Solution Manual For Microeconomics 12e David Colander Chapter(1-23)

Solution Manual For Microeconomics 12e David Colander Chapter 1-23

CHAPTER 1: ECONOMICS AND ECONOMIC REASONING Questions and Exercises 1.

Coordination refers to how the three central problems facing any economy are solved. Those three problems are what and how much to produce, how to produce, and for whom to produce. Inevitably, individuals desire more than is available regardless of how much they’re willing to work for what they desire, causing a problem of scarcity.

The concept of scarcity has two elements: our wants and our means of fulfilling those wants. These two elements are interrelated since wants are changeable and are partially determined by society. In addition, the degree of scarcity is constantly changing, depending upon the available means of production and the development of new wants.

Therefore, the author focused on coordination rather than on scarcity to emphasize the subsidiary nature of scarcity to the overall concept of coordination.

Economics is not merely about our wants or the means of fulfilling those wants; it is also about reconciling our wants with reality, where reality consists of decisionmaking mechanisms, social customs, and political realities.

2. a. b. c. d. e. f.

Macroeconomic Microeconomic Macroeconomic Microeconomic Microeconomic Microeconomic Microeconomics studies how economic forces influence individual choices such as the pricing policies of firms, households’ decisions on what to buy, and how markets allocate resources among alternative ends. Macroeconomics studies aggregate relationships such as how household consumption is related to income and how government policies can affect growth.

3.

Answers will differ. Two microeconomic problems are the pricing policies of firms (price-fixing in particular) and the way wages are determined in labor 1

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markets. (Why do athletes and celebrities make so much money, anyway?) Two macroeconomic problems are unemployment and inflation (business cycles and growth are also macroeconomic problems).

4. a. The opportunity cost of attending college is the sacrifice one must make by attending college. It can be estimated by figuring out the benefit of the nextbest alternative. If that alternative is working, one would guess the likely wage that could be earned at a job that does not require a college degree and then multiply by 40 hours for each week in college. The opportunity cost is also what could be done with the money used for tuition and other costs related to attending college. b. The opportunity cost of taking a course could also be estimated using the same technique as in part a if you otherwise would be working during these hours. If you had taken another course instead, the opportunity cost would be the benefit you would have received from taking that other course. c. The opportunity cost of attending yesterday’s lecture would depend on what you otherwise could have done with that time (sleep, eat lunch with an interesting person, etc.). Although this is no longer a choice to you, past activities do have opportunity costs.

5.

Answers will vary. A correct answer will indicate that the student compared the marginal costs and benefits and chose the activity because the marginal benefit exceeded the marginal cost.

6.

The marginal costs are the additional costs of the additional activity. In this case, the additional activity is driving (200 − 100) miles. The marginal cost is the 10 cents per mile for all miles over 100 plus the additional cost of gas. Therefore, the marginal cost is $10.00  [0.10  (200  100)] plus the cost of gas. The initial payment can be forgotten because it is a sunk cost; it is not part of the marginal costs.

7.

No, since the marginal cost of drug control exceeds the marginal benefit; the government should not spend $4,170 to deter one person from using drugs.

8.

The opportunity cost of buying a $20,000 car is the benefit you would have gained by using that $20,000 for the next-best alternative, which could be spending it on other goods and services or saving it.

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9.

Only the marginal costs and benefits of taking the job are relevant. That means that the sunk cost of the bachelor’s degree is irrelevant. Therefore, the relevant costs are the opportunity cost of taking the job (forgone earnings from your current job) and other things you could have done with the money you need to pay for business school. The relevant benefit is the increased lifetime earnings of $600,000.

10.

You should spend the $5 million on projects that provide the highest marginal benefit per dollar spent. The opportunity cost of spending the money on one project is the lost benefit that the college would have received by spending it on a different project. Thus, another way to restate the decision rule is to spend the money on the project that minimizes opportunity cost per dollar.

11.

