and education.

The U.S. in particular features a business-friendly legal system with few regulations. Low taxes on corporations and the wealthy, coupled with strong higher education and patent systems, foster numerous revolutionary innovations. However, the small welfare state and lack of a national health care system mean that the U.S. is the most unequal developed country in the world.

Social Market Economies (SMEs) are economic systems in which social values take a leading role in directing the economy, usually through the actions of a government which manages the economy in accordance with social values. Many services are provided to all citizens as human rights, including health care, child care, dental care, housing, education, and employment. Citizens receive much more generous vacations and family leaves. The government also plays a primary role in stimulating industrial development in strategic sectors of the economy to promote growth and employment.

Norway’s government runs the oil industry and uses the proceeds to benefit all citizens.

Workers have a generous safety net, and flexicurity programs insure that workers who lose jobs will receive a stipend and training to get them a new job. The safety net is instrumental in fostering entrepreneurship, since there are few risks associated with starting a business—if the business fails, the government will provide you with training and a stipend. SMEs generally have much lower levels of poverty and inequality. (b) The US economy, as the least regulated economy, is most in line with the ideas of Smith and Hayek.

The private sector makes most economic decisions, and the role of government is small.

Nonetheless, the US does include some Keynesian ideas, especially stabilization policy, a basic social safety net (welfare, unemployment insurance, social security), and basic environmental regulation.

In a nod to Marx, the US does have worker safety laws and the right to unionize, although these laws are much less strong than similar laws in other countries. The US does very little in line with Veblen’s ideas, since firms are encouraged to make the most money possible without regard for whether or not they are producing a useful product.

The Nordic model includes a much more direct acknowledgment of the ideas of Marx, Veblen and Keynes. In terms of Marx, they remove many items from the market, instead providing health and education as human rights for all citizens. By trying to insure that all citizens have a job (via flexicurity) or a secure income, they are acknowledging the problems created by the reserve army of unemployment (Marx). They are also, in the process, emphasizing the importance of human needs over the consumption of luxuries, a principle Veblen would appreciate. Their hyperKeynesian policies also are more interventionist than the stabilization policies of the US. There is still some Smith and Hayek in these economies, in that they emphasize startups and innovation.

Thus they are still capitalist economies. (c) Both MDEs and SMEs can be quite wealthy and both have similar rates of economic growth. The strengths of the US system are that it is particularly innovative and provides a strong incentive to work. The weaknesses of the US system include the fact that it generates significant levels of inequality and poverty, has been less stable, and treats laborers less well. The strengths of the Nordic model are the elimination of poverty, low unemployment, high rates of labor participation,

high levels gender equality, and the healthy economy that stem from the productivity incentives and Keynesian economic policy. The weaknesses are that the system may be so generous that it doesn’t always reward hard work and people may take advantage of it (which has happened on occasion in the past).

10. What role does culture seem to play in structuring economic systems? Explain using specific examples.

Culture plays an important role in every economic system, shaping the values of a country’s citizens, which in turn shapes how they structure their economic system. U.S. citizens value hard work, individualism, and independence. Therefore, they tend to prefer a laissez-faire type of system without significant government regulation or interferences. Private interests usually trump public interests.

Nordic countries evolved cooperative cultures built to survive harsh conditions. This evolved into economic systems which involve sharing (significant redistribution), cooperation, and an emphasis on the public good that is placed ahead of the private good.

Countries with a Confucian history emphasize respect for elders and authority. This leads to unique organizational hierarchies where government and corporate leaders are shown deference and respect.

11. Would it be possibly to implement a Social Market Economy in the United States? Why or why not?

Answers will vary on this question. The U.S. values of individualism and freedom from interference imply that citizens would not want a large government presence. However, certain actions by government can actually foster independence and individual actualization. To achieve a true meritocracy, where the best and hardest working citizens succeed, all citizens must have access to good education, health care and opportunities. Since unregulated markets do not provide those services, an active government could do much to foster individualistic development, which implies taking some steps toward a social market economy. For example, a safety net plus good education fosters entrepreneurship in Norway. Such measures would likely prompt more robust economic development in the U.S. as well.

Chapter 9, Markets and how they work Answers to Questions for Review 1. Carefully explain what a market is and give specific examples of two different kinds of markets.

A market is an institution which organizes and facilitates transactions between buyers and sellers. Buyers and sellers agree to exchange goods, services or assets basted on existing laws and informal rules of behavior. Examples of markets include the following: 

Retail markets are where firms such as Wal-Mart and Amazon (suppliers) sell directly to consumers (demanders).







Wholesale markets are where retailers like Wal-Mart and Amazon (demanders) purchase the goods they sell from the companies that produce them (suppliers). For example, Wal-Mart buys food containers from Rubbermaid, which it then resells directly to consumers.

Resource markets are the markets for labor, land, capital and natural resources where producers purchase the inputs they need (producers are the demanders) from the owners of those resources (suppliers).

Financial markets are where those wishing to borrow money (demanders) are matched with those with money to lend (suppliers).

Your answer should cover at least two of the above.

2. Which of the institutions that make markets work do you think is most important? Why? Explain carefully.

Key market-supporting institutions are property rights, laws to facilitate the aggregation of capital, trust, contract laws, competition, a lack of coercion, and infrastructure to lower transactions costs. Many conservative economists emphasize property rights, which provide incentives to earn money by utilizing property for personal gain. Adam Smith emphasized competition. Marx emphasized a lack of coercion. Markets cannot exist without infrastructure such as a good transportation system and a safe internet architecture.

3. Cuba has little history of using markets over the last half century. Suppose that the Cuban government wants to develop a robust market system while still preserving the equality and high level of human development they have achieved via a communist approach. What should they do? Explain in terms of the institutions necessary to support markets.

Cuba would need to develop market-supporting institutions, including property rights, laws to facilitate the aggregation of capital, trust, contract laws, competition, a lack of coercion, and infrastructure to lower transactions costs. To do this without generating inequality and poverty, they could insure that everyone has access to property, or that property rights are allocated to workers or citizens so they are allocated fairly and equally. Then, the worker-owned or community-owned enterprises could pursue profits and expansion while benefitting a broad section of the population. This approach was used quite successfully by China with their Town and Village Enterprises, and by worker-owned cooperatives such as the Mondragon Cooperative Corporation in Spain.

4. Suppose that the cost of engaging in internet transactions increases substantially due to cyber crime. What are the likely consequences? What markets would be affected, and what types of impacts would you expect to see?

This would decrease the use of the internet to engage in market transactions. This would cause a decline in all forms of e-commerce (Amazon, etc.), and all electronic trading of assets. This dramatic decrease in the size of the market would reduce economic growth, causing unemployment and possibly a recession.

5. Which of the assumptions of the supply and demand model are most likely to cause the model to lead to inaccurate results. Explain carefully. Give specific examples to support your argument.

There are 10 assumptions in the supply and demand model. Some of these are unrealistic given the structure of the current economy. The most problematic assumptions are numbers 2, 5 and 10.

1) Transactions take place in a capitalist market system with privately owned firms and individual consumers. This is a reasonable reflection of most developed-country markets, but does not reflect markets in socialist or communist countries.

2) Markets are perfectly competitive or at least competitive enough to mirror the behavior of perfectly competitive markets. This is a problematic assumption in many markets that are not competitive.

3) Suppliers and Demanders engage in optimizing behavior, with suppliers maximizing profits and demanders maximizing the satisfaction, or “utility” they get from purchases. This captures some aspects of the behavior of economic actors, but neglects impulse-buying, emulation and satisficing behavior.

4) Markets tend towards a stable equilibrium, settling on an equilibrium price and quantity.

Markets are sometimes stable and sometimes unstable.

5) Consumers are rational, calculating, fully informed and self-interested about their purchasing options. This only captures some of consumer behavior. Most research demonstrates consumers are deeply affected by the views and behaviors of peers, so the assumption of independent selfinterest is unrealistic.

6) Consumers prefer having more to having less, but they have a limited budget so they cannot buy all that they want, and they get less and less satisfaction from having more and more of the same good. This is a reasonable assumption in most materialistic cultures.

7) There are substitutes for each good, and consumers can rank goods according to how much of each good they want at various prices, which leads them to want more of a good at lower prices and less of a good at higher prices. This is a reasonable assumption for competitive markets.

8) Firms pursue as much short term profit as possible, and in doing so decide what to produce, how much to produce, and how to produce it. This is a reasonable assumption most of the time, although many firms use rules of thumb to determine how much to produce and are not as precise as the model implies.

9) Capital and technology are fixed in the short run. Most firms are limited in these areas in the short run, so this assumption is reasonable to a degree. However, many firms prioritize longterm decision-making, so short term decisions are less important.

10) Firms are encouraged to increase the quantity of a good supplied when the price increases. This is only true of competitive markets. Many markets dominated by large firms feature businesses that try to increase price, monopolize markets and make goods more exclusive, often limiting the quantity of a good supplied.

6. Draw a graph of the U.S. market for wheat. Show how the supply and demand curves for wheat will be affected by specific events, and show what happens to equilibrium price and quantity.

(Note: make sure to identify whether or not the demand and supply curves shift, or whether you are moving along the demand and supply curves. Draw a new graph for each part (a-d).

a. Wealth increases due to a boom in the stock market.

6a. U.S. Market for Wheat P ($ per bushel)

When wealth or income increases, consumers purchase more of normal goods, which would include products made from wheat (bread, beer, etc.). We would expect the Demand for wheat to increase (shift to the right) along with a movement along the supply curve for wheat up and to the right.

S B ●

P2 A ●

$5

D2 D

b.

Lower oil prices cause the price of fertilizer used in growing wheat to decrease.

6d. U.S. Market for Wheat P ($ per bushel)

S2 B ●

P2 $5

S

A ●

D

c. Consumers’ preferences change towards buying more gluten-free products, so they reduce the amount of products they buy that contain wheat (which contains gluten).

6c. U.S. Market for Wheat

Q P ($ per bushel)

1

$5 P2

Q (trillions of bushels per year)

S

2

The decrease in the demand for products that contain wheat will reduce the demand for wheat, shifting the demand curve down and to the left. There is a movement along the supply curve.

Farmers will shift from growing wheat to growing corn, decreasing the supply of wheat. The supply curve shifts to the left. There is a movement along the demand curve.

bushels per year)

2

When a cost of production decreases, the supply curve shifts down and to the right. This causes a movement along the demand curve.

d. Corn prices increase. (Note: most farmers grow both corn and wheat on their farms. Consumers do not consider wheat and corn to be substitutes or complements.)

Q (trillions of

1 Q

B ●

A ●

D2

D Q (trillions of

Q

6b. U.S. Market for Wheat 1 P ($ per bushel)

$5 P2

bushels per year)

2

S

S2

A ● B ● D 1 Q 2

Q (trillions of bushels per year)

7. Using a graph of the U.S. market for Uber Rides as your starting point, show how the supply and demand curves for Uber Rides will be affected by specific events, and show what happens to equilibrium price and quantity. (Note: make sure to identify whether or not the demand and supply curves shift, or whether you are moving along the demand and supply curves. Draw a new graph for each part (a-d). a.

New, inexpensive technology allows all Uber vehicles to become driverless, replacing existing drivers without compromising service.

The decrease in costs causes the supply curve to shift down and to the right. There is a movement along the demand curve.

7a. U.S. Market for Uber Rides

P ($ per mile)

S

A ●

$1.50

P2 b.

The price of Lyft, another type of taxi/ride-sharing service, increases significantly.

S2

B ● D

7b. U.S. Market for Uber Rides

Q (millions of

Q1 Q P ($ per mile)

miles per year)

S

2

The price of a substitute increases. This will lead more consumers to choose Uber instead, increasing the Demand for Uber Rides.

There is a movement along the supply curve.

P2

A ●

$1.50

B ●

D D 2 Q (millions of

Q1 Q

miles per year)

2

c.

An Uber self-driving vehicle has a major accident in which several people die due to a software glitch.

Consumers start to prefer rides with non-Uber 7c. U.S. Market for Uber Rides companies.

P ($ per mile)

S

The demand for Uber Rides will decrease, shifting to the left.

$1.50

P2

B ●

A ●

D

Q Q1 2

2

D Q (millions of miles per year)

d. Wages increase for workers around the country (including Uber drivers and others) due to an economic boom.

7d. U.S. Market for Uber Rides

Consumers have more money so the demand for Uber Rides increases. But Uber has to pay its drivers more, so their costs increase and the supply curve shifts up and to the left.

P ($ per mile)

S2

P2

B ●

$1.50

A ●

S

D D 2 Q1

Q (millions of miles per year)

8. Find an article in a major newspaper that describes a change in the price of some type of good or service. Use a graph of supply and demand to explain the forces that caused the price of the good or service to change.

Answers will vary. Example: In September 2019, there was a drone attack on Saudi Arabian oil fields. This reduction in the supply of oil caused the supply curve for oil to decrease, shifting to the left, and resulted in an increase in the price of oil. The Russian invasion of Ukraine in 2022 caused decreases in the supply of natural gas, oil, and wheat causing prices to increase. The war in Ukraine also caused an increase in demand for weapons, shells, and tanks, causing an increase in price. And so on.

Chapter 10. Applications of Supply and Demand Answers to Questions for Review 1.

a.

Using a graph, show how the supply and demand curves for US-made Sport Utility Vehicles will be affected by each of the events listed below. Also show what happens to equilibrium price and quantity. Assume that the equilibrium price of a US-made SUV is $35,000 and the equilibrium quantity is 500,000 US-made SUVs sold per year.

Wages for all U.S. workers increase due to an economic boom.

Higher wages mean people have a higher income which increases the demand for all normal goods, such as SUVs. Higher wages means higher costs for firms, which decreases the supply curve (shifts to the left).

The end result is higher prices and a quantity that stays about the same.

b.

1.a. US SUVs P2

B ●

$35,000

A ●

U.S. SUV companies institute a very successful “Buy American SUVs” advertising campaign.

The higher costs from advertising shift the supply curve up and to the left. But the successful ad campaign will increase demand and increase loyalty to American SUVs, causing the demand curve to get steeper as well. The result is a large increase in equilibrium price and an increase in equilibrium quantity.

S2

P

P P2

S

D2

1.b. US SUVs B ●

D2 S SQ (1000s)

500 A ●

$35,000

D D2 c.

Lower oil prices cause energy and gas prices to decrease.

Lower oil prices reduce energy costs, and the decrease in these costs of production causes the supply curve to increase (shifting S to the right). Gas is a complement to SUVs. Lower gas prices mean that consumers will buy more SUVs which use a lot of gas,

Q (1000s)

500 Q2

1.c. US SUVs P

S S2

$35,000

A ●

B ●

D2 D 500

Q2

Q (1000s)

increasing the demand for SUVs (shifting D to the right).

d. The Environmental Protection Agency convinces Congress that SUV pollution is contributing to global warming, so Congress institutes a $30,000 per-SUV excise tax (with the revenues to be used to clean up pollution).

The supply curve shifts up by exactly $30,000. This causes the market for SUVs to move to a new equilibrium at point C with an equilibrium price of about $50,000 and an equilibrium quantity below 500,000.

1.d. US SUVs

S2=S+30,000

P

S B ●

$65,000 C ●

$50,000

A ●

$35,000

D Q (1000s)

Q2 500 e. Consumers find out that the markup on SUVs is higher than on all other cars and demand that prices come down. In response, politicians install a price ceiling of $20,000 per SUV. In addition to showing what happens on the graph, explain the likely consequences of the price ceiling.

With a price ceiling, no curves shift. There is a decrease in the quantity supplied from point A to point B and an increase in the quantity demanded from point A to point C. The result is a shortage of US SUVs equal to the distance from B to C. Explain the likely consequences of the price ceiling: The chronic shortage of SUVs will lead to non-price rationing. We would expect to see long waits, black markets, side payments (bribes) and other efforts of SUV sellers to raise the price of an SUV.

2. The equilibrium price of eggs is $2 per unit (a dozen eggs is one unit), and the equilibrium quantity of eggs is 300 million units per day. The demand and supply of eggs are both inelastic (very, very steep). In order to help egg producers, the government is considering a $4 price floor or a $2 per unit subsidy. a. Draw a graph of the egg market in equilibrium based on the information above. Now show how the graph will be affected by a $4 Price Floor on Eggs. How will the price floor affect the total revenue (Total Revenue = Price * Quantity) of egg producers? How much will the price floor cost the government if they government buys the surplus?