Answers will differ. Two examples of social forces are our unwillingness to charge friends interest and our unwillingness to ―buy‖ friends. These issues are still subject to economic forces; however, there is no market in ―friends‖ or in loans to friends, and so the economic force does not become a market force.

12.

Answers will differ. Two examples of political or legal forces are rent control laws and restrictions on immigration. Both prevent the invisible hand from working. Rent control laws place a price ceiling on rent, causing shortages of apartments, and immigration restrictions cause the number of immigrants seeking entry to exceed the number allowed to enter, which tends to cause wage rates to differ among countries.

13. a. Both parties benefit. The person who gains the kidney benefits if it works when transplanted into his or her body as he or she will no longer have the emotional and financial burden of dialysis. The person selling the kidney gains the $30,000.

Their gains will also have impacts on others (their family, for example). b. Both parties must undergo surgery and face all the attendant risks and costs. The seller faces the potential cost of a future illness or injury harming his or her only remaining kidney, causing the seller to need dialysis. It raises moral issues that could be seen as hurting society because organs change from being inalienable to being a commodity and, hence, is another element that negatively affects the individuals. c. Whether a society should allow this transaction is a question of value judgments and cultural norms. Our society has chosen not to allow such transactions because (among other reasons) those with more money would have increased access to organs and therefore would have advantages over those of limited means. Thus, the poor could be exploited in such transactions.

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14.

An economic model is a framework that places the generalized insights of a theory in a more specific contextual setting. Policymakers need to understand the empirical evidence supporting the theory as well as real-world economic institutions to make policy recommendations.

15.

No. Economic theory proves nothing about what system is best. It simply provides a way to look at systems and indicates what the advantages and disadvantages of various systems will likely be. Normative decisions about what is best can only follow from one’s value judgments, which are subjective.

16.

A theorem is a proposition that is logically true based on the assumptions of the model, whereas a precept is a policy rule that a particular course of action is preferable. Economists can agree about theorems but disagree about precepts if they have different value judgments regarding the intended goals.

17.

A normative statement reflects ethical judgments about what should be. It reflects values and is subjective. A positive statement refers to a fact or a logical relationship. It is in principle testable or is the result of logic analysis. Positive statements of facts are not subject to debate among individuals. The art of economics refers to issues of judgment on how to achieve the goals determined in normative economics, giving the facts and logical relationships one finds in positive economics. Art of economics statements are subject to debate.

18. a. Positive statement, since it is a statement of logic. b. Normative economics, since it deals with what the goals of the economy should be and is subjective. c. Since this is relating a normative goal to a decision, this could be a statement in the art of economics. It could also be seen as a normative statement if one interprets it as a normative imperative. d. Positive statement, since it is a statement of fact.

Questions from Alternative Perspectives 1.

Austrian Most economists would answer ―yes‖ because they see economic variables such as unemployment as objective measures, which make them available as measures for planning. Most economists see only individual preferences, not social 4

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preferences, as subjective. Austrians believe in a radical subjectivity, uncertainty with respect to time, knowledge, and matters beyond preferences. This eliminates the possibility of using objective economic analysis as the basis for government planning. For an Austrian study on the nature of time and uncertainty for economics, see the work of Mario Rizzo and Gerald O’Driscoll, Jr.

2.

Religious a. The rational choice model assumes that individuals are one-dimensional, that they know what they want, and that they will do what is in their best interest.

Addictive behavior undermines that assumption, leading to a conflict between passion and reason. b. The conflict suggests that we have to be careful not to apply the economic model in cases in which that conflict is important, such as with behaviors that have addictive elements. When there is a conflict between passion and reason, there may be greater reason for government to limit access to the addictive good or behavior.

3.

Feminist a. Patriarchy is a social institution in which men exercise a disproportionate amount of social power and are in a position to define the roles of women and children.

Because patriarchy affects the way people behave and interact, it is an institution.

Gender affects the labor market because those who are in power will make hiring decisions that perpetuate their position of power. For example, husbands and fathers may make, or heavily influence, the decisions of whether a woman will look for work. b. Some economists might argue that men and women are merely expressing their preferences in job choices, whereas feminist economists might argue that these choices are culturally determined by institutions, or patterns of behavior, such as the patriarchy. It is impossible to separate the market from the institutions within which they are embedded. The free market may not determine the institutions or mores of a society, but it nevertheless operates within those institutions.

4.

Institutionalist a. A free market outcome would provide the flu vaccine to those willing and able to pay the most for it, which probably would not include all of those given priority under the rationing scheme. b. The determination of which option is ―just‖ requires delving into theories of justice. The free market solution best mirrors commutative justice—one based on 5

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efficiency of exchange— and the rationing scheme best mirrors distributive justice—one based on some notion of fairness that favors those with a greater predisposition to illness.

5.

Post-Keynesian a. This answer will differ among students but should include an assessment of the marginal benefits incurred between various institutions. b. Most students probably will answer this question ―no.‖ The standard theory presented in the book is based on the assumption that decision makers have full information about all factors that might influence their decisions: They have substantive knowledge of all possible outcomes of their decision making and the consequences of each decision. Most likely you had limited knowledge of the pros and cons of the schools you were considering when deciding which college to attend. As a result, you probably turned to the advice and norms of a small group of friends, family members, or teachers to help you make a decision. c. Recognizing that you have limited time, knowledge, and ability to compute all the possible outcomes of each economic decision, you probably rely on social norms and rules of thumb to help you make many of your economic decisions. For example, when you go to the grocery store, you may continue to buy Diet Coke even though other diet sodas might provide you with a higher level of satisfaction at a lower price because you are in the habit of buying Diet Coke and uncertain of the exact benefit you will incur from other diet beverages. d. The implication of this behavior is that individuals do not follow the economic decision rule of gaining complete information to optimize their choices but rely on rules of thumb or habit to come up with a satisfactory outcome even though it might not be the most optimizing. This means that economic analysis, which assumes that humans are one-dimensional rational beings who calculate all relevant marginal costs and benefits, is limited.

6.

Radical a. It implies that there is no clear-cut distinction between positive and normative economics and that seemingly positive economics has implicit value judgments hidden within it. b. Economics is value laden. The relevant question about whether the distinction is tenable is whether it is relatively less value-laden than the alternatives. That is an open question.

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Issues to Ponder 1.

Regretting a decision doesn’t necessarily mean that we did not use the economic decision rule when making that decision. The economic decision rule infers that the individual has perfect information, which is an idealization of the reality of decision-making. At the time the decision was made, we weighed the marginal costs and marginal benefits, undertaking the activity if the marginal benefit exceeded the marginal cost and not undertaking the activity if the marginal cost exceeded the marginal benefit. Many decisions are made without knowledge of the full marginal costs and marginal benefits. Sometimes these marginal costs and marginal benefits are revealed at a later date, making us regret the initial decision.

An example is going out to a restaurant. From recommendations, we form an expectation about the marginal benefit. If that recommendation overstates our actual experience, we will have overestimated the marginal benefit of eating out.

We may regret having spent the money to eat out.

2. a. It depends on the perspectives used to answer the question. From a purely economic perspective, we would conclude that it is reasonable to execute hackers based on cost/benefit analysis. However, since this decision can by no means be simplified to pure economics, we need to take into consideration social, political, and religious factors. Therefore, Landsburg’s argument should be evaluated in a more holistic context. b. Cost/benefit analysis can be extended to many areas, such as social welfare programs and almost all the policy discussions. (Source: ―Feed the Worms Who Write the Worms to the Worms,‖ http://slate.com/id/2101297/), Slate Magazine, May 26, 2004.)

3.

The Theory of Moral Sentiments emphasizes the importance of morality. The invisible hand directs people’s selfish desires (tempered by the social and political forces) to the welfare of society but is based on certain presuppositions about the morality of individuals which constrains individuals’ selfish actions. What Smith is suggesting is that the way individuals calculate marginal cost and marginal benefit must be interpreted within a social context.