Total Revenue for egg producers at equilibrium: $2*300million = $600 million.

1.e. US SUVs P

S

A ●

$35,000 $20,000

C ●

B ●

D QS

500

QD

Q (1000s)

Total Revenue for egg producers after the price floor: $4*350million=$1400 million Cost of the price floor to the government: Surplus * Price floor = 100 million * $4 = $400 million b.

Draw a graph of the egg market in equilibrium at a price of $2 and a quantity of 300 units. Now suppose that the government institutes a $2 per unit subsidy on eggs. How will the subsidy affect equilibrium price and quantity and the total revenue of egg producers? How much will the subsidy cost the government?

The $2 subsidy shifts the supply curve down by exactly the amount of the subsidy. This gives us a new equilibrium price of about $1 and a new equilibrium quantity of about 340 million (you need to pick your own numbers, estimating from the shape of the curves).

Total Revenue for Egg Producers after the Subsidy: (Price+Subsidy)*(New Quantity)=$3*340 million = $1020 million.

Cost of the subsidy to the government: ($2*340million)=$680 million. c.

Given your answers in parts a and b above, which policy should the government choose?

Explain briefly.

Comparing the two policies, the price floor costs the government much less and benefits producers more, so the better policy given the inelastic nature of the demand and supply curves is the price floor. (The goal is to help farmers at the lowest cost to the government.)

3. Suppose that the government imposed a $3 per pack excise tax on cigarettes. Using a graph, show how the cigarette market is affected by the $3 per pack excise tax. Discuss how the cigarette excise tax will affect consumers and producers, and how much revenue it will generate for the government. Also discuss how the excise tax will affect consumer surplus, producer surplus and deadweight loss, and evaluate if this policy is likely to be a good one given these impacts.

The supply curve shifts up by exactly $3. The equilibrium price increases from $2 to $4. (The equilibrium price was not given in the problem so students should pick one.)

Consumers: now pay $2 more per unit and they buy 8 million instead of 9 million packs of cigarettes.

Producers: now get $4 per pack minus $3 they pay to the government (excise tax) so they only get $1 per pack. This is $1 less than they used to get before the tax.

Thus, 2/3 of the tax is paid by consumers and 1/3 is paid by producers.

Government Revenue: $3 per pack * 8 million packs = $24 million. (Note: quantity was not given in the problem, so answers will vary.)

S

The graph shows the lost consumer surplus and the lost producer surplus.

Together, they make up the dead weight loss.

Even though the excise tax creates dead weight loss, the loss to consumers and producers will likely be more than made up by the improvement in public health from the reduction in cigarette smoking, so the policy is likely to be a good idea despite the dead weight loss.

D 4.

The city council of San Francisco wants to lower the price of housing to increase their tax base and revitalize the city economy. The supply of apartments is very inelastic and the demand for apartments is very elastic. The average price (monthly rent) of a typical apartment is $1600 per person, and 500,000 people rent apartments in San Francisco at this price. Using a graph, determine if the city council should use a price ceiling of $1200 or a $400 per apartment subsidy to lower rents and increase the number of city residents. Explain carefully which policy will most effectively lower rents and increase the number of city residents, how much each policy will cost the government, and how both policies affect the graph. Draw your graph as precisely as possible.

P (Rent/month)

S

S-400

1600 1450 1200

The price ceiling does not shift any curves. It D causes quantity demanded to decline from 500 (thousand) to (about) 590, and quantity supplied 500 510 490 Q (Thousands) to increase from 500 to about 510. This creates a 505 shortage. A price ceiling doesn’t cost the government money directly, however, the decline in the number of apartments rented will reduce the tax base, thereby reducing tax revenues slightly. This does not achieve the goal of increasing the number of city residents.

The subsidy shifts the supply curve down by exactly $400, resulting in a new equilibrium rent at about $1450 and a new equilibrium quantity of about 505 thousand apartments. The number of apartments does increase

slightly, which achieves the goal of the policy. However, the policy is expensive, costing $400*505,000=$202,000,000.

Your numbers may vary, since you must estimate the numbers on the graph.

5. Suppose that the price elasticity of demand for gasoline is –0.2 and the equilibrium price of gasoline is $4 per gallon. Now suppose that OPEC reduces the supply of gasoline such that the equilibrium quantity falls by 20% from 100 million gallons per day to 80 million gallons per day. What will happen to the price of a gallon of gasoline? ed = (%Qd)/(%P) -0.2= ed = (-20%)/(%P) %P=-20%/-0.2=100% A 20% decrease in quantity demanded will result in a 100% increase in price. So the price will double to $8 per gallon.

Another way to solve the problem:

=

6.

Large Colorado ski areas discover that the price elasticity of demand, ed, is very elastic (ed = -1.9) for in-state skiers and very inelastic (ed = -0.6) for out-of-state skiers. How can we explain the difference in price elasticities? What pricing policy should the ski areas pursue?

In-state skiers live close to many ski areas in Colorado. The large number of substitutes means an elastic demand curve: If one ski area is expensive, in-state skiers can go somewhere else. Prices must be kept low to lure in-state skiers.

Most out-of-state skiers come for one or two trips a year, flying in and staying at a resort near the ski area. Once they have invested a huge amount in flights and lodging, they will ski even if the price of a lift ticket is very high.

Thus, the have an inelastic demand curve. Ski areas should charge them high prices to maximize revenue.

The pricing solution is for ski areas to offer in-state skiers season passes and off-peak discounts, while charging outof-state skiers full prices.

7.

Suppose that the cross-price elasticity of demand for ski area lift tickets with respect to the price of ski lodging is -1. What should happen to the quantity of ski lift tickets demanded if the price of ski lodging increases by 20%? Explain your answer briefly and show your work.

There will be a 20% decrease in the quantity of ski lift tickets demanded when the price of ski lodging increases by 20%. Fewer people will visit ski areas due to the higher price of lodging, which also means fewer people will purchase lift tickets.

8. The income elasticity of the demand for designer clothes is 2.5. What will happen to the quantity of designer clothes demanded if the economy hits a recession and income (GDP) falls by 5%? Explain and show your work.

.

A 5% decrease in income will cause the demand for designer clothes to fall by 12.5%.

9. If the price of energy increases dramatically as we run out of fossil fuels, and this increases the price of storing and shipping goods significantly, what effect is like to happen to the price elasticity of supply curves? What impact will this have on the equilibrium prices and quantities of goods whose supply curves are impacted?

The major factors affecting the price elasticity of supply are (1) productive capacity and the availability of inputs, (2) the cost and availability of storage and shipping, and (3) the time frame. This has important implications for the price elasticity of many supply curves. First, if the cost of storing goods in warehouses increases, businesses will not want to keep as many goods in storage. This means if there is a large increase in consumer demand for a product, there may well be shortages. The supply curve becomes more inelastic in the short term because firms cannot increase the supply as easily when the prices of the goods they sell increase. Second, the higher cost of shipping means that the more goods shipped, the higher shipping costs will be. This also causes the supply curve to become steeper (more inelastic).

As supply curves for goods become more inelastic, shifting up and to the left and becoming steeper, we can expect the prices of goods and services to increase, and the equilibrium quantity sold to decrease.

Chapter 11, Consumer and Supplier Behavior Answers to Questions for review 1. Give an example of a Veblen Good that is different from the examples given in the book. Explain why this is considered to be a Veblen good.

With a Veblen Good, the quantity of the good demanded increases as the price increases because the scarcity and exclusivity associated with the good increase the display value and honorific character of the good. Luxury goods tend to be Veblen goods. For example, the exclusivity associated with Louis Vuitton purses has been shown to increase the demand as the bags become higher priced and more exclusive. Other examples could include Tesla cars, Rolex watches, etc.

2. How do the consumption habits on your campus or in your community relate to Veblen’s concept of pecuniary emulation and the concept of the bandwagon effect? Explain and give specific examples.

Answers will vary. Pecuniary emulation refers to peoples’ tendency to compare themselves to others. The bandwagon effect occurs when as more people have a particular good, more other people also want that good. Examples from recent years include Vineyard Vines shirts, Ugg boots, and any other item that is initially seen on a few people but then explodes such that large numbers of people are wearing the same or similar items.

3. In your household and other households you have observed, how does gender affect major decisions on purchases of goods and services? Explain and give examples.

In a typical heterosexual U.S. household, women usually make most of the decisions regarding furniture, home accessories, small appliances and cell phones while men make most of the decisions regarding power tools, lawn and garden care, and consumer electronics. Your answers will vary regarding the extent to which your household matches these patterns.

4. The results of the Ultimatum Game and the Haifa child care experiment demonstrate that most people value fairness and reciprocity in their dealings with each other. Looking at the transactions that you have been involved in or observed, do you see similar examples of fairness and reciprocity on display? Explain and given examples.

Answers will vary. In most financial transactions, people expect you to be fair and to follow norms and existing laws. If you pay for a good, you expect someone to deliver it to you in new

condition. If they violate that norm, you might call the police, sue, or write a negative review, demonstrating a belief in fairness. People do many things out of civic duty (voting, volunteering), and expect others to do the same, indicating a belief in reciprocity, fairness and the value of community. People do favors for friends without receiving compensation, but they likely expect similarly generous behavior from their friends, a reflection of norms, reciprocity and fairness.

5. Using your own behavior and the behavior of people close to you, find examples of anchoring, over-optimism, loss aversion, and status quo bias that are different from those given in the book. How widespread do these issues seem to be? Do they affect most human behavior most of the time, or are these rare examples? Explain, and support your answer.

Anchoring: when people rely too heavily on the first piece of information shared with them when making a decision. Example: Any retailer that shows a list price as well as a sale price to manipulate consumers into thinking they are getting a good price. Also, any good priced just less than a round number, such as $99 vs. $100, is playing on people’s cognitive bias where they will not think the product is as expensive when, for all practical purposes, the price is the same.

Over-optimism: when people tend to be overly optimistic. You might see examples about people being over-optimistic about how much time they need to study for a test, a sports result, how long it will take to get across town or catch a taxi, etc.

Loss aversion: people are reluctant to accept losses. When they gamble, after losing money they will often keep betting to try to get their money back, falling deeper and deeper into a hole. Or, they will refuse to sell a stock that has fallen below the price they paid, even if its prospects are poor.

Status quo bias: People oppose changing their minds and behaviors unless there is a very strong reason to do so. Examples include: Sticking with cable television even though streaming is much cheaper; keeping a home phone even though they have a cell phone; sticking with existing providers; etc.

Behavioral economists see such behaviors as extremely prevalent. Other economists see them as rare variations in otherwise rational behavior. Your answer will vary.

6. The table below shows information on labor and output for one week for a firm that manufactures the Slinky toy. The wage rate is $800 per week. a. Complete the table below.

L

Q

0 10 20 30

0 1000 3000 5400

MPL = ΔQ/ΔL 0 100 200 240

TVC = w×L

MC=ΔTVC/ΔQ

AVC=TVC/Q

$ ---$ 8,000 $ 16,000 $ 24,000

$ $ $ $

$ $ $ $

---8.00 4.00 3.33

---8.00 5.33 4.44

40 50 60 70 80 90

7400 9000 10200 11000 11400 11400

200 160 120 80 40 0

$ 32,000 $ 40,000 $ 48,000 $ 56,000 $ 64,000 $ 72,000

$ 4.00 $ 5.00 $ 6.67 $ 10.00 $ 20.00

$ $ $ $ $ $

4.32 4.44 4.71 5.09 5.61 6.32

b. Does this table display the law of specialization and the law of diminishing returns?

Explain briefly.

The marginal product of labor increases from L=0 to L=30, indicating increasing productivity due to specialization. After this, the marginal product of labor decreases, indicating the law of diminishing returns. This is also reflected in the fact that the marginal cost of a slink decreases at first, from L=0 to L=30, and then increases after that point. c. If the equilibrium price of a Slinky is $5, how many laborers should the firm hire and how many Slinkys should the firm produce?

A firm should produce each unit for which P≥MC. This means they should hire 50 laborers and produce a quantity of 9000 units of the slinky. d. If the equilibrium price of a Slinky increases to $10, how many laborers should the firm hire and how many Slinkys should the firm produce?

Comparing P and MC, the firm should hire 70 laborers to produce 11,000 slinkies. In mainstream economics, the profit maximizing level of output is found by producing every unit for which P≥MC. 7. Suppose that you work for a marketing firm and you are in charge of deciding how many laser printers to buy for your work team of 50 people. How would the laws of Specialization and Diminishing Returns apply to your purchases of additional laser printers? Explain.

At first, you would want to have printers dedicated (specialized) to particular work groups. This would reduce time waiting for printouts, time walking to the printer, etc. Once each work group has a printer, adding additional printers would increase productivity, but not by as much. This is when diminishing returns would set in. Productivity would likely continue to increase (by smaller and smaller amounts) until every worker has a printer, at which point adding additional printers would have no effect on output.

8. Why do economists include a normal profit in the costs of production?

In order to stay in business, a firm must cover all of its opportunity costs. This includes paying the owners a rate of return on their time and investment. The minimum amount a firm needs to stay in business is a normal profit of about 10% on their investment. If a firm earns less than that amount, the owners will shift their investment to a more profitable alternative, and the firm will close. Therefore, a normal profit is just another cost of production which must be covered for the firm to survive.

9. Explain how the firm’s supply curve is derived from the Marginal Cost Curve and the Average Variable Cost Curve.

The firm’s supply curve is the portion of the Marginal Cost Curve above where MC intersects the Average Variable Cost Curve, AVC. Below the AVC curve, the firm would lose so much money it would such down, so there would be no supply at all. Above the AVC curve, the firm determines how many units to supply by comparing the revenue per unit to the cost per unit (MC). Therefore, we determine how many units are supplied at each price based on the MC curve.

10. Compare and contrast the mainstream economics view of supply decisions with the views of political and behavioral economists. In your response, explain what types of questions each approach is trying to answer.

Mainstream economists view supply decisions as a rational, mechanical act in which suppliers compare price and marginal cost to determine what quantity to supply.

Political economists and behavioral economists find that supply decisions are determined by other factors. For example, many firms engage in satisficing, where they make prudent decisions using rules of thumb given limited information. They use average cost, add a markup, and produce based on what they sold during the last time period. Furthermore, managing a firm involves dealing with all of the complexities that occur when dealing with workers, consumers, suppliers, and other human relationships. None of this is certain or mechanical. Firms also pay attention to long-term, strategic interests such as competing for profits, innovating, and establishing monopoly power, and they pay more attention to these things than they do comparing marginal revenue and marginal cost.

In general, the supply and demand model of mainstream economics focuses on how short term prices tend to stabilize around an equilibrium price and quantity. The supply and demand model is particularly useful for analyzing how a variety of key determinants affect equilibrium prices and quantities in the short term. The political economy approach is useful in studying the factors that cause industries to evolve and change, such as the forces of creative destruction and monopolization, and the power relations within particular industries. Political economy and behavioral economics are useful in determining how economic actors actually make decisions when facing the complexities of the real world. Note that one can find all of these tendencies in most markets. The key is to determine which tendency is most useful for particular types of analysis.

11. Why do political economists believe that power is a key element of supply decisions? Explain, and give specific examples.

Markets feature numerous power imbalances that affect economic behavior, including supply decisions. Large corporations have the power to raise prices and gobble up competitors (Facebook’s purchase of Instagram; Google’s purchase of What’s App), to exploit workers (sweatshops abroad) and extract government subsidies (Boeing’s $8.7 billion subsidy), and so on. Consumers, unions, communities and the government can establish the (countervailing) power to reign in corporate behavior if they are united. Consumers have demanded product labeling. Unions have successfully fought for higher wages and safer working conditions. New York City recently refused to open an Amazon facility due to concerns about the impact on the community. And the government of California imposed strict mileage requirements on carmakers to reduce greenhouse gas emissions and smog.

Chapter 12, Different types of market structures, by Geoffrey Schneider Answers to Questions for review 1. Suppose that you are a corn farmer and the market price of corn is $5 per bushel. Explain why you should also charge $5 per bushel of corn rather than a higher or lower price.