4. a. & b.

Parts a and b have no ―right‖ answers. Most people would say ―no‖ to a and ―yes‖ to b. If one were answering this question from the perspective of the economic decision rule alone, one would measure the marginal benefits against the marginal costs of the choice.

c. People tend to believe that children should be afforded greater protection than is afforded to adults and are therefore repelled by the idea of sacrificing a child even 7

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though it would save the lives of other children. Sick people are closer to death, and therefore their lives tend to be valued less. d. Brain imaging suggests that the moral sense behind one’s answers does not come from rational thought, but instead from emotional, gut responses. This suggests that a kind of moral intuition exists that is quite separate from reason. If that is the case, opportunity costs were not central to the decision. It was a moral, not an economic, decision. Opinions among philosophers and economists differ on this issue.

5. a. It depends. On the basis of cost/benefit analysis, one could figure out cases in which most people would say that they should be dishonest, but cost/benefit analysis is not the final arbiter if you believe that dishonesty is wrong.

Additionally, you should consider the social implications of dishonesty, as your reputation and future interactions may be impacted. b. You can make yourself more believable by developing a reputation for honesty.

Developing such a reputation usually has a cost because it requires you to be honest even when others might be dishonest. To encourage the other person to tell the truth, you could use economic incentives.

6. a. Answers will vary. b. Economic theory says that prices are determined by supply and demand, but businesses often use cost-plus-markup rules, or rules of thumb, to set their prices.

If two firms have different costs of supplying the same item, they probably will set different prices for that item. People might be willing to pay the higher price if the store is closer to where they live or simply to support a smaller, local store. c. Again, answers will vary, but the reasoning is the same as in part b.

7.

It depends on the perspective one takes. It is economically reasonable to legalize organ sales. But from a moral perspective, organ sales may be unethical, and poorer people might feel compelled to sell their organs to support their family, a result that many people would find morally reprehensible. Economics has nothing definitive to say on normative moral issues such as this.

8.

Answers will vary. Here is an example: Banks are economic institutions. They take a cost/benefit approach to deciding to whom to give loans, and they influence decision making by allowing individuals to spend more money than they earn or have as wealth.

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9. a. This is a matter of personal views; there are arguments for and against it. An argument against the practice is that wealthy songwriters would have too much power in promoting their songs. The songs of the songwriters who can afford to share profits will get more play time and become even more famous to the detriment of new entrants into the industry. Arguments for this practice are that it could be used to offset racism as in the example given and, to the extent that new songwriters have the capability of offering such royalty share, promote new kinds of music. b. The royalty payment gave Freed a strong incentive to choose what he considered the best song and to promote that song heavily. The flat payment would have just given him an incentive to play any song and no long-term interest in whether the song succeeded or failed. c. Answers will vary. Here are a few examples: Product placement in movies is legal, as are free newspapers to professors for getting a class to use the newspaper. Direct payments to doctors for prescribing a particular type of drug are illegal, although taking doctors to lunch is not.

10.

Three ways (among many) that dormitory rooms could be rationed are administrative decree, lottery, and a market system. In the first, individual behavior would be forced to fit the will of the administrator. Individuals probably would complain and try to influence the administrator's decision. Because administrative decree is not necessarily an efficient system, some people probably would attempt to trade rooms after the allocation. In the second, individual behavior would be forced to fit the luck of the draw; individuals probably would attempt to trade rooms after the draw. In the final example, individual behavior would have already been subject to economic forces, and thus, there would be no tendency to trade after one has "bought" the room one can afford.

11.

It suggests that policy should be willing to give up more in possible gains to avoid losses than otherwise would be the case. Economic policies should be riskaverse—more committed to maintaining the current standard of living than to risking economic losses by trying to improve it. Another possible policy response would be to offset this tendency by making gains more salient than losses.