You can sell your entire crop at $5 per bush, so there is no reason to lower your price. If you raise your price any amount over $5, buyers will get their corn from one of the thousands of competitors. So, you have no choice but to charge the market price of $5 per bushel.

2. If firms in an industry with easy entry and exit are earning an economic profit, what can we expect to happen in the long run to the number of firms in the industry? If firms in an industry with barriers to entry are earning an economic profit, what can we expect to happen in the long run to the number of firms in the industry? Explain and give examples.

If firms in a competitive market—one that is easy to enter and exit—are earning an economic profit, we expect new firms to enter the market in the long run. This will compete away the economic profits and firms will be left earning a normal profit. This occurred in the Quinoa market. When demand for Quinoa exploded in 2014, farmers made an economic profit. But as more farmers began growing Quinoa due to the economic profits, prices fell 40% in 2015.

Similarly, in the monopolistically competitive restaurant industry, changes in customer tastes towards healthier, higher quality food that was still provided quickly led to the rise of fast-casual restaurants such as Chipotle and Starbucks. This took customers away from casual chains and fast food outlets. However, the high profits in the fast-casual sector is leading to many more new companies entering the market, and fast food places like McDonald’s are imitating the fast casual firms to recapture customers. Economists expect the fast-casual sector to return to earning a normal profit in the long run.

In markets with barriers to entry—oligopolies and monopolies—there is no reason to expect new firms to be able to enter in the long run. Barriers to entry keep out new competitors. For example, Coca-Cola and Pepsi in the oligopolistic soft drink market paid retailers to exclude competitors’ products. Microsoft, a near-monopolist in the PC computer operating systems market in the 1990s, used its market power to punish firms that used other operating systems and designed the Windows operating system so that programs written by other companies would not work well with Windows. In both cases, firms use their market power and financial resources to prevent other firms from entering the market and from competing.

3. Explain why a firm earning a 5% profit might end up going out of business using the concept of a normal profit.

Firms must earn a normal rate of profit, usually about 11%, to survive. If a firm is only earning a 5% profit, its owners / shareholders will sell their stake in the company so they can invest in a venture earning the normal rate of profit. This will cause the company to become worth so little that eventually it will be sold off for the value of its assets and cease to exist, going out of business.

4. Why are local hair salons considered to be a monopolistically competitive industry? If hair salons in your town were doing extremely well and earning an economic profit, what would you expect to happen to the industry in the long run?

Hair salons have a monopoly on certain unique business characteristics—the skill of the stylists and the location. But the market is very competitive, with large numbers of salons in every town.

If salons are earning an economic profit, the fact that the market is easy to enter means that new hair salons will open to take advantage of the above-normal profits. This will eventually cause existing firms to lose business, and the industry will return to earning a normal profit in the long run.

5. Why do we tend to see the most collusion in Oligopolistic industries with fewer than 4 main competitors?

In industries with large numbers of competitors, collusion almost never works because some firm will eventually cheat on any collusive arrangement to make a quick windfall profit. Once the number of competitors drops to 2 or 3 it is much easier to coordinate activity. With that few competitors, profits are so great from collusion that firms are unlikely to cheat and thereby ruin the monopoly profits they are earning from collusion.

6. How do economies of scale influence the amount of competition in an industry? Explain.

In an industry with significant economies of scale, only big firms can compete, so there will be less competition. In fact, in the case of a natural monopoly, the economies of scale are so significant that one firm will dominate the industry. However, when few economies of scale exist, we can see many small firms and much competition in an industry. Diseconomies of scale in an industry would make it inefficient to be large, which would then lead to small, competitive firms. Constant returns to scale would result in both small and large firms in the same industry.

7.

Would Microsoft Windows be considered a natural monopoly? Why or why not?

This issue is complex. It may be more efficient (lower long run average total cost) to have only one company producing a computer operating system. But, the lack of competition would stifle innovation and would allow the dominant player to make economic profits even it its costs were high. In software industries, we may see flat long run average total cost curves, which would allow for multiple competitors of different sizes, which would not be a natural monopoly.

8. Why does the government regulate monopolies even if they are natural monopolies?

In the case of natural monopolies, it is more efficient to have one firm because average total costs decline as the firm produces a larger quantity. However, that does not mean the firm will produce efficiently or innovate. Therefore, we need to regulate natural monopolies to give them appropriate, market-like incentives. This usually means establishing a price ceiling to limit price gouging, and freezing that price ceiling in place for a long enough period of time, perhaps 10 years, to encourage the firm to innovate and reduce costs.

9. Which of the 8 characteristics of markets laid out in Figure 12.1 is most important in determining market structure? Explain and support your answer.

Answers will vary. Economists tend to focus on barrier to entry, which determines the number of competitors possible in an industry, and product differentiation, which determines the type of competition we tend to see in a market (price vs. non-price competition.

10. Identify which market structure best characterizes each of the markets below. Explain your answer. a. (5) Internet search engines.

Monopoly (or near-Monopoly): Google controls almost all of the market, and the other competitors, Bing and Baidu, are very small. There are huge barriers to entry and no significant product differentiation or competition. b. (5) Local banking.

Monopolistic competition: there are many competitors, relatively easy entry into the market, and some product differentiation (mainly location). c. (5) Driveway snow shoveling.

Perfect competition: easy to enter (all you need is a shovel), lots of competitors, undifferentiated product (a shoveled driveway). d. (5) Online bookstores.

Oligopolistic: Dominated by Amazon (64% of sales) with a few other big players like Barnes and Noble. Huge barriers to entry (economies of scale). Some substantial product differentiation.

11. Identify which market structure best characterizes each of the markets below. Explain your answer. a. T-shirts.

Monopolistic competition: some differences in quality and branding, but many, many competitors and easy entry into the market. b. Athletic shoes (for field hockey, basketball, tennis, soccer, running, etc.)

Oligopoly: a few large firms, such as Nike, Adidas and Puma, dominate due to economies of scale and brand name recognition. c. Dog walking.

Perfect competition: Product is homogeneous as far as the customer is concerned (the dog is getting a walk), and the market is very, very easy to enter. d. Cable television.

Monopoly: Only one firm is allowed to offer cable television in almost all towns because it is a natural monopoly—it is more efficient to have only one cable going to every household.

12. Use the data provided in this chapter to compute a Herfindahl Index for the four largest soft drinks companies and the four largest car companies. What does this information tell us about these two industries? Explain briefly.

In the soft drink industry, market share are Coca-Cola 46.3%, Pepsi 25.6%, Dr. Pepper/Snapple 21.7%, and Cott/RC 2.1%. This gives us a Herfindahl Index of 46.32+25.62+21.72+2.12=3,326.55 For cars, the market shares are Volkswagen (12.4%), Toyota (11.7%), Ford (6.9%) and General Motors (6.8%). His would give us a Herfindahl Index of 12.42+11.72+6.92+6.82=384.5 This tells us that the soft drink industry is much more heavily concentrated than the car industry.

While the concentration in soft drinks is not as high as some industries, such as search engines, it is high enough that the government should monitor behavior and consider anti-trust action against Coca-Cola and Pepsi. The car industry is quite competitive by comparison and has no dominant player. No anti-trust action is necessary in the car industry.

Chapter 13 Theories of Firm Behavior, and short-run and long-run costs,

By Geoffrey Schneider Answers to Questions for Review 1. Do you think the laws of specialization and of diminishing returns apply to a University’s hiring of professors? What are professors “producing”? Will the productivity of each professor improve as they are able to specialize? Will it decline eventually as more professors are hired? Explain carefully.

Professors “produce” research and learning in students. There is certain some benefit from specialization. A group of professors who teaches all social sciences is likely to be less productive in research and teaching than a team of professors specializing in all of the different social sciences (psychology, economics, political science, sociology, etc.). The specialized professors will know their specialized discipline better, making them more effective at teaching and research in their area. As more professors are hired, keeping the student body and the size of the university the same, there will definitely be diminishing returns. Eventually, once every classroom, lab and office is filled and all major subjects covered, adding additional professors beyond this point will have a negligible impact on student learning, and the lack of research facilities will mean that research productivity will also decline.

2. What would it mean if a firm’s Marginal Cost curve is always decreasing? What would it mean if a firm’s Marginal Cost curve is always increasing? Explain carefully.

If Marginal Cost (MC) is always decreasing, then the law of specialization always applies to that firm: It is always more efficient to get bigger. Diminishing returns never set in. The bigger the firm is, the lower its costs per unit will be.

If the MC curve is always increasing, there are no benefits from specialization, and diminishing returns set in immediately. The bigger the firm is, the higher its costs per unit will be.

3. Why does the Average Total Cost curve get closer and closer to the Average Variable Cost curve as quantity (Q) increases?

ATC=AFC+AVC. Therefore, AFC=ATC-AVC. The difference between ATC and AVC is AFC. AFC= . TFC is fixed and does not change. Therefore, AFC decreases as Q increases.

This means that the difference between ATC and AVC decreases as Q increases. This also means that the ATC curve gets closer and closer to the AVC curve as quantity increases.

4. Why does the Marginal Cost curve always intersect the Average Total Cost curve at its minimum point?

When MC<ATC, ATC falls. When each additional unit costs less than the average, the average falls. MC falls quickly at first due to specialization, but it starts to increase after diminishing returns set in. Eventually, as MC increases, MC intersects the ATC. After that, each additional unit has a marginal cost more than the average total cost, causing ATC to increase. This means that for the first part of the graph, MC<ATC and ATC falls. Then MC=ATC. After that, ATC rises. Therefore, MC must hit ATC at its minimum point, since ATC is higher at lower and higher quantities.

5. Explain why economists include a “normal profit” as a normal cost of doing business.

Normal profit is the rate of profit that occurs when the owners can cover the opportunity cost of running a business. The businesses’ owners could invest their money in another business venture if the business they were running became unprofitable. Given that most businesses in the U.S. economy earn an 11% profit, any business the earns less than an 11% profit will see likely close as its owners sell their share of the business so they can earn higher profits elsewhere. This means that a business must earn at least an 11% profit to stay in business, and that this is a cost that must be considered in determining if the business is earning enough to survive.

6. Complete the table and then answer the questions afterward.

Q TFC TVC MC AVC AFC TC ATC ----0 42 0 -------42 ---1 42 10 10 10 42 52 52 2 42 18 8 9 21 60 30 3 42 24 6 8 14 66 22 4 42 32 8 8 10.5 74 18.5 5 42 42 10 8.4 8.4 84 16.8 6 42 54 12 9 7 96 16 7 42 70 16 10 6 112 16 8 42 92 22 11.5 5.25 134 16.75 a) Does the table display the laws of specialization and diminishing returns? Why or why not?

Yes. The marginal cost column declines from 10 to 6 and quantity increase from 1 to 3, indicating that specialization is improving efficiency and productivity. After that, MC increase as Q increases, indicating that each unit is getting more and more expensive to produce due to the declines in productivity that accompany diminishing returns.

b) Using the table, explain the relationship between MC and AVC, MC and ATC, and AVC and ATC.

When MC<AVC, from Q=1 to Q=3, AVC falls. MC=AVC=8 at Q=4. After that, MC>AVC and AVC rises as Q increases. This reflects the fundamental principle that when each additional unit costs less than the average, the average falls, and when each additional unit costs more than the average, the average rises. We see a similar pattern with MC and ATC. When MC<ATC, from Q=1 to Q=6, ATC falls. At Q=7, MC=ATC. After Q=7, MC>ATC and ATC rises as Q increases.

The difference between AVC and ATC is AFC: AFC=ATC-AVC. AFC= . TFC=42, so AFC decreases as Q increases. This means that the difference between AVC and ATC decreases as Q increases. c) Using the mainstream model of profit maximization, what is the profit maximizing level of output if the market price is fixed at $12? How much economic profit or loss would the firm make if the price is $12?

Q=6 (Where P=MC=12). TR=12*6=$72 TC at Q=6 is $96. Economic profit/loss = TR-TC=$72$96=$-24. The firm would earn an economic loss of $24. d) What would happen if the market price increased to $16? How much economic profit or loss would the firm make?

Q=7. TR=7*16=$112. TC=112. TR-TC=112-112=$0. The business experiences a normal profit because TR=TC. e) What would happen if the market price increased to $20? How much economic profit or loss would the firm make?

Q=7. TR=$140. TC=$112. TR-TC=$28. The firm earns an economic profit of $28. f)

Should the firm shut down in the short run if the price falls to $6? Why or why not?

The firm should shut down in the short run if the price falls below the minimum AVC, which is $8, where they would lose their fixed costs if they stayed open. The firm should shut down if the price falls to $6, because they would lost more than their fixed costs.

7. What would the Long Run Average Total Cost curve look like in an industry in which there were no economies of scale and no diseconomies of scale?

The LRATC curve would be a straight line, never increasing or decreasing. Constant Returns to Scale would exist.

8. Farming is an industry that contains both very small and very large farms. Explain why this might is the case using the concepts of economies of scale and diseconomies of scale.

This means that small firms have the same costs as large firms, so both can complete and survive in the market. This means that there is a section of Constant Returns to Scale on the LRATC curve, such as the one depicted in Figure 13.12 (b).

9. Compare and contrast the Political Economy theory of the firm with the Mainstream Economics theory of the firm. Where are the similar? What are the major differences?

In mainstream economics, the firm’s goal is short run and long run profit maximization, which the firm achieves by comparing marginal revenue and marginal cost and selecting the optimal size of operations. In the political economy theory of the firm, the firm’s primary goals are survival, growth and profit maximization, and those goals are achieved by determining quantities and setting prices based on markup pricing and the firm’s strategic focus on surviving difficult economic conditions, gaining market share, or securing profits from monopoly power.

Firms with monopoly power can establish a markup greater than the normal rate of profit.

Firms in competitive markets set a markup equal to the normal rate of profit, operating like the mainstream model predicts. But firms that are trying to gain market share may set their markup below the normal profit rate to gain an advantage over competitors (a strategy used by Wal-Mart, Amazon).

Mainstream economists construct models of cost curves and focus on optimizing behavior where firms produce as long as Marginal Revenue is greater than or equal to Marginal Cost. Political economists see firms as engaging in satisficing behavior, making prudent decisions using rules of thumb given limited information.

Mainstream economists tend to see most markets as competitive, while political economists see many markets having some degree of monopoly power.

10. Why do political economists argue the firms engage in satisficing behavior rather than optimizing behavior? Explain and give examples.

Satisficing is when firms make prudent decisions using rules of thumb given limited information, rather than engaging in optimizing behavior by comparing MC and MR. Research on firm behavior indicates that firms rarely change prices (they charge what they used to in the past), and they rarely have data on their marginal costs and marginal revenues. Instead, they develop a pricing strategy, which is usually (a) markup pricing, (b) competition-based pricing, or (c) customer-based pricing. This determines how much they produce, and the price for which they sell their goods.

Chapter 14 Perfect Competition, By Geoffrey Schneider Answers to Questions for Review 1. Given the assumptions and characteristics of the mainstream model of perfect competition, how important and useful do you think it is for understanding the functioning of modern economies?

Explain, and support your answer using examples.

The characteristics of perfect competition are: homogeneous product, easy entry and exit, large number of buyers and sellers, and firms are price takers. Only a small number of markets fit this set of assumptions, most importantly, agriculture markets. Therefore, it is not a particularly helpful market structure in terms of the actual economy. The assumptions behind the model include perfect information, equal access to resources and technology, optimal decision making, specialization and diminishing returns, and u-shaped long run cost curves due to economies and diseconomies of scale. These assumptions are not necessarily realistic when it comes to actual firm behaviors. However, many mainstream economists find it to be a useful depiction of the ideal market structure, which can be used for comparison with other market structures.

2. Why is the demand curve for a perfectly competitive firm in the wheat market flat whereas the demand curve for a large firm with market power like Coca-Cola is downward-sloping? Explain.

In perfect competition, each firm is so small they cannot affect the market price. As far as the firm is concerned the market prices is fixed and out of its control. The firm’s demand curve is a flat line at the market price. No matter how much the firm supplies, it will have no effect on the market price.

Coca-Cola is the largest firm in the soft drink industry. If they increase supply, they will flood the market and that will cause the price of soda to fall. They can also use brand name recognition to raise their prices. Therefore, the downward-sloping nature of Coca-Cola’s demand curve has to do with their size and degree of monopoly power. In general, firms with monopoly power face downward sloping demand curves. Firms in perfectly competitive markets face flat demand curves.

3. Why should a firm shut down in the short run if the market price falls below the firm’s minimum Average Variable Cost? Explain carefully.

When P=AVC, the firm just barely covers its variable costs and loses its fixed costs. If the price falls any lower, the firm loses even more money, in an amount greater than its fixed costs. If a firm shuts down, it only loses its fixed costs. Therefore, whenever P<AVC, a firm should shut down.

4. A firm in a perfectly competitive market will earn an economic profit whenever (select the correct answer below and explain your answer): a. P > AVC. b. P = ATC. c. P > ATC. d. P < ATC.

When P=ATC, the firm covers all of its costs, including its opportunity costs, thereby earning a normal profit. When P>ATC, the firm earns an above normal profit, which is the definition of an economic profit.

5. Complete the table and answer the following questions.

Q

P=MR

TR

TC

ATC

MC

Economi c Profit

0

15

0

5

-----

-----

-5

1

15

15

15

15

10

0

2

15

30

23

11.5

8

7

3

15

45

33

11

10

12

4

15

60

45

11.25

12

15

5

15

75

60

12

15

15

6

15

90

84

14

24

6

(a) What amount is Total Fixed Cost in this example?

TFC=$5. TC when Q=0 is equal to TFC. (b) What is the profit maximizing level of output in the short run

Q=5 is the profit maximizing level of output, where P=MC=15 (c) What is the amount of economic profit or loss the firm will earn at the profit maximizing level of output?

At Q=5, TR-TC=Economic Profit=$15.

6. Groundworks Farm operates in the perfectly competitive market for 6.(a) Groundworks Farm Experiencing an Economic Loss P ($) Kale.

AFC=distance from a to b (a) In 2010, Groundworks Farm sold MC 20,000 bunches of Kale for a price of $2 per bunch, while incurring Average Total Costs of $3 per bunch and Average Variable Costs of $1 ATC per bunch. Show this situation a graph that includes ATC, AVC, MC, ●a 3● AVC and D curves and all relevant Economic Loss numbers. On your graph, show each D=P=MR ● AFC 2● of the following as precisely as ●b TR 1● possible: (1) economic profit or loss, (2) Average Fixed Cost (AFC), (3) AVC Average Variable Cost (AVC) and (4) ● Total Revenue (TR).

Q (1000s) 20 (b) In 2016, after Kale had been labeled a “super food,” the price of Kale shot up to $5 per bunch. Draw a new graph of Groundworks Farm using the new market price of $5. Include ATC, AVC, MC, and D curves. Select appropriate numbers for ATC, AVC and Q based on the numbers in part (a) above. Next to your graph of Groundworks Farm draw a graph of the Kale market. Show what will happen to both graphs in the long run, select appropriate new numbers, and explain your answer briefly in words. Assume LRMC=MC, 6. (b) Groundworks earning an economic profit $

P

(a) Groundworks Farm

(b) Kale Market

S1

LRMC a ●

5 Economic Profit 3.30 2.90

c ●

b ●

D2 LRATC D1

A ● S2,LR B ●

D1

30 22 Q (100s of bushels per year)

Q2 Q1 Q (billions of bushels per year)

LRATC=ATC, and that Groundworks is a typical Kale farmer.

At P=$5, Groundworks earns an economic profit. This causes new firms to enter the kale market in the long run, increasing the market supply and decreasing the market price until the remaining firms earn a normal profit. This occurs at the minimum point on the LRATC curve, which should be about $2.90 given previous numbers. Note that in the graph in part (a), $3 is above the minimum ATC and 20,000 is to the left of the minimum ATC. So the minimum ATC must occur at a number just below $3 and just above a Quantity of 20,000.

7. Complete the table and answer the following questions. (a) What is the profit maximizing level of output?

Where P=MC=20, at Q=1000. (b) What is the firm’s economic profit or loss at the profit maximizing level of output?

At Q=1000, TR=20,000, TC=22,300, so TR-TC=-$2300. The firm experiences an economic loss of $2300. (c) If we assume that this firm is typical of firms in the industry and that this firm’s short run costs are the same as its long run costs, what can we expect to happen in the long run? What price will end up being the market equilibrium price in the long run? Explain.

In the long run, we can expect the losses to cause firms to exit the market. This will decrease the market supply and increase the market price until remaining firms earn a normal profit. Normal profit occurs at the minimum ATC, which is $22.30 in the ATC column. Thus, we can expect the market equilibrium price to increase to $22.30.

Q TC TVC MC ATC AVC P TR 0 $ 10,000 100 11,000 200 11,800 300 12,500 400 13,300 500 14,300 600 15,500 700 16,900 800 18,500 900 20,300 1,000 22,300 1,100 24,600 1,200 27,200 1,300 30,200 1,400 33,700 1,500 37,900 Figure 14.12 Answer

0 1000 1800 2500 3300 4300 5500 6900 8500 10300 12300 14600 17200 20200 23700 27900

$ 10 8 7 8 10 12 14 16 18 20 23 26 30 35 42

110.0 59.0 41.7 33.3 28.6 25.8 24.1 23.1 22.6 22.3 22.4 22.7 23.2 24.1 25.3

10.0 9.0 8.3 8.3 8.6 9.2 9.9 10.6 11.4 12.3 13.3 14.3 15.5 16.9 18.6

20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

$0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 $16,000 $18,000 $20,000 $22,000 $24,000 $26,000 $28,000 $30,000

8. Contrast the political economy analysis of competitive markets with the mainstream economics analysis of competitive markets. Which perspective do you think best captures the dynamics of a competitive market such as agriculture?

Answers will vary. First, political economists see power as an essential characteristic of all markets, even perfect competition. Huge conglomerates control seeds, fertilizer, meat processing and distribution, and even farms themselves. As Marx predicted, the government tends to side with the huge firms, including industrial farms rather than small, family farms. Agricultural workers, usually immigrants from countries with a huge reserve army of surplus labor, are desperate and have few rights, so they end up working at very low wages in unsafe conditions.

Firms are not just “price takers.” Firms in competitive markets engage in continuous attempts to displace rivals and fend off competition. This can involve aggressive (cut-throat) pricing, innovation, and cost-cutting, and it often leads to a race to the bottom, where firms ignore the environment and working conditions, slashing wages and benefits, and moving operations to where production is the cheapest. Other firms must follow suit or they will be driven out of business. Competitive markets are turbulent, destructive and fundamentally unstable, as evidenced by the decline of small, family farms in recent years. Once the most successful firms grow large in size, they try to preserve markups via collusion, lobbying, patenting, research and development efforts, and other forms of activities to reduce competition. There is usually considerable variation of profit rates within a particular industry, with differences especially significant between highly profitable large firms and barely profitable small firms.

Regarding whether the perfect competition model is better than the political economy approach, a good answer might highlight the potential usefulness of both models. The mainstream model captures some of the important general tendencies in competitive markets. The political economy model is particularly good at analyzing when markets depart from the traditional mainstream model.

Chapter 15: Monopoly Answers to Questions for review 1.

What are the key differences between the characteristics of a Monopoly industry and the characteristics of a Perfectly Competitive industry? Explain briefly.

Monopoly has one seller; perfect competition has many sellers.

Monopolies sell a unique product unlike any others; perfectly competitive firms sell a homogeneous product that is identical to that produced by many other firms.

Monopolies have prohibitive barriers to entry, so they face little threat of entry and competition and can earn economic profits in the long run; perfectly competitive markets feature easy entry and can only earn a normal profit in the long run because of this.

Monopolies have complete control over prices; perfectly competitive firms have no control over prices.

2.

Explain the relationship between the demand curve and the marginal revenue curve. Why does a monopolistic firm use marginal revenue instead of price when determining the profit maximizing level of output?

There are two forces at work on firms that face a downward-sloping demand curve: Lowering their price brings in more money from selling additional units of output (Q), but lowering prices reduces the amount of marginal revenue the firm gets on each unit it sells. The more the firm lowers prices the less marginal revenue they get for each unit. When Q=1, P=MR. After that, P>MR and the MR curve is twice as steep as the D curve. Since MR tells the firm how much revenue actually changes with each unit they sell, it is more useful than price in determining the profit maximizing level of output. Therefore, monopolists produce as long as MR≥MC. 3.

What will happen in the long run to a Monopolist that is earning an economic profit?

Barriers to entry mean that a monopolist can continue to earn an economic profit in the long run, and they will continue to do so unless the government intervenes, or there is some fundamental shift in the nature of the market.

4.

The table shows cost and revenue data for Citizens’ Electric Co., a Monopoly which sells power in the Lewisburg, PA area. Q is in millions of kilowatt hours per day. a. Complete the table.

Q TC MC ATC P TR MR 0 $90 $-$--- $78 $0 $-1 140 50 140 73 73 73 2 180 40 90 68 136 63 3 210 30 70 63 189 53 4 232 22 58 58 232 43 5 250 18 50 53 265 33 Q* 6 264 14 44 48 288 23 7 282 18 40.3 43 301 13 P=ATC 8 304 22 38 38 304 3 9 328 24 36.4 33 297 -7 P=MC 10 356 28 35.6 28 280 -17 11 391.6 35.6 35.6 23 253 -27 12 444 52.4 37 18 216 -37 Figure 15.12 Answer b. Based on the table, is Citizens’ Electric a natural monopoly? Why or why not?

It is a natural monopoly, because the ATC column declines over the entire market as Q increases. The bigger the firm, the more efficient it becomes, which is the definition of a natural monopoly. c.

Determine the profit maximizing level of output. What is the firm’s economic profit or loss at that level of output?

The profit maximizing level of output is Q*=6, because the firm produces every unit for which MR≥MC. At that quantity, TR=288, TC=264, so economic profit is TR-TC = 288-264 = $24 d.

What Price and Quantity would result if government regulators imposed average total cost pricing?

P=ATC=$38 at Q=8. (Note that P=ATC=$58 at Q=4, but the goal is to lower prices and increase quantity sold to help consumers, so this would not be an appropriate option.) e.

What Price and Quantity would result if government regulators imposed marginal cost pricing?

P=MC=$28 at Q=10. f.

What would happen if government regulators installed a profits tax?

The firm would produce the profit maximizing level of output (Q=6), but the government would tax away the economic profits of $24, leaving the firm with an economic profit of $0 (a normal profit). g.

What is the best way to regulate this monopoly? Support your argument carefully.

Answers may vary. Electricity is not a good that generates positive externalities, so marginal cost pricing would be in appropriate. Utilizing anti-trust laws would not be appropriate because this is a natural monopoly. If you believe the production of electricity is harmful to society, perhaps because of pollution and its contribution to global climate change, you could argue that a profits tax would be the most appropriate policy, with the revenue from the tax used to clean up the environment. If you wanted to keep electricity inexpensive for consumers and businesses, then average total cost pricing would be appropriate.

5.

Use Excel or another spreadsheet program to construct a graph that plots out Demand, Marginal Revenue, Average Total Cost and Marginal Cost curves based on the table in question 4 above (Figure 15.12). Show the firm’s profit maximizing level of output, and the price and quantity that would result from Average Total Cost pricing, Marginal Cost pricing, and a Profits Tax.

Profit maximization occurs at point a at Q=6, P=48. This is also the price and quantity associated with the profits tax. Average Total Cost pricing occurs at point b where D intersects ATC at Q=8 and P=ATC=38.

Marginal Cost pricing occurs at point c where D intersects MC at Q=10 and P=MC=28.

6.

The table below is cost and revenue information for a day of trash pickup and disposal by the Lewisburg Trash Company (LTC).

Q TC ATC MC P TR MR a. Complete the table.

0 $16,000 ------ $180 $ 0 ----100 23,000 160 $230.00 70 16,000 160 b. Based on the data, if LTC wishes to 200 29,000 140 145.00 60 28,000 120 maximize profits, what price should they 300 34,000 120 113.33 50 36,000 80 charge and what quantity should they 400 38,000 100 95.00 40 40,000 40 produce?

500 40,000 80 80.00 20 40,000 0 600 41,000 60 68.33 10 36,000 -40 Produce as long as MR≥MC. The profit maximizing 700 41,500 40 59.29 5 28,000 -80 quantity is Q*=400, and the price they will charge 800 43,500 20 54.38 20 16,000 -120 is P*=$100.

900 48,000 0 53.33 45 0 -160 Figure 15.13 Answer c. What are the maximum economic profits per day for LTC? At Q*=400, TR=40,000. TC=$38,000. Economic Profit=TR-TC=$2000

d. If the government decided to regulate the price of trash pickup and disposal to ensure that more businesses and consumers would have access to it, what price and quantity would result under Average Total Cost Pricing and Marginal Cost Pricing?

For average cost pricing, P=ATC=$80 at Q=500.

For marginal cost pricing, P=MC=$20 at Q=800. e. The government is considering 3 options to regulate trash pickup and disposal: (1) Average Cost Pricing, (2) Marginal Cost Pricing, and (3) using antitrust laws to break up LTC so that there is more competition.

Compare these options, and explain which option you think is best and why.

(1) Average cost pricing lowers prices for consumers, getting them a fair price without requiring a subsidy from the government. Firms earn a normal profit. This is a good option.

(2) Marginal Cost pricing lowers the price to consumers even further, to $20, but it requires a subsidy of $27,500 to keep LTC in business. This would only be a good option if trash removal has external benefits. Many people argue that it does, beautifying the town and raising property values, so Marginal Cost Pricing is also a good option.

(3) ATC continually falls as Q increases so this is a natural monopoly where the bigger the firm is the lower their costs are. Using anti-trust laws to break the company into smaller firms is therefore not appropriate as it would lead to higher prices.

You can argue for either Average Cost Pricing or Marginal Cost Pricing, depending on whether or not you think there are significant positive external benefits to trash collection.

7.

What incentive problems are created by guaranteeing a monopolist a normal profit? How can those incentive problems be addressed by regulators?

Once price ceilings are installed, firms have an incentive to lie about their costs, and they have less of an incentive to produce efficiently and provide adequate service. Under average total cost pricing, firms are guaranteed a normal profit, even if their costs increase. So firms could pad their costs or produce inefficiently, and they would still make the same profit. Meanwhile, the guarantee of a normal profit would mean that no matter how bad their service became, they would still make the same amount of money. To circumvent this problem, regulators can fix the price ceiling place for long periods of time (such as 5-10 years). Then if the monopolist’s costs increase, they lose money but cannot raise prices. But if the monopolist lower costs, they can earn an economic profit for a short period of time, after which regulators would lower the price ceiling.

8.

Determine which of the following monopolistic industries would be best suited for marginal cost pricing instead of average cost pricing -- sewage, postal service, public transportation, and vaccinations. Explain your answer.

Marginal cost pricing is most suitable when substantial positive externalities exist, so that it is worth the government subsidy that is required with marginal cost pricing. All of these industries generate some positive externalities. Sewage treatment improves public health and property values. Postal service improves the efficiency of the economy and reduces transportation costs. Public transportation reduces traffic congestions and pollution and allows people to get to work more quickly than they could otherwise. Vaccinations benefit employers and society by improving health and productivity, and the community members who are less likely to get sick. The question you must decide, therefore, is which of these goods generates the most external benefits. Any answer could be correct.

9.

Do you think the government should regulate Google given its near-monopoly on search engines described above? Why or why not? Support your argument.

Some laissez-faire economists argue that Google has to provide quality search results or users would switch to other search engines, so Google’s market dominance isn’t a problem. Also, they argue that technology firms rarely stay dominant forever.

Other economists who are more concerned with Monopoly argue that there are incredibly high barriers to entry in this market. Consumers are so used to searching with Google that Google can degrade its search results selectively without fearing that users will switch. Google’s purchases of other apps and companies, and the extension of its dominance into Gmail and cloud computing (Google Docs), imply that Google is leveraging its market dominance in search engines to expand and dominate other software sectors, just as Microsoft did when it controlled Windows.

From this perspective, only a strong antitrust action to preserve competition will ensure that consumers are protected and that innovations continue in the software market.

10. Why do you think many countries and municipalities use state-owned enterprises to supply goods and services in industries that are natural monopolies? Why might a state-owned enterprise be more efficient than a private sector monopoly?