12.

A good economist always tries to be objective. However, no one can ever be completely objective. Sometimes the best we can hope for is an awareness of the cultural norms and value judgments that influence our views and decisions.

Additionally, many policy issues (such as organ markets and minimum wage laws) probably should not be approved in a purely objective way since they also have moral and social implications.

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13.

―Letting the data speak‖ means using computer power to find patterns in data. As computational methods have improved exponentially, the patterns that computers find are more robust and useful in finding patterns. So, the reason modern economists are more likely to let the data speak is due to technological change in computational methods.

CHAPTER 2: THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION Questions and Exercises 14.

In the figure to the right, wadget production is measured on the vertical axis and widget production is measured on the horizontal axis. If the society becomes more productive in its output of widgets, it can produce more of them, and the end point of the curve on the horizontal axis will move to the right, as shown. If the society is also less productive in its production of wadgets, the end point on the vertical axis will move down, as shown. The result is a new production possibility curve.

15.

If a society became equally more productive in the production of both widgets and wadgets, the production possibility curve would shift out to the right as shown in the accompanying graph.

16.

Any production possibility curve that shows the principle of rising trade-off must be bowed out. The accompanying grade production possibility curve embodies the principle of rising trade off. The table is presented below. Notice that for each 20-point gain in the History grade the amount of points lost on the Economics grade steadily increases.

History

40 60 80

100 80 50

Economics 10

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17. a. In order to produce one more Peep, JustBorn must give up 3 Mike and Ikes.

Hence, the trade-off for 1 Peep is 3 Mike and Ikes. The trade-off for one Mike and Ike is 1/3 of a peep. d. See the accompanying graph. Opportunity costs are constant.

e. Point A is efficient. Point B is inefficient. Point C is impossible. f. See the accompanying graph.

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18.

The theory of comparative advantage underlies the shape of the production possibility curve. By taking advantage of each person's comparative advantage, higher total output can be reached than if each produced all goods on his or her own, or if each produced goods for which he or she did not have a comparative advantage. As more and more of a good is produced, resources that have less of a comparative advantage are brought into the production of a good, causing the production possibility curve to be bowed outward.

19. a. See the accompanying graph.

g. As the output of food increases, the trade-off (opportunity costs) between food and clothing increases. To illustrate, giving up 4 units of clothing (from 20 to 16) results in a gain of 5 units of food (from 0 to 5), but giving up another 4 units of clothing (from 16 to 12) results in a gain of 4 units of food (from 5 to 9), and this pattern continues. h. If the country gets better at producing food, the production possibility curve shifts out along the food axis only. i. If the country gets equally better at producing food and clothing, the production possibility curve will shift out along both axes by the same proportion.

20.

There are no gains from trade when neither of two countries has a comparative advantage in either of two goods.

21.

The fact that the production possibility model tells us that trade is good does not mean that in the real world, free trade is the best policy. The production possibility model does not take into account the importance of institutions and government in trade. For example, the model does not take into account externalities associated with some trades, the provision of public goods, or the need for a stable set of institutions or rules. The production possibility model shows maximum total output, but that is not the only societal goal to take into account when formulating policy.

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22. a. See the accompanying graph.

j. The United States has a comparative advantage in the production of wheat because it can produce 2 additional tons of wheat for every 1 fewer bolt of cloth while Japan can produce 1 additional ton of wheat for every 2 fewer bolts of cloth. Japan has a comparative advantage in producing cloth. k. The United States should trade wheat to Japan in return for bolts of cloth. One possibility is that the United States produces 1,000 tons of wheat and Japan produces 1,000 bolts of cloth and they divide total production equally. Both get 500 tons of wheat and 500 yards of cloth. Both end up with more of each good.

(Note: Other combinations are possible.) l. See the accompanying graph. Point A is the bundle of goods each country will be able to consume. Because point A is outside the production possibility curve for each country, trade clearly benefits both countries.