Privately owned industries have a goal of maximizing profits. In natural monopolies, this can lead to inefficient and destructive behavior, where firms neglect quality, charge high prices, or try to manipulate data given to government regulators. A state-owned enterprise can operate with the goal of serving the public interest, trying to provide the best service for the lowest possible price. In countries with a tradition of good governance, stateowned enterprises are often very efficient and provide quality. In countries without an effective government, state-owned enterprises can be very inefficient and provide poor quality.

Chapter 16 Monopolistic Competition, by Geoffrey Schneider Answers to Questions for Review 1. How does monopolistic competition differ from perfect competition? How does monopolistic competition differ from monopoly?

Monopolistic competition is similar to perfect competition with one major exception: Perfectly competitive firms produce identical, homogenous products while monopolistically competitive firms’ products are differentiated in some way, such as quality, location, or branding. This means that monopolistically competitive firms can charge different prices. Nonetheless, the market is easy to enter.

Monopolies have no close substitutes, and have control over their prices. Monopolistically competitive firms have a monopoly on some aspect of a product (location, quality, brand), but there are many close competitors, so they have limited ability to raise prices.

2. What are the major ways in which firms in a monopolistically competitive industry differentiate their products from the products of their competitors? Explain, and give examples from an industry other than those that are described in this chapter.

The major areas of product differentiation are quality, location, service and branding. For example, a local car mechanic can charge more and get more business by providing high quality service, and being completely straight with customers by giving them information on what repairs are absolutely necessary and what repairs could wait. They might locate their garage near to major highways to make the location convenient. And, they might establish a particular branding niche, such as being known for working on imported cars. Your examples may vary.

3. The table contains cost and revenue data for Cafe Latte, a local cafe in the monopolistically competitive café market. Q = Quantity; P = Price; TC=Total Cost; TR = Total Revenue; MR = Marginal Revenue; MC = Marginal Cost; ATC=Average Total Cost. a) Complete the table and determine the profit maximizing level of output. Compute profit or loss at this quantity.

Q

TC

MC

ATC

P

TR

MR

Econ. Profit

0

9

---

---

12

0

---

-9

1

13

4

13

10

10

10

-3

2

14

1

7

8

16

6

2

3

16

2

5.33

6

18

2

2

4

20

4

5

4

16

-2

-4

5

26

6

5.2

2

10

-6

-16

6

38

12

6.33

0

0

-10

-38

Figure 16.5 Answer

MR=MC at Q=3. Profit = TR - TC = 18-16 = $2 economic profit.

b) Now suppose that a number of new cafes enter the market. What do you expect to happen to Cafe Latte?

Explain carefully.

As the new competitors enter, this will cause the Demand and Marginal Revenue for Cafe Latte to decrease and become more elastic due to the increased number of substitutes. In the long run, this will continue until they end up earning a normal profit.

4. In 2022, the top grossing mobile gaming apps were Honor of Kings ($1.7 billion), Genshin Impact ($1.3 billion, PUBG Mobile ($1.1 billion), Candy Crush Saga ($1.0 billion), Roblox ($0.8 billion), and Coin Master ($0.8 billion). There were almost one million gaming apps available at that time, and the total annual gross revenue from iPhone mobile app gaming was estimated at over $92 billion.

Revenue sources included download purchases, in-app purchases, and advertising. Would this industry be characterized as monopolistic competition? Why or why not?

The largest app had 2% of the market, which is not a dominant share. There are many competing apps, and new apps come out every day, indicating the market is easy to enter. But, gaming apps are very different from each other, so there is significant product differentiation. Thus, this market does fit the characteristics of monopolistic competition. Products are differentiated (the apps are quite different), ruling out perfect competition. The market is easy to enter, ruling out monopoly and oligopoly.

5. Wineries are considered to be in a monopolistically competitive industry. Suppose that the Fero Winery of Lewisburg current sells 10,000 bottles of wine per month at a price of $15 per bottle, while incurring Average Total Costs of $10 per bottle. Draw a graph of the Fero Winery displaying this information, and show what you expect to happen in the long run. Include D, MR, ATC, and MC on your graph. Assume that the firm’s short run cost

P

MC

ATC

A

●

P1=$15

D1

● B ●

ATC1=10 P2=ATC2=$9

MR1 D2

●

MR2 Q2=8

Q (1000s)

Q1=10

curves are the same as its long run cost curves. Explain your answer briefly in words.

Fero initially earns an economic profit at point A, with a price of $15 and ATC of $10. This lures new firms to enter the market in the long run, increasing the number of substitutes, causing Fero’s demand curve to P decrease and become more MC elastic until Fero earns a normal profit at a price of ATC $9 and a quantity of 8000.

Your numbers will vary depending on how your graph is drawn.

6.

Suppose that C Pronto Restaurant and Deli ● 15 in Lewisburg, operating in ●B 12 the monopolistically ●

D

Total Cost

0

20

Q MR

competitive restaurant market, currently sells meals for an average price of $12 per meal while producing a quantity of 200 meals per day and incurring average total costs of $15 per meal. (a) Draw a graph depicting Pronto’s situation. Include D, MR, ATC, and MC on your graph.

See graph to the left

Economic Loss (b) Show Total Cost and any Profit or Loss on the graph.

Total Cost is the entire box from 0 to 15 to point C to 200. Economic loss is the top box from 12 to 15 to C to B. (c) Assuming that Pronto is typical of other Lewisburg restaurants, what do you expect to happen in the long run?

Economic losses will cause firms to exit. As Pronto’s competitors exit, there will be a decrease in the number of substitutes, Pronto’s demand curve will increase and become steeper, continuing until they earn a normal profit (assuming they are not one of the firms to exit the market). (d) Explain, and show on P the graph what you MC expect to happen to ATC Pronto in long run.

Assume that the firm’s short run cost curves are the same as its long run cost curves.

In the long run, Pronto ●E will earn a normal profit P2=14 B ● 12 at a slightly higher price ●D and higher quantity with ● a demand curve that has D D2 shifted to the right, gotten steeper, and MR become tangent to the 200 MR2 Q ATC curve.

210 7. Compare and contrast the mainstream model of profit maximization in monopolistic competition with the political economy analysis of strategic behavior in monopolistic competition. What additional insights can be gleaned from the political economy approach?

Rather than emphasizing profit maximization using MR and MC and long-run entry and exit of firms, political economists look at the unique characteristics and types of competition featured in each monopolistically competitive industry. Monopolistic competitors compete based on six strategic factors: costs, quality, location, service, branding, and developing monopoly power. In terms of costs, we see frequent outsourcing of production to inexpensive, developing countries with low labor costs. Some firms compete based on quality, such as brand name clothing companies like True Religion. Location is important, as firms try to locate stores and place products in places where they will get the most customers. Customer service can lure additional

customers. Branding is particularly crucial, and can lead to above-normal profits. If possible, firms try to develop monopoly power by lobbying to keep out foreign competition, for example.

Franchising shows us how firms have tried to generate economic profits in the restaurant market.

Even though individual restaurant franchises tend to make very little money, the franchise owner, in selling to thousands of individual franchises, can make monopoly profits via advertising and branding, creating a global, low-cost supply chain, developing new products and cheaper manufacturing processes, expanding into new markets, and expanding rapidly thanks to the additional investments required of individual franchise owners.

Chapter 17 Oligopoly by Geoffrey Schneider Answers to Questions for review 1. How do oligopolies differ from monopolistically competitive industries?

The main differences are that oligopolies feature barriers to entry and as a result they are dominated by a few large firms. Monopolistic competition, on the other hand, features easy entry and exit and such markets are not dominated by a few large firms.

2. How does competition in oligopolies differ from competition in other market structures? Explain carefully.

In perfect competition and monopolistic competition, most of the competition focuses on getting prices as low as possible. Oligopolies sometimes feature price competition, but they also feature strategic competition, including the use of advertising, branding, mergers, innovation, and other methods of getting ahead of the competition. And, oligopolies often feature collusion, where firms act like a monopoly in order to increase their profits.

3. Pick an oligopolistic industry that you are familiar with that is not discussed in detail in this chapter.

Explain the types of strategic competition we see in the oligopoly you picked.

Answers will vary. In the automobile market, which is quite competitive, companies are competing to produce the best, reasonably priced electric car. This is leading to competition for innovative new designs. At the same time, American consumers are demanding bigger cars and trucks, so car companies are trying to compete by making cars and trucks bigger and roomier, with less attention paid to fuel economy. Hyundai and Kia have bolstered their brands by offering 10-year warrantees. Thus, we see elements of competition for innovation, trying to please consumers, and trying to compete with quality and security.

4. How does the kinked demand curve model explain why prices in oligopolies tend to be sticky?

Firms in an oligopoly do not want to raise prices for fear they will lose most of their customers by being the most expensive option (a flat demand curve). Firms do not want to lower prices for fear of starting a price war (a steep demand curve). Either way they would lose revenue by changing their prices. The rational strategy for any firm facing this dilemma would be to charge the same price as all of the other firms, and then to compete in other ways. This means prices change rarely, and tend to be “sticky.”

5. In December of 2017 McDonalds announced a new “Dollar” menu, which would contain a number of items for sale for only $1. In response, Taco Bell announced it was reducing the price of 20 items

to $1. Wendy’s, Burger King and Carl's Jr. all began offering similar competing deals. How does this behavior compare with the kinked demand curve model of oligopoly? Explain carefully.

One company lowering its price and then all other competing companies matching that decrease is an example of a price war. This is exactly what we expect to happen in an Oligopoly when firms decrease prices. No firm wants to be more expensive than its rivals, so all firms match the price cuts. This will likely lead to only small increases in the quantity demanded for these firms, since consumers only eat a certain amount of fast food each week and are unlikely to consume significantly more if prices fall slightly. Thus, we are in the inelastic portion of the kinked demand curve.

6. The payoff matrix in Figure 17.9 shows the payoffs for two supermarkets, Giant and Weis, who are considering two different strategies: low advertising expenditures or high advertising expenditures. (a) Using the payoff matrix below, what is Giant’s dominant strategy (if any)? What is Weis’s dominant strategy (if any)? Explain briefly. (b) In what quadrant of the payoff matrix are we likely to end up? Explain briefly.

Figure 17.9

Weis’ Advertising Expenditures

Giant’s Advertising Expenditures Low Expenditures High Expenditures Low Expenditures High Expenditures

Weis Profits: $250,000 Giant Profits: $200,000 Weis Profits: $300,000 Giant Profits: $100,000

Weis Profits: $100,000 Giant Profits: $180,000 Weis Profits: $200,000 Giant Profits: $150,000

7. The payoff matrix in Figure 17.10 shows the payoffs for two supermarkets, Giant and Weis, who are considering two different strategies: low advertising expenditures or high advertising expenditures. (a) What is Giant’s best strategy?

If Weis chooses Low Advertising Expenditures, Giant makes more money choosing High Advertising expenditures ($300,000 > $250,000). If Weis chooses High Advertising Expenditures, Giant makes more money choosing Low Advertising Expenditures ($300,000 > $250,000). Giant has a consistent strategy, doing the opposite of whatever Weis does. (b) What is Weis’ best strategy?

If Giant chooses low expenditures, then Weis will choose low expenditures ($250,000>$200,000). If Giant chooses high expenditures, Weis will choose low expenditures ($200,000>$150,000). So Weis’s dominant strategy is to choose Low Ad Expenditures. (c) Does either firm have a dominant strategy or a consistent strategy?

Giant has a consistent strategy, always doing the opposite of what Weis does. Weis has a dominant strategy, always choosing Low Ad Expenditures. (d) Is there a Nash Equilibrium where the firms will end up? Explain your answers briefly.

Weis will always choose Low Ad Expenditures. If Weis chooses low ad expenditures, Giant will choose High Ad Expenditures. Thus, we will end up in the top right corning of the payoff matrix, which is the Nash equilibrium. Neither Giant nor Weis can benefit from changing their strategy given that Weis will always choose low ad expenditures.

Giant’s Advertising Expenditures

Figure 17.10

Weis’ Advertising Expenditures

Low Ad Expenditures

High Ad Expenditures

Low Ad Expenditures

Weis Profits: $250,000 Giant Profits: $250,000

Weis Profits: $200,000 Giant Profits: $300,000

High Ad Expenditures

Weis Profits: $200,000 Giant Profits: $300,000

Weis Profits: $150,000 Giant Profits: $250,000

8. How might your answer to question 7 above change if the game were a repeated game instead of a 1-time game? Explain.

In a repeated game, if there is an option where the companies can collude to improve their profits, they are likely to do so. However, in the payoff matrix for question 7, there is no outcome where both companies can become better off. Therefore, there is not likely to be any change in the result of this payoff matrix if this is a repeated game.

9. (a) Why do firms in an oligopoly have an incentive to collude?

The kinked demand curve and payoff matrices shows us why it is almost irresistible for companies in oligopolies to collude. The demand curve when all firms change prices together is very inelastic—the firms are acting like a monopolist with no competition. If they all raise their prices together then they will make a lot more total revenue. In a payoff matrix, when firms collude they can usually make more money. In general, oligopolies dominated by fewer than 4 firms often collude because they can raise prices and eliminate price competition, thereby making a lot more money. (b) What types of collusion are possible?

Tacit collusion: when firms find a way of agreeing on prices or production quotas without actually discussing such things. Price Leadership is a type of tacit collusion that occurs when one firm, the industry leader, sets the prices for the industry and the other firms follow suit by adopting the same pricing structure.

Illegal Price Fixing: when setting prices is done via conversations between firms to plan out price increases.

Cartels: when firms engage in formal collusion by working together to coordinate prices, quantities and sales practices. (c) What does the OPEC case study tell us about the benefits of colluding and the difficulties in maintaining a collusive agreement?

OPEC initially made a huge amount of money when they colluded to reduce production and raise prices. But, the huge profits and high prices made it very profitable for other countries to search for oil, and as more and more companies became oil producers, OPEC found it increasingly difficult to maintain their ability to keep production low.

Chapter 18 Corporations, by Geoffrey Schneider Answers to Questions for review 1. Explain the principal-agent problem and the concept of moral hazard. How are stock options designed to address this problem?

The principal-agent problem happens when the agents (managers) may have different interests than the principals (owners). Moral hazard occurs when agents act in their own best interests, and when those interests are contrary to those of their principals. Paying CEOs in stock options was supposed to align the interests of upper management with those of stockholders, thereby solving these two problems.

2. Using the case studies of corporate misbehavior in this chapter, identify the commonalities between the cases. Taken together, what are the major lessons regarding corporate misbehavior that emerge?

The case studies provide examples of corporations that exploit workers and provide unsafe working conditions (Savar, BP), ruin the environment (BP, ExxonMobil), defraud and manipulate the pubic (ExxonMobil, Enron, Wirecard, VW, Facebook), and produce unsafe products for consumers (VW, General Motors, Boeing, Facebook). In general, the patters that emerge imply that the pursuit of profit trumps morality and ethics, so much so that workers, consumers and the environment are trampled in the process. Another pattern is the inability or unwillingness of the government to hold corporations responsible.

3. Critically analyze the argument that corporations are psychopaths.

Many corporations behave ethically, and many invent useful and innovative products that improve our lives. Yet, every year a certain number of corporations cast ethics and morality to the side and engage in unscrupulous behavior, resulting in fraud and even deaths. There appear to be aspects of the corporate structure that encourage such behavior, including the relentless quest for maximum short term profits, the lack of personal responsibility for any illegal actions taken by the corporation, and the power corporations have to manipulate the legal system and government regulators. Your answer may vary.

4. Critically analyze Baumol’s argument that large corporations are the central reason for the rapid growth and widespread wealth that is generated in modern developed capitalist economies like the United States.

Baumol argues that oligopolistic competition is responsible for innovations, growth and wealth.

Oligopolies have the profits levels and the competitive need that encourages them to invest in innovation, which is the root of the benefits that come from this market structure. However, oligopolies only generate positive results under particular circumstances. If they have too much power over workers, too much monopoly power, or too much control over regulators, then the worst side of large corporations can prevail, undermining their benefits to society.

5. Write an essay in which you critically analyze the arguments for and against large corporations.

Given these arguments, how should the government approach regulating them? Do you think the corporate structure is fundamentally flawed, as argued by many political economists? Or do

you think the corporate structure is fundamentally a useful one that is largely responsible for the high standard of living in developed countries?

Corporations are the dominant institution in modern capitalism. Their primary focus is on generating short term profits. This focus generates both negative and positive outcomes.

The negative side of corporations covers the fact that they regularly participate in terrible behaviors. Those terrible behaviors fall into three general categories: mistreating workers, producing unsafe products, and harming the general public via polluting the environment or putting their own profits ahead of public health and welfare.

On the positive side, oligopolistic corporations tend to me the most innovative and to stimulate the most economic growth. These industries have enough competition to keep them innovative. So they establish entire divisions in charge of innovation and generate a steady stream of new products and better production methods, which enhances society’s well-being. As long as they are prevented from completely dominating markets and from unethical behaviors, oligopolies can be extremely productive and innovative.

6. Economist Milton Friedman argues that the only responsibility of corporations is to make profits. Do you agree with his argument? Why or why not?

Answers will vary. The pursuit of profits, in theory, generates the maximum economic growth and the maximum benefit to society, as long as a strong legal and regulatory structure exists, along with sufficient competition and equal bargaining power for laborers. In the absence of those conditions, corporate pursuit of profits can have very negative impacts on society. Many people think that corporations should also take ethics and morality into account, so that their responsibilities go beyond just seeking profits.

7. In his book Small is Beautiful, Economist E. F. Schumacher argues that the problem with corporations is their bigness. When corporations become huge and impersonal, they tend to act to maximize profits without concern for people, communities and the environment. From this perspective, only by re-embedding corporations in communities can we insure that they serve the common interest instead of the narrower interests of stockholders. Given the information in this chapter, evaluate that perspective.

If corporations are operated by people living in the communities that they affect, they will be less likely to ruin the local environment, treat their customers and workers badly, and manipulate the local government for their benefit at everyone else’s expense. However, there are exceptions to this. The old company mining companies in Pennsylvania were brutal to workers, communities and the environment, so clearly Schumacher’s argument does not always hold.

8. Do you agree with Baumol and Friedman that anti-trust laws should not be used as frequently to regulate large corporations such as Google and Microsoft? Why or why not?

The argument that large corporations should be regulated even less than they are now stems from a belief that deregulated corporations will be the most innovative, growth-generating institutions possible. However, both Google and Microsoft abuse their monopoly power to reduce competition and manipulate markets. It is difficult to see how such behaviors are good for consumers, workers, or communities.

Chapter 19 Market Failure v Government Failure by Geoffrey Schneider Answers to Questions for Review 1. Which of the 8 market failures do you think is most important? Explain your answer.

Answers will vary. Many economists believe that failure to preserve resources and the environment, and the global climate change that is resulting from this, is one of the most important problems modern society must confront. Others note that inequality has gotten to extreme levels in the modern world, which is undermining faith in countries and political-economic systems in the developed world.

2. Construct a table in which you list each market failure, give an example of each one, and list the U.S. government programs designed to correct each market failure.

(1) Imperfect information about unsafe products.

Example: firms like GM (faulty ignition switch) regularly produce products that are unsafe for consumers. Consumers are often unaware of the problems with the products until it is too late.

The U.S. has regulatory bodies (FDA) and lawsuits to check this behavior.

(2) Unequal bargaining power in the labor market.

Unskilled laborers have few employment options and therefore lack the ability to bargain effectively with employers for decent wages and working conditions, as we see in the Bangladesh sweatshops.

The government has laws and agencies (labor department, EEOC) to address this problem.

(3) Monopoly power and insufficient competition.

Monopoly power can allow firms like Google and Microsoft to dominate markets, charging high prices without being particularly efficient.

The U.S. has anti-trust laws and regulators (Federal Trade Commission) to reign in corporate power.

(4) Negative and positive externalities.

Many markets contain spillover costs or benefits that make market outcomes inefficient, such as climate change which is a result of carbon dioxide emissions.

The U.S. has laws and regulators (Environmental Protection Agency) to regulate such behavior.

(5) Failure to preserve common resources and the environment.

Companies make profits by using up resources and their costs are lower if they do not have to make efforts to preserve those resources, such as in the fishing industry.

The U.S. has laws and regulatory agencies (NOAA) to preserve resources via limiting catch size.

(6) Inadequate supply of public goods.

Unregulated markets do not provide sufficient quantities of public goods such as infrastructure (roads, bridges, train tracks, airports, and ports) and national defense, and market institutions such as laws, regulations, property rights and contract enforcement.

U.S. government provides public goods via various government agencies, such as the DoT. (7) Increasing costs of essential services.

Essential services such as education and health care have been increasing in price so dramatically in recent years that many people cannot afford them.

The U.S. provides or subsidizes health care and education to the poor or the elderly.

(8) Fostering of inequality and poverty.

Laissez-faire capitalist economies are associated with extremely high levels of inequality and poverty. Inequality and poverty in turn erode the health of communities.

The U.S. has a slightly progressive income tax to combat inequality.

3. Which of the 8 market failures is the U.S. government least effective in correcting? Why do you think the U.S. government is particularly ineffective in this area?

Many economists argue that the U.S. government is least effective at correcting environmental problems and inequality and poverty, where the U.S. is more extreme than other developed countries.

Environmental regulation is lacking due to the power of industry to lobby politicians. Similarly, inequality and poverty are not effectively addressed because of the power of the wealthy to push for tax policies and government program cuts that leave them with more money than the wealthy in other developed countries.

4. Explain the role of unions in correcting the market failure of unequal bargaining power in the labor market. Do you think the U.S. government should encourage or discourage the formation of unions? Explain your answer briefly.

Unskilled laborers have very little power in the labor market, leaving them vulnerable to exploitation, in the form of poverty-level wages, poor working conditions, and poor benefits.

5. Describe the debate over the use of anti-trust laws to prevent mergers and monopolies. Why are many conservative economists untroubled by monopoly power? Why do other economists consider monopoly power to be a major market failure? Which position do you support? Why? Milton Friedman, Alan Greenspan and other conservative mainstream and Austrian economists argue that it is not a problem for large corporations to become even larger due to the efficiency gains from economies of scale and the continuous presence of rivalrous competition. Liberal mainstream and political economists view economic concentration and monopoly power as a major problem that needs constant, vigilant attention by regulators. Your position will vary depending on which of these perspectives you find most compelling.

6. Explain what is meant by “internalizing” an externality, and why governments attempt to achieve this goal when externalities are present.

Internalizing an externality involves incorporating costs or benefits that are external to the market into the cost and benefit structure of the market. The government attempts to achieve this goal because it moves markets to the efficient equilibrium. If externalities are not internalized, markets will be inefficient, producing too much of goods that generate negative externalities and too little of goods that generate positive externalities.

Figure 19.1 The effect of a negative externality on the market for electricity P ($) S2=MSC=MC+MEC S1=MC

C●

B ●

DW L

$120 $115

MEC=$20

7. Using a graph, explain why markets lead to inefficient outcomes when a negative externality is present.

Also using the graph, explain how the government can internalize a negative externality.

●A

In the graph to the left, an unregulated market will produce at point A, at a higher quantity and lower price than the efficient equilibrium at point C. Point C is the equilibrium D1=M when external costs are included in B the market. The government can 10 11 Q (thousands of Kilowatt Hours Per Day) move the market from its equilibrium at point A to point C via an excise tax or other policies that increase the costs of producing this good in an amount equal to the Marginal External Cost, MEC. $100

8. Which market failures are created by a lack of property rights? Explain how “cap and trade” and “Individual Transferable Quotas” solve the property rights problem in specific types of markets.

All externality disputes involve property rights in some way. The problem is that no one owns the water, air or other natural resources that are being destroyed by pollution. The result is the tragedy of the commons: if no one owns a common resource to which everyone has access, the resource will be used until it is gone. Similarly, failure to preserve common resources and the environment also involves a problem with the lack of definitive property rights.

With an Individual Transferable Quota (ITQ), the regulatory body determines an overall limit for how many fish can be caught sustainably. Each fishing boat is allotted a quota, which is a percentage of the overall catch limit. The fishing boat owners can even buy and sell quota allotments. In essence, the ITQ has become a property right—the right to a certain percentage of the common resource of ocean fish.

Similarly, a cap and trade pollution control system involves the government setting a cap (a legal limit) on the amount of a certain pollutant and then allowing permits to emit that pollutant to be bought and sold. A limited amount of permits is established by the government and granted to existing firms.

Any firm needing to pollute more than the amount their permits allow will have to pay for the right to emit the pollutant by buying additional pollution permits from another company. Essentially, the government creates a property right—the right to a certain amount of pollution—which can then be bought and sold.

9. How are market failure and government failure connected with the problem of moral hazard?

How might moral hazard be reduced or eliminated?

With respect to market failure, moral hazard happens when sellers have information about negative aspects of a product but refuse to share that information with buyers so that they can continue to earn profits. The existence of moral hazard is, unfortunately, all too common in capitalist markets. For example, car companies regularly find out information that their cars are unsafe or unhealthy but do not

tell consumers. This form of moral hazard can be fixed by vigilant government regulation and sufficient disincentives (fines and lawsuits) for bad behaviors.

In terms of government failure, moral hazard occurs when the pursuit of self-interest by politicians and civil servants leads them to operate for their own benefit rather than for the good of society, especially due to the role of money in politics. This can be deterred by oversight, whistleblower laws, and stiff penalties for such behaviors.

10. Why do unregulated markets work poorly when it comes to common resources or goods that are non-excludable? Explain and give specific examples.

A good is non-excludable if the owner of a good cannot exclude other actors who have not paid for the good from having access to it. Examples include goods that generate positive externalities and common resources such as fish stocks. In general, unregulated markets under produce goods that are nonexcludable, such as vaccinations and public transportation, since the external benefits are not included in the market price. And, unregulated markets overuse common resources such as fish stocks because everyone has access to these resources and their incentive is to use them up until they are gone.

11. Explain why the prices of essential services such as health care and education are increasing faster than the prices other goods. How can the government deal with this market failure?

The prices of essential services increase faster than the prices of other goods because of the different impact of technology. In manufacturing, better technology lowers costs and prices. In services, invention of a new technology requires an additional investment which requires an additional cost. The service quality is improved, but the cost of the service is more expensive. The government needs to take efforts to make sure essential services are affordable. This can include subsidies or government direct provision of the service, which is usually less costly.

12. Analyze the issue of market failure and government failure and evaluate whether or not the U.S. strikes the right balance of government and markets. Should the U.S. government intervene more strongly in markets? Or do you think markets are efficient enough and government intervention inefficient enough that we should have less government intervention? Support your argument with specific examples.

There are 8 forms of market failure that economists have identified. With each one, the government corrects some of the problems but not all of them.

(1) Imperfect information about unsafe products. As highlighted in chapter 18, firms regularly produce products that are unsafe for consumers. Consumers are often unaware of the problems with the products until it is too late. The U.S. has regulatory bodies and lawsuits to check this behavior, but the continuing problems indicate that the disincentives of regulation are too small to stop companies from continuing to sell unsafe products.

(2) Unequal bargaining power in the labor market. It is regularly the case in capitalist economies that many laborers have few employment options and therefore lack the ability to bargain effectively with employers for decent wages and working conditions. In recent decades the U.S. government has been openly hostile to unions under conservative Presidents, but unions are usually the best vehicle for workers to improve their bargaining power. Political economists believe that more unions would improve wages and conditions for workers, which can actually help with growth by stimulating spending.

(3) Monopoly power and insufficient competition. In non-competitive markets, monopoly power can allow firms to dominate markets, charging high prices without being particularly efficient.

The U.S. has stopped some mergers and it has pushed some markets to be more competitive (the restrictions on Microsoft Windows to allow competing software, for example). But, the U.S. largely allows economic concentration and monopoly power, in agreement with conservative economists who believe that markets are always sufficiently competitive thanks to the constant threat of rivalrous competition. Liberal economists and political economists disagree with this approach, advocating greater regulation of corporate power and more fostering of competition.

(4) Negative and positive externalities. Many markets contain spillover costs or benefits that make market outcomes inefficient. Markets tend to overproduce goods which generate negative spillovers, such as goods whose production causes pollution, and markets under produce goods that generate positive spillovers, such as education and health care. Thus U.S. has a variety of regulations of pollution, which has worked to mitigate the worst environmental problems of the short term such as acid rain and smog. The U.S. does very little to combat climate change, however. The U.S. is also uneven in providing positive externality goods such as vaccinations and public schools. We have the world’s best university system via public and private universities but a mediocre K-12 education system. U.S. public health is ranked poorly in international comparisons.

(5) Failure to preserve common resources and the environment. Corporations make profits by using up resources and corporations’ costs are lower if they do not have to make efforts to preserve those resources. But, using up precious resources and ruining the environment on which we all depend places a tremendous burden on future generations. The U.S. has taken steps to protect common resources when faced with crisis (such as the crash in fish stocks from overfishing), but our government is not proactive in preventing problems before they occur.

(6) Inadequate supply of public goods. Unregulated markets do not provide sufficient quantities of public goods such as infrastructure (roads, bridges, train tracks, airports, and ports) and national defense, and market institutions such as laws, regulations, property rights and contract enforcement. U.S. infrastructure is generally ranked poorly by international standards.

(7) Increasing costs of essential services. Essential services such as education and health care have been increasing in price so dramatically in recent years that many people cannot afford them.

This presents significant economic problems to individuals and economies. The U.S. provides health care to the poor or the elderly and it subsidizes some college education. But, access these goods is quite uneven, and millions of Americans lack access to health care and college.

(8) Fostering of inequality and poverty. Laissez-faire capitalist economies are associated with extremely high levels of inequality and poverty. Inequality and poverty in turn erode the health of communities. The U.S. does less to combat inequality and poverty than any other developed country.

What emerges from these examples is the fact that the U.S. in general prefers to let markets dictate outcomes without a significant amount of government intervention. Much of this stems from the prevalence of conservative ideologies in U.S. politics, which believes in the power and benefit of unregulated markets and the debilitating problem of government failure.

Chapter 20 Environment by Geoffrey Schneider Answers to Questions for Review 1. Compare and contrast Ecological Economics and Environmental Economics. Which approach do you find most compelling in addressing the issue of climate change? Explain, and support your answer.

Ecological Economics is the study of the interdependence between the economy and natural ecosystems, including the flow of energy and raw materials to the economy from the ecosystem’s sources (mines, wells, fisheries, and land) and the return of wastes and pollutants from the economy to planetary sinks (dumps, oceans, and the atmosphere).

Environmental Economics uses cost benefit analysis to determine the efficient allocation of environmental resources, such as the optimal level of pollution.

The key difference, therefore, is the explicit focus on ecology and the situating of the economy within an ecosystem in ecological economics, as opposed to the more narrow focus on the efficient allocation of resources and pollution that we find in environmental economics.

Your answer about which approach you find most compelling will vary. Some people like the attempt to be very precise in the development of policies that comes with environmental economics. Others find that approach insufficient in acknowledging the interconnectedness of the economy and ecology.

2. Critically evaluate the approach of environmental economists in determining the optimum level of pollution abatement. Do you think it is appropriate to value human life and environmental services in this way? Why or why not? How might ecological economists respond to this approach?

In environmental economics the socially efficient level of pollution results when the marginal social cost of pollution abatement is equal to the marginal social benefit from abatement. In making such calculations, environmental economists must put a value on human life and environmental services. Some people are offended by this approach, because of its implications.

For example, if the production of a product generates $40 million in profits, and if the pollution from that product kills three people whose lives are each worth $10 million, then the environmental economics approach would imply that the product should be produced despite the fact that people die from its production. If this ethical or not?

Ecological economists do not believe it is possible to be so precise with measurements, and they note that environmental services and human life are often undervalued in such calculations.

3. How does a carbon tax differ from a cap-and-trade system? Why do many mainstream economists prefer a cap-and-trade system? What are some of the problems that can occur with a cap-and-trade system?

A carbon tax would charge a fee to producers for every ton of carbon that the use of their product will generate. This would make it less profitable to produce or use products that emit carbon

dioxide, thereby encouraging the creation of technologies to reduce carbon emissions along with development of alternative, clean energy. A carbon tax would increase the price of carbonintensive products, discouraging consumers from purchasing such products.