23.

Globalization increases competition by allowing greater specialization and division of labor. Because companies can move operations to countries with a comparative advantage, they can lower production costs and increase competitive pressures. The decreased importance of geographical location increases the size of potential markets, increasing the number of suppliers in each market and thus increasing competition.

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24.

The law of one price rules, meaning that U.S. wages can only exceed foreign wages to the degree that U.S. workers are more productive than foreign workers.

The adjustments, therefore, that will need to occur will equalize wage rates. So, either Western nominal wages will grow slowly and foreign nominal wages will grow rapidly and catch up or U.S. exchange rates will decline to equalize wages.

Some combination of the two is most likely. It is possible that there will develop areas of production/services that will allow U.S. wages to remain high.

25.

The law of one price states that wages of workers in one country will not differ significantly from wages of (equal) workers in another institutionally similar country. As the world is globalizing, the law of one price causes firms to hire workers in other countries. Because wages adjusted for productivity differences are lower in other countries, firms choose to use workers in foreign countries. As they do so, wages will be bid up until wages, adjusted for productivity differences, are equal between the two countries.

Questions from Alternative Perspectives 26.

Austrian In a market economy competition, the market process translates individual actions into actions that are good for society. There is no such mechanism for government; government has a monopoly on power, which allows individuals in government to use that monopoly to achieve their ends, which may not be ―good‖ ends. This monopoly on power makes government less reliable than the market to do good, since the government is not subject to entry and exit as firms are in the market. Also, whether or not every individual voice is taken into account depends on the government system, while the market will always include any individual’s voice by either their entry or exit.

27.

Religious m. Most people would say that while it might be a component of the goals of society, it is not ―the‖ goal of society. Other goals might include virtues such as kindness and generosity. n. If a country is Christian, maximizing output probably should not be "the" goal of society. o. In a Christian society the paramount goal would be to discern and fulfill the will of God.

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28.

Feminist p. Companies definitely think that sex sells products. Just look at the cover of any number of magazines. q. Sex is used in the advertising of numerous products. r. All people are subject to abuse by advertising, but women are more likely to be portrayed as objects instead of people and are therefore at greater risk of exploitation. s. While men and women may both be used in advertising, many times men are shown to be in a dominant position of power, while women are shown in subordinate positions.

29.

Institutionalist t. Back in the 1950s President Eisenhower warned of the military/industrial complex, which maintains all types of military spending on projects so that they continue to generate jobs for those areas. Senators with power on the appropriations committee inevitably have larger defense expenditures in their districts than senators not on the appropriations committee. This high spending on military production results in a trade-off. It means that there is less money to spend on consumer goods, leading to a lower production of consumer goods. u. The short-term consequence is a loss in consumer goods. The long-term consequences are potentially much more serious, because in order for the military to justify the expenditures, wars are necessary; thus, the production of military goods over consumer goods can increase the probability of wars. Some argue that the 2003 Iraq war is an example, because Halliburton benefited from it, and the former head of Halliburton, Vice President Cheney, leading the group pushed for U.S. entrance into the war.

30.

Radical v. Yes, not only does technology still have such effects, those effects on our lives seem to be increasing in some areas. While technology has freed us from some arduous jobs, it has also eliminated jobs that gave meaning to people's lives.

Technology is leading to more and more specialization in the methods of production to include more and more computational work. This is making more and more jobs that we used to consider desirable human jobs done by technology.

So the job becomes designing the technology to do the job, not doing the job.

In modern society technology is replacing many human activities that were called work with activities associated with computers. Today computers can design buildings, diagnose medical problems, drive cars, and many more tasks. This is 5

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reducing the types of labor that are needed. The type of labor that is needed now is much more involved with software design. Many other types of labor, such as physical labor, or quasi-skilled labor are being replaced. If work were only something to be avoided, this might be without cost and an overall benefit to society. But it misses the broader issue of what the purpose of life it. As Ralph Waldo Emerson said, ―The purpose of life is not to be happy. It is to be useful, to be honorable, to be compassionate, to have it make some difference that you have lived and lived well.‖ All too often economic models miss these broader fundamental cultural issues and miss the point that technological change is making it harder for many to find that purpose. It makes them redundant to society. w. When making policy decisions, society must take into account not only what is produced, but the methods and means of production.