A cap and trade system, also called tradable carbon permits, begins with the measuring how much carbon is being emitted by each firm. Then, the government sets a cap for carbon emissions below the level existing emissions to reduce carbon pollution. The government then allocates permits to industry, with the permitted amount of carbon pollution set below each firm’s past levels. Faced with a limited amount of permits, companies would need to reduce pollution to below their current level or purchase permits from another company that had excess carbon permits to sell. Companies would have to pay for polluting above the level of their permits, and they could profit from polluting below the amount of permits they possessed by selling excess permits to other firms. This gives companies a direct financial incentive to reduce pollution. The government can reduce the cap on the amount of permits each year to pressure companies to continue to reduce carbon dioxide emissions.

Mainstream economists often prefer a cap-and-trade system to an emissions tax because of the potential for efficiency gains. In theory, those firms that can reduce their emissions most easily will do so and then sell their excess pollution permits to companies less able to reduce their emissions. This could lead to a very efficient reduction in pollution, as the firms that can reduce emissions in the most cost effective manner do so in order to profit from selling their excess pollution rights.

However, the cap and trade system is more easily manipulated by firms, who can lobby and pressure politicians to allocate more permits than would be effective.

4. List the various policies that economists advocate for addressing climate change.  Carbon tax.  Tradeable carbon permits.  Public investments in clean energy.  Expansion of public transportation.  Provide financing or require investment in energy efficiency.

5. Suppose that you are elected President of the United States. Design a set of economic policies to address climate change. Support the approach that you take.

Answers will vary, depending on the degree of government intervention you prefer and how serious you think climate change is. The least amount of government involvement would mean a carbon tax or cap and trade system, with any revenues returned to the public. Liberal economists would add to that subsidies for green energy, and public investment in transportation and energy efficiency. Political economists would advocate even stronger government efforts to reduce or eliminate production of the worst offending industries (coal, fossil fuels), create new green industries, and reign in businesses that contribute to climate change.

6. Compare and contrast the approaches to climate change taken by the following groups:

a. Conservative Mainstream Economists.

Conservative economists prefer the least amount of government involvement possible, which would mean a carbon tax or cap and trade system, with any revenues returned to the public. b. Liberal Mainstream Economists.

Liberal economists would install a carbon tax and would add to that subsidies for green energy, and public investment in transportation and energy efficiency. c. Political Economists.

Political economists would advocate even stronger government efforts to reduce or eliminate production of the worst offending industries (coal, fossil fuels), create new green industries, and reign in businesses that contribute to climate change. They would also install a steep carbon tax.

7. Answer the following questions related to Figure 20.5. a. What Price and Quantity combination would an unregulated market generate?

Why would economists consider this outcome inefficient? Explain carefully are refer specifically to the graph in your answer.

Unregulated markets only reflect private benefits and marginal costs, so unregulated markets would produce Q1 and the price would be P5. This is inefficient because the marginal social benefit at Q1 is much higher, at P2, than the marginal private benefit. The efficient equilibrium must use marginal social benefit. b. What is the Socially Efficient Amount of Pollution in this graph?

Q3 is the socially efficient amount of pollution removal, where MSB=MC. If this amount of pollution is removed, then the amount of pollution remaining is the distance from Q3 to where the MSB curve intersects the x-axis.

c. How does this graph help us to understand the argument environmental economists often make that we should not strive to eliminate pollution completely?

If we continued to eliminate pollution after we reach Q3, that pollution elimination would have a very high marginal cost and a very low marginal social benefit, which would be inefficient from a mainstream economics point of view. d. How might ecological economists respond to the environmental economic analysis displayed in this graph?

Ecological economists would question whether all costs and benefits are truly captured in this model, and especially if there are other costs to the ecosystem that cannot be measured.

8. One of the major arguments politicians make against environmental regulations is that they will reduce the number of jobs. Is this a sound argument? Why or why not? Explain using specific examples from this chapter.

Environmental regulations do not necessarily cause a loss of jobs. But they do cause jobs to shift away from polluting industries and towards cleaner industries. In Germany, the government gradually tightened environmental standards, while providing funds for the development of green technology and renewable resources. The result was rapid growth in green technology companies and renewable energy companies, while older, environmentally destructive industries declined.

There was net growth of jobs in the German economy, implying that there is no reason to expect environmental regulations to reduce the number of jobs if they are implemented effectively.

9. Magdoff and Foster argue that capitalism is fundamentally incompatible with a sustainable economic system. Given what you know about capitalism and how it functions, construct an argument for or against this perspective. Use specific examples to support your answer.

Answers will vary. The strongest argument for Magdoff and Foster is that capitalist businesses work very, very hard to avoid paying for external costs, and there is no reason to expect them to change. Therefore, without regulation, they will inevitably ruin the environment. Furthermore, they are so powerful that government regulations are rarely sufficient.

The strongest argument against this perspective is the fact that some of the most dramatic progress on environmental issues has occurred in capitalist economic systems with strong, efficient governments. A strong government can regulate the environment reasonably well in some cases.

Chapter 21 Public Goods and Services, By Geoffrey Schneider Answer to Questions for Review 1. List the seven categories of public goods. Which category do you think is most important for economic growth? Which category is most important for quality of life of a country’s citizens?

Explain briefly, and support your answer.

The seven major categories of public goods are: 1) physical infrastructure, 2) market infrastructure, 3) security services, 4) governance and public services, 5) environmental services, 6) public knowledge, and 7) public health.

As for which is most important, your answers will vary. For economic growth, many economists would emphasize physical and market infrastructure, governance, and public knowledge. For quality of life, public services, physical infrastructure, environmental services and public health loom large.

2. How are quasi-public goods different from public goods? Explain.

Quasi-public goods such as individual health care and education have some but not all the characteristics of public goods. Even though these goods benefit certain individuals the most, there are broad benefits to society in insuring everyone has access to these goods and in providing them in the most efficient manner possible. Public goods benefit everyone equally, which is not true of quasi-public goods.

3. Would vaccinations be considered a public good or a quasi-public good? Explain briefly.

Vaccinations would be considered a quasi-public good because they benefit the person getting vaccinated the most, but there would be external benefits going to their employer, co-workers, community and family.

4. Using a graph of the market for a public good, use mainstream economic analysis to explain carefully why markets do not tend to provide the optimal quantity of public goods.

In Figure 21.1, individuals will only pay for quantity Q1 at price MC1. But society as a whole receives benefits much greater than that at point B (MSB1). If we incorporate all of the social benefits from a public good, then society should produce quantity Q2 at a cost of MC2.

5. Using the graph in Figure 21.9, answer $ the following questions: (a) Which point represents the socially efficient equilibrium?

Figure 21.9 MC, MPB and MSB

• A

•

Point D (b) Which point represents the private market equilibrium?

MSB

Point B MPB

B

•

D

C

•

•

E

•

MC

Q

(c) What distance on the graph would represent the lost social benefits from producing at the private market equilibrium?

The distance from point A to point B. (d) What are some methods that can be used to move the economy to the socially efficient equilibrium?

Government provision of the good to move the equilibrium to point D; or subsidies to the private sector to move the market to point D. 6. Explain why privatization was effective in providing train service in Britain but not effective in providing the infrastructure for train service (the train tracks).

Train service was competitive, so companies competed with each other to offer the best quality train service at the lowest possible price. Also, the government subsidized unpopular routes to that train service was preserved to all locations.

Infrastructure for train service was a monopoly, so the firm had no incentive to improve or expand the infrastructure. Also, there was no incentive to spend on maintenance as long as the firm could count on extracting monopoly rents from the operation and as long as the infrastructure did not fail.

7. Write a short essay in which you contrast the analysis of public goods by (a) mainstream economists, (b) progressive political economist John Kenneth Galbraith, and (c) Austrian economist Murray Rothbard. Which approach do you find most convincing? Why? Mainstream economists argue that politicians should attempt to provide the quantity of public goods desired by the public by comparing Marginal Cost and Marginal Social Benefit. This is an interesting theoretical exercise, but whether or not political systems can function in this manner is an open question.

Galbraith posits that increases in private expenditure require an increase in public expenditure.

Private goods cannot be enjoyed to their full potential without the necessary public spending supporting them. Without proper upkeep of roads, people cannot safely drive their car. Inadequate transportation infrastructure also has the effect of impeding citizen’s ability to get to the places that they need to go to acquire or use their own private goods. Without the protection of the public sector, pollution can taint our air and water to the point where outdoor recreation is no longer enjoyable. An expansion of the private sector into a new industry requires public expenditure for regulation. Evidence from recent events in Flynt, Michigan (tainted water) to the explosion of global warming indicates to Galbraith that we have an abundance of private goods but our public goods are inadequate, often because of inadequate government regulation.

Advertising influences consumers toward private spending and opulence by creating our wants artificially. There is no comparable force advocating public expenditure. Conspicuous consumption also greatly favors private goods. The communal nature of public goods does not allow consumer envy or the subsequent competitive spending that fuels the private sector. These factors create a dependence on certain level private expenditure by telling us what amount of private spending is expected from us.

The perceived inferiority of public expenditure also contributes to social imbalance. Taxation is perceived as a loss of the freedom to choose how your money is spent. With this perception, people prefer to keep their options open and avoid taxation. In a democratic society, elected officials find the prevailing perception of public expenditure makes it hard to be elected on a platform that includes tax

increases. Without the needed tax revenue, public goods will continue to be underfunded and low quality.

There are inherent dangers in expanding the role of government to reign in the market system, just as there are inherent dangers in allowing the market free reign without the countervailing power of government. The cost of government interventions could outweigh the benefits, a perspective more in line with Rothbard. Rothbard thinks businesses are efficient and effective at innovating and providing the right quantities of goods, whereas the government is large, overbearing and inefficient. Rothbard would prefer to replace government with private sector actors wherever possible.

Your answer will depend on which arguments you find most compelling.

8. Compare and contrast the U.S. health care system with those of other developed countries. In what ways does the U.S. system stand out?

The U.S. health care system is much more expensive than other systems, largely due to the emphasis on small, private provision of care as opposed to larger, public provision of care. The U.S. also fares poorly when it comes to health outcomes, largely due to the fact that so many poor people get such poor care. The U.S. is good at providing cutting edge health care to those with money, however. The U.S. is the only developed country without a national health insurance system. Some countries such as the U.K. and Cuba go even further, providing national health insurance and government health care at public clinics and hospitals. Some countries like Sweden provide public health insurance and a mix of public and private care.

9. Should the U.S. adopt a single-payer health care system? Explain, and support your answer.

Answers may vary. If you do not have much faith in government to run health care, you may prefer a pay-as-you-go system, like Rand Paul advocates. However, this comes with consequences, including millions of uninsured people and high costs. Single-payer health insurance means everyone gets health care as a human right and costs are likely to be much lower because it is more efficient to provide health care to large groups of people using regional medical centers.

10. How does the U.S. education system compare with those of other developed countries? Explain briefly.

The U.S. emphasizes private education spending much more than other developed countries. For example, college education in the U.S. is about 2/3 private spending and 1/3 public spending. In other developed, OECD countries, 30% of spending is private and 70% is public. The U.S. has a very good university system. However, the U.S. is no longer spending as much as other countries on education, which may have negative effects in the future.

11. Given the importance of education in developing human capital and fostering economic growth, how would you reform the U.S. education system? Explain, and support your answer.

Answers will vary. Those who believe the state can foster innovation would like to see substantial increases in government funding for scientific research and innovation, and the expansion of educational opportunities to all citizens. Providing free college education would be a possibility from this perspective. Others might see the high quality of the U.S. education system as a result of being mostly private rather than public, which would imply maintaining a significant private education system.

Chapter 22 Labor Market, by Geoffrey Schneider Answers to Questions For Review 1. Given the trends described in this chapter regarding the skills employees need and the industries that are expanding and contracting, what course of study makes the most sense for you? How can you leverage your strengths into a skill set that employers would value?

Answers will vary. A smart plan would be to target a growing industry that also makes use of your skill set, or a skill set you can acquire.

2. List the major sources of conflict between workers and owners. Which of these sources of conflict do you think is most pervasive in white collar work such as investment banking? Which sources of conflict might be most pervasive in blue collar work in an Amazon warehouse?

1.

2.

3.

4.

5.

6.

7.

Wages and salaries.

Benefits.

Number of hours worked.

Intensity of work and work effort.

Working conditions and safety.

Job security.

Legal and political environment.

White collar workplaces tend to feature conflicts about salaries, benefits and work hours. Amazon warehouses feature conflicts about wages, work intensive, safety, job security, and the legal and political environment.

3. Compare and contrast the stick approach to worker motivation with the carrot approach. How can either approach be profitable for firms operating in the same industry (e.g., Wegman’s vs. WalMart)?

The stick method of worker motivation refers to efforts by employers to achieve maximum work effort via the threat of job dismissal (firing), attacking unions, and closely monitoring workers. This can lead to high profits by keeping costs low and motivating workers with threats.

The carrot method of worker motivation refers to efforts by employers to cultivate loyalty and productivity from workers via offering job security, strong wage incentives (bonuses and profit-sharing), employee involvement in decisions, and strong unions. This can be profitable by encouraging worker productivity and skill development high enough to more than offset higher wages and benefits.

4. List the major sources of power in the relationship between workers and owners. Which of these do you think is most important? Why? 1.

2.

3.

4.

Unions and working class solidarity.

The balance of political power between workers and employers.

Social attitudes and class consciousness.

Market and Macroeconomic conditions.

5. International environment.

Your answer regarding which is most important will vary. Most political economists argue that unions and working class solidarity are the most important, since they affect all of the other factors.

5. Workers in the U.S. are paid considerably less than workers in Germany. Using the political economy approach to the labor market, analyze why this is the case.

Given the 5 sources of power (Unions and working-class solidarity, the balance of political power between workers and employers, social attitudes and class consciousness, market and macroeconomic conditions, and the international environment), we see that workers in Germany have more power in each of these areas, which explains their higher wages. Unions are more powerful in Germany, they have political power via labor parties, there is a greater degree of class consciousness, the German macroeconomy is strong (especially in manufacturing), and German workers are more protected from foreign competition thanks to EU laws.

6. Use the political economy model of the working day to determine how each of the following events would impact wages and the rate of profit.

A--------B--------C wages profits a. The government increases the minimum wage.

This moves B to the right, raising wages and reducing the rate of profit. b. The government reduces the maximum number of work hours allowed per week from 40 to 35.

This moves C to the left, reducing the rate of profit. c. New robots are invented that can increase the productivity of workers.

This moves B to the left (workers pay for themselves more quickly), which increases the rate of profit. d. The government passes laws that make it more difficult for workers to unionize.

This will reduce wages, moving B to the left and increasing the rate of profit.

W2 W1

7.

Using Figure 22.9 as your starting point, with a minimum wage of W2 in place, analyze how each of the following events will affect the demand and supply curves for unskilled labor, the number of laborers hired by firms, and the amount of surplus labor that exists. a.

The economy booms and the demand for goods and services increases significantly.

Businesses will want to produce more goods, and they will need more labor to do so. The demand for labor increases. The surplus of laborers will decrease. The number of workers employed will increase, but the wage rate will stay the same unless the increase in D is more than enough to eliminate the entire surplus. A typical outcome would be for the number of workers hired to increase from QD1 to QD2 (the movement from point A to point B).

b. The federal government raises the minimum wage above W2.

When the minimum wage rises from W1 to W2, the quantity of labor demanded falls from QD1 to QD2 (the movement along the demand curve from A to A’) and the quantity of labor supplied increase from QS1 to QS2 (the movement along the supply curve from B to B’). Workers are making more money, but there is a very slight drop in employment, and the size of the surplus increases, which will result in more non-price rationing.

W3 W2 W1

c. Immigration into the U.S. increases significantly.

Assuming that this is legal immigration, the supply of labor increases. With the minimum wage in place, wages cannot fall, so the end result is no change in the number of workers hired (QD1), but an increase in the surplus of workers as the quantity supplied increases from Qs1 to Qs2. This would likely result in additional non-price rationing (worsening job conditions).

W2 W1

d. The government reduces the amount of social security taxes paid by employers who hire workers, and reduces the amount of social security taxes withheld from workers’ paychecks.