Issues to Ponder 31.

This statement can be true or false depending on the implicit assumptions made in the analysis. It is true given that individuals will eliminate all inefficiencies they see through trading. It might be false if not everyone knows all the benefits and the inefficiencies or does not have the opportunity to correct the inefficiencies, or if the costs of eliminating the inefficiency are too high.

32.

If achieving a particular distribution of income is one of society’s goals, a particular production technique that leads to greater output might be considered an inefficient method of production if it also leads to a less desirable distribution of income. Remember, efficiency is achieving a goal as cheaply as possible.

Maximizing output is not the only goal of a society.

33. a. From the numbers alone, one would choose not to work because the opportunity cost of working is giving up an $80,000 increase in lifetime income while the benefit is $32,000 of income now. Although there is a correlation between working time and GPA, we cannot conclude that working an after-school job causes the decrease in GPA. Therefore, one might be able to maintain a decent GPA while working. Moreover, earning money might be the priority for a particular student to reach another goal, such as saving for college that will lead to even greater lifetime earnings. x. It depends on the particular student. Working takes time from study and thus might be a reason for the decrease in GPA. But the situation varies from student 6

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to student. In some cases, work experience may complement what is learned in class and can lead to higher grades.

34.

The fact that lawns occupy more land in the United States than any single crop does not mean that the United States is operating inefficiently. Although the cost of enjoying lawns is not included in GDP, lawns are nevertheless produced consumption goods and are included in the production possibility curve for the United States. The high proportion of land devoted to lawns implies that the United States has sufficient food that it can devote a fair amount of land to the production of goods for enjoyment such as lawns.

35.

Following the hint that society’s production possibility curve reflects more than just technical relationships, we realize that trust is an input to production to the extent that it is necessary for transactions. If everyone could fake honesty, the production possibility curve would shift inward since no one could trust anyone else leading to the disintegration of markets. If some could fake honesty, those few will gain at the expense of others.

36. a. Firms may produce in Germany, because (1) transportation costs to/from the other countries may be very high, so that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led to production in Germany and the cost of moving production may exceed potential gains. y. There would probably not be a significant movement of workers right away. One would expect some movement from Greece and Italy into Germany, but this is limited by social restrictions such as language, culture and the economic climate in Germany, which currently has high unemployment. Movement in the long run, however, may be substantial. z. I would want to know about the rule of law in Thailand that will govern business practices, the stability of the government, and the infrastructure. All of these will affect the costs of production.

CHAPTER 2 APPENDIX: GRAPHISH: THE LANGUAGE OF GRAPHS

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a

37.

See the accompanying graph. d.

c b

38.

See the accompanying graph. aa. The relationship is nonlinear because it is curved, not straight. bb. From 0 to 5, cost declines as quantity rises (inverse relationship). From 5 to 10, cost rises as quantity rises (direct relationship). cc. From 0 to 5, the slope is negative (slopes down).

From 5 to 10, the slope is positive (slopes up). dd. The slope between 1 and 2 units is the change in cost (30−20) divided by the change in quantity (1 − 2), or −10.

39.

See the accompanying graph.

10 9 8 7 6 5 4 3 2 1

d

b a

c

1

2 3 4

5 6 7

8 9 10

40. a. 1 ee. −3 ff. 1/3 9

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gg. −3/4 hh. 0 41. a. C ii. A and E jj. B and D kk. B is a local maximum; D is a local minimum.

42. a. See line a in the accompanying graph. ll. See line b in the accompanying graph. mm. See line c in the accompanying graph.