W2

W1 This should increase the demand for labor (workers are more profitable to hire) and increase the supply of labor (workers should want to work more if they get to keep more of their money). Higher incomes for workers might also encourage more spending, increasing the demand for products and increasing the demand for labor. The demand for labor increases from A to A2 and the supply of labor increases from B to B2. More laborers are hired, but the surplus persists.

e. The government cuts education spending significantly, which results in a large decrease in the productivity of unskilled workers.

The decrease in productivity makes workers less profitable to hire, decreasing the demand for labor. This decreases the quantity of labor demanded from point A to point B, increasing the amount of unemployment and the surplus of workers.

W2 W1

8. What are the main arguments of opponents of the minimum wage? What are the main arguments of supporters of the minimum wage? Which arguments do you find most convincing?

Opponents of the minimum wage argue that it will increase unemployment, raise costs for businesses, and thereby slow economic growth. Supporters of the minimum wage note that the best studies indicate that increases in the minimum wage do not increase unemployment or reduce growth. They do raise costs for businesses, but they are able to pass on those costs to consumers in the form of slightly higher prices. Furthermore, higher minimum wages reduce poverty and increase spending in communities where minimum wage workers live. The argument that you find most convincing should be drive by the data reported in the text and your ideas regarding whether or not a steep increase in the minimum wage might have a more dramatic impact than a small increase.

9. Figure 22.20 depicts hypothetical information for a firm. a. Is this firm a monopsony?

Why or why not?

No. The wage rate does not change as the firm hires more laborers, so the firm does not have monopsony power. b. Is this firm a monopoly?

Why or why not?

No. The prices does not change as the firm produces more, so this must be a perfectly competitive market. c. Complete the table. (See table)

Figure 22.20 Output & Price information for a hypothetical firm Labor Total Price of Total Marginal Revenue units Product of Output Revenue Product of Labor Labor L Q P = P*Q

Wage

W

0

0

$5.00

$0.00

1

100

$5.00

$500.00

$500.00

$1,100

2

300

$5.00

$1,500.00

$1,000.00

$1,100

3

600

$5.00

$3,000.00

$1,500.00

$1,100

4

950

$5.00

$4,750.00

$1,750.00

$1,100

5

1350

$5.00

$6,750.00

$2,000.00

$1,100

6

1740

$5.00

$8,700.00

$1,950.00

$1,100

7

2100

$5.00

$10,500.00

$1,800.00

$1,100

8

2400

$5.00

$12,000.00

$1,500.00

$1,100

9

2620

$5.00

$13,100.00

$1,100.00

$1,100

10

2740

$5.00

$13,700.00

$600.00

$1,100

$ ---

$1,100

d. Determine the optimal quantity of laborers for this firm to hire.

The firm should hire as long as MRPL≥W. The optimal quantity of laborers is 9. e. Use Microsoft Excel to plot out a graph of the demand curve for labor and the supply curve of labor. Show the optimal, equilibrium quantity of laborers hired on your graph.

f.

If the wage rate increases to $1200, what is the new optimal quantity of laborers for the firm to hire.

The optimal quantity of laborers to hire would now be 8.

Chapter 23 Inequality by Geoffrey Schneider Answers to Questions for review 1. Describe how inequality has changed in the U.S. and other developed countries since 1970.

All developed countries have become more unequal since the 1970s. This is likely due to globalization, automation, and the declining power of unions, factors that have undermined the ability of laborers to demand fair wages. Inequality has increased much more in the U.S. than in other developed countries, due to reduced taxes on the wealthy, a very unequal education system, government hostility toward unions, and the least generous safety net of any developed country.

2. What are the main reasons why U.S. inequality has worsened more than inequality in other developed countries?

Inequality has increased much more in the U.S. than in other developed countries, due to reduced taxes on the wealthy, a very unequal education system, government hostility toward unions, and the least generous safety net of any developed country.

3. Brazil’s Gini coefficient fell from 63.3 in 1989 to 51.5 in 2014. What does this tell us about inequality in Brazil? Explain carefully.

This means that inequality lessened in Brazil from 1989 to 2014. The Gini coefficient measures how far a country is away from perfect equality. the Gini coefficient ranges from 0 to 1, with lower numbers associated with more equal societies and higher numbers associated with more

unequal societies. A country with a Gini of 0 would have no inequality.

4. List the most important factors that economists believe are contributing to inequality in the modern world.

1. Class divisions, that give those in the upper class advantages 2. Globalization.

3. Decline of unions.

4. Skill-biased technological change.

5. Why is class correlated with inequality?

One’s social class provides advantages or disadvantages, which are very important in determining one’s chances of success in life. Economic capital allows the children of the rich to stay rich, simply by investing that money. Educational capital allows the children of the rich to go to the best schools, even if they are not particularly smart. Social capital gives the children of the rich access to networks of highly placed individuals who will assist them with their careers.

And, cultural capital give the rich an advantage in succeeding in the business world by knowing how to dress, speak, and relate to others in the culturally accepted manner. Thus, there are huge advantages to coming from the upper class, which means that the children of the rich usually stay rich. This is especially true in countries that make few efforts to reduce class inequality, as shown by the Great Gatsby Curve.

6. What is personal capital, and how does this concept help us to understand why some people are more successful than others?

Personal capital is the economic, educational, social and cultural capital derived from a person’s class position. Economic capital refers to the ownership and control of resources, educational capital refers to years of schooling and the quality of institutions attended, social capital is the network of family, friends and associates a person can access and draw on, and cultural capital refers to the knowledge of unique cultural patterns associated with living in elite circles.

Economic capital allows the children of the rich to stay rich, simply by investing that money.

Educational capital allows the children of the rich to go to the best schools, even if they are not particularly smart. Social capital gives the children of the rich access to networks of highly placed individuals who will assist them with their careers. And, cultural capital give the rich an advantage in succeeding in the business world by knowing how to dress, speak, and relate to others in the culturally accepted manner. Personal capital is thus one of the main factors that determines success in life, and one’s class position is the primary determinant of personal capital.

7. Write an essay in which you explore the consequences of social class divisions in the modern U.S. What, if anything, do you think the U.S. government should do to address social class inequality?

Explain, and support your answer.

Answers will vary. Statistically, social class is one of the most important factors in determining your chances of success in life. In addition, social class position is correlated with health. Social class tends to have a significant effect on one’s opportunities via facilitating or denying educational opportunities, personal contacts, and even cultural capital such as good manners and knowledge of high culture.

According to the latest data, class separation is becoming more rigid in the US and there is less class mobility than there used to be. There is also less class mobility in the US than in other

countries that offer greater access to education and health for all citizens, such as Denmark and Sweden. It now takes 5-6 generations for someone to escape their class background. Race is still highly correlated with social class. People with connections are much more likely to get jobs at elite firms, which further entrenches class divisions and inhibits class mobility. Class inequality is exacerbated by policies promoted by elites, including cutting social programs and spending, while keeping taxes for the rich low.

Putting this all together, the factors that affect the degree of class mobility include the level of government support for education, health care and opportunity, the extent to which opportunities are only open to those with certain connections or influence (which in turn depends on other institutional factors such as racism or the lack thereof), the fluidity of the economic system, and the degree to which key personal characteristics such as intelligence and health are transmitted across generations. Policies to address these issues would therefore address class inequality.

8. Given the information in this chapter on racial inequality, how do you think colleges should make decisions about which students to admit?

The chapter provides data regarding systemic racial discrimination. Given that SAT scores are directly correlated with income, and that income is not highly correlated with innate abilities, utilizing SAT scores seems to be a poor way of determining which students to admit. The University of Texas admits students based on class rank as a better measure of students’ ability to succeed in their particular environment. Your answer may vary.

9. Describe the degree of racial and gender inequality that exists in the modern U.S. What factors explain the ongoing existence of this inequality? What could be done to reduce this type of inequality?

Black people face systemic racial discrimination in hiring, and they have lower incomes and wealth on average, but higher rates of poverty and unemployment. Women also face systemic gender discrimination, and they receive lower pay for equal work. The U.S. has laws that make it illegal to discriminate based on race and gender, and affirmative action laws to open up occupations that have systematically discriminated against women and people of color in the past. However, there still remains a disturbing degree of inequality with respect to race and gender, especially with the glass ceiling the restricts access to top positions. Possible solutions include strengthening existing policies, enacting stricter regulations on corporate boards to promote hiring of women and people of color, and reparations for slavery.

10. Why do Feminist economists, Stratification and LGBTQ+ economists focus on culture as a key determinant of gender and racial inequality? Explain and give examples.

The primary factor contributing to ongoing gender and racial inequities is culture, and the cultural beliefs that value men’s work more than women’s work and white work over the work of people of color. Gender beliefs stem from a history of patriarchy, which is a society in when men hold power and women are largely excluded from power structures. Patriarchal structures establish social norms that resist changes along gender lines. Similarly, stratification economics studies the desire of whites to maintain their social standing and to avoid being at the bottom of a social ranking (last place aversion). Also, stereotype threat shows how cultural beliefs have a negative impact on the performance of individuals for underrepresented groups, reducing selfconfidence and performance.

Chapter 24 Trade and Exchange Rates, By Geoffrey Schneider Answers to Questions for review 1. a) Explain the theory of comparative advantage, and why most mainstream economists believe that unregulated trade increases the welfare of citizens on average.

According to the theory of comparative advantage, unregulated trade will result in maximum global productivity and increased standards of living. Each country specializes in what it is relatively best at producing, which increases productivity and makes people in all trading countries better off. As one concrete example, economists Robert Lawrence and Lawrence Edwards estimated that trade with China increased the standard of living of U.S. citizens by $250 a year in 2008. This is why most mainstream economists believe that unregulated trade increases economic welfare, on average. b) List and briefly explain the main problems with the Theory of Comparative Advantage.

1) Unregulated trade tends to benefit countries which have an advantage in lucrative industries, such as high end manufactured goods. It hurts producers of primary products.

2) The theory of comparative advantage is often wrong when it comes to explaining global trade patterns. Companies do not always end up producing what their resources are best suited for.

And, countries export and import the same goods, indicating that comparative advantage does not reside with countries. Instead, particular companies have a comparative advantage.

3) Companies can shift operations overseas, which can shift comparative advantage.

4) Technological changes can shift comparative advantages, such as the shift of steel production in the U.S. to more efficient production in Japan.

5) Resources do not flow easily from exporting sectors to import-competing sectors. This means lost factory jobs in Ohio are not replaced with new computer programming jobs in Ohio.

6) Trade is not free and fair. Many countries manipulate trade flows, such as Japan’s collaborative business relationships that make it hard for US companies to sell cars to Japan.

7) Exports do not balance imports in all cases, as epitomized by the chronic U.S. trade deficit.

2. Protectionism has long been utilized as a tool for economic development. a) What are the major policies used in protectionism?

A country can use tariffs, import quotas, subsidies, or laws and regulations that affect trade, to protect industries. b) What are the main arguments for protectionism?

1. Infant industry protection: Protection of key industries with substantial growth potential is essential in the early stages, so they can eventually grow to be competitive.

2. Strategic industry protection: Protecting key industries for defense or for networked industrial development (Silicon Valley) to preserve defense or industrial vitality.

3. Strategic trade policy: policies to target foreign countries who trade unfairly.

4. Raise revenue: Tariffs increase government revenues. c) What are the main costs generated by protectionism?

Protectionism usually raises the prices of goods for consumers, which can reduce their standard of living. Sometimes, protectionism can reduce an economy’s efficiency if inefficient, dying industries are protected and preserved. However, these criticisms do not apply to the case of infant industry protection, which has widespread benefits if the industry eventually becomes competitive.

3. The Theory of Comparative Advantage demonstrates that, in theory, ALL countries can benefit through specialization and trade. a) The graphs in Figure 24.8 show production possibilities curves for the U.S. and Kuwait, using an identical amount of resources for one month. Copy the graphs onto a sheet of paper.

Determine which country has a comparative advantage in oil, and which in rocket launchers using the PPCs. Show your work.

US: 1oil=1rl; Kuwait: 1oil=1/3rl and 1rd=3oil. US has a comparative advantage in RL (lower opp. cost) and Kuwait has a comparative advantage in Oil (lower opportunity cost). Therefore, the US should specialize in rocket launchers and Kuwait in Oil. b) Draw consumption possibilities curves on your graphs.

Assume that the international terms of trade are 1 rocket launcher for 2 units of oil (1RL = 2O).

See the graph. For 50RL, the US could trade for up to 100 units of Oil. For 90 units of oil, Kuwait could trade for up to 45RL. 4. The graphs in Figure 24.9 show production possibilities curves for the US and Japan, using an identical amount of resources for one day. Determine which country has a comparative advantage in Beef, and which in Automobiles using the PPCs. Show your work. Copy the graphs onto a sheet of paper. Draw consumption possibilities curves on your graphs. Assume that the international terms of trade are 1 Automobile for 3 units of Beef (1A = 3B).

Japan: 50B = 25A; 1B=0.5A; 1A=2B. US: 100B=25A; 1B=0.25A; 1A=4B. Japan: Comparative advantage in Automobiles. Japan will produce 25A, 0B. US: Comparative advantage in Beef. US will produce 100B, 0A. See the graph for the new consumption possibilities curves.

5. In 2018, the Trump administration imposed 25% tariffs on imports of steel into the U.S. Using a graph, show how that tariff would affect the 3200 equilibrium price and quantity of imported steel.

S S*1.25 D Assume that the initial price of steel is $2000 per ton.

3000 What impact would these tariffs have on U.S. steel makers? What impact would the steel tariffs have on 2800 U.S. car companies who use a lot of steel to manufacture cars?

2600 2400 2200 2000 1800 1600 1400 1200 1

2

3

4

5

6

7

8

9

10 11

Initially, the market is in equilibrium at a price of $2000 and, in the graph to the left, a quantity of 6.

The tariff of 25% shifts the supply curve up so that each number is 1.25 higher than before, making the new supply curve steeper as well. The new equilibrium price of steel would be higher, about $2200, and the new equilibrium quantity would be lower, about 4 on this graph. The increase in the cost of steel, an input in cars, would cause their costs to increase, shifting the supply curve for cars up and to the left. This causes the equilibrium price of cars to increase and the equilibrium quantity of cars sold to decrease.

6. For each question below, draw a graph of the Foreign Exchange Market for U.S. dollars in British pounds, and show how each of the following events will affect the price of the dollar and the quantity of dollars exchanged for British pounds. Explain your answer briefly. a) Incomes in the United Kingdom decrease.

Explanation: UK consumers will buy fewer American goods; demand decreases.

Dollar depreciates.

b) Interest rates in the United States decrease.

Explanation: UK investors will want to place more money in British banks where they will get a higher return on their investments; demand decreases.

Americans will want to invest in the UK where interest rates are relatively higher; supply increases. Dollar depreciates.

c) The prices of US goods decrease.

UK consumers want more relatively cheaper American goods; demand increases.

Americans will buy fewer expensive British goods; supply decreases.

Dollar appreciates.

7. Suppose that US interest rates rise relative to those in Europe. What effect will this have on the value of the US Dollar relative to the Euro?

S decreases and D increases. Investors seeking the highest possible returns on their savings place more money in US banks and less in European banks.

8. Suppose the European Central Bank decides to sell Euros and buy dollars with them. What effect will this have on the value of the Euro relative to the US Dollar? Explain using a graph of the Foreign Exchange Market for Euros.

Selling Euros increases the Supply of Euros (and the demand for dollars). The Euro depreciates.

9. Write an essay in which you assess the strongest arguments in favor of unregulated trade and the strongest arguments in favor of protectionism. Determine what approach you think your country should utilize when it comes to trade and exchange rates, and support your arguments with examples from the text and from other sources.

The strongest arguments in favor of unregulated trade are that it increases efficiency and productivity, thereby increasing the standard of living of people, on average. Evidence indicates that incomes do increase on average from trade. These arguments are made by mainstream economists.

The strongest arguments against unregulated trade are that it leads to the exploitation of workers, reduces effective demand, harms poor countries, and it is not an effective economic development strategy to pursue. Almost all developed countries used protectionism and other forms of managed trade policies to develop a comparative institutional advantage in key industries. These arguments are made by political economists.

Your argument will depend on which of these factors you find most important.