10

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43. a. y = 5x + 1,000 nn. y = 3x + 1,500.

44. a. line graph oo. bar graph pp. pie chart qq. line graph

CHAPTER 3: ECONOMIC INSTITUTIONS Questions and Exercises 45.

In a market economy, fluctuations in prices play a role in coordinating individuals’ wants. Price is the mechanism through which people’s desires are coordinated and goods are rationed.

46.

In a centrally planned socialist economy, sometimes called a command economy, economic activity is governed by central planning. These planning boards set society’s goals and then direct individuals and firms as to how to achieve those goals.

47.

Market economies solve the three problems through markets and the system of rewards and payments. What gets produced is what businesses believe can be sold. How it gets produced is determined by businesses; generally, they choose the method that makes the largest profit. Those who are willing to pay for the goods at the market-determined prices will get them.

48.

Centrally planned socialist economies solve the three problems by using administrative control. Central planners decide what to produce according to what they believe is socially beneficial. In deciding how to produce central planners are guided by what they believe is good for the economy. Central planners decide distribution based on their perception of individuals’ needs.

49.

Although economics does not provide an answer to normative questions such as this, economics can be used to describe the characteristics of capitalistic and socialistic economic systems, the degree to which each economy relies on markets, and how this reliance has changed over time. Economics can explain 1

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how each system functions and explain how efficient each system is, but economics does not provide an answer to normative questions without imposing normative judgments.

50.

A market economy depends on coordination, and the mechanisms of coordination depend on the people who choose which goods to supply and what to demand.

People supply the labor that makes the economy run. Economic growth, and what is considered a resource depend on technology, and people develop new technologies. Even the institutions that oversee the economy are governed by that economy’s people. It follows that the economy’s ultimate strength resides in its people.

51.

Business is dynamic; it involves meeting new problems constantly, recognizing needs, and meeting those needs in a timely fashion. These are precisely the skills of entrepreneurship. Entrepreneurship is the ability to organize and get something done and is an important part of business. Businesses in the United States decide what to produce, how to produce, and for whom to produce, and entrepreneurs solve these dynamic coordination problems.

52.

The three forms of businesses are corporations, partnerships and sole proprietorships. a. In the United States, most small firms are sole proprietorships. b. Corporations account for most sales.

53.

You would most likely choose a sole proprietorship because it’s easy to start, requires minimal bureaucratic hassle, and is controlled by you, the owner. If you need more money than you have to start this business, you might consider taking on a partner. This would also allow you to share the work and the risk, but you will also have to share the profits and figure out a way to work together successfully.

54.

The state and local government’s two largest categories of spending are education (approximately 28 percent) and health & welfare (approximately 36 percent), with expenditures on public safety being the third largest (approximately 7 percent).

55.

The six roles of government in a market economy are (1) providing a stable set of institutions and rules, (2) promoting effective and workable competition, (3) correcting for externalities, (4) ensuring economic stability and growth, (5) providing public goods, and (6) adjusting for undesired market results.

2

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56.

Pollution permits require firms to pay the cost of pollution they create. When these permits are tradable, firms that face the lowest cost of reducing pollution will reduce pollution emissions the most and sell their extra rights to firms who face a higher cost of reducing pollution. Permits assign the right to pollute, thereby correcting for the externality.

57.

A merit good is a good that government believes is good for you even if you choose not to buy it. An example might be going to the opera.

A demerit good is a good that government believes is bad for you even if you choose to buy it. An example is alcohol or drugs.

A public good is a good that if supplied to one person must be supplied to all and whose consumption by one does not preclude the consumption by another. An example is national defense.

An externality is the effect of a trade on a person not involved in the trade. An example are the second-hand effects from cigarette smoke.

58.

Economic actions are coordinated by a wide variety of international organizations such as the United Nations, The World Trade Organization (W TO), and the World Bank. (The answer needs to mention only two of these three organizations.)

59.

Countries have developed global and regional organizations whose role is to coordinate trade among countries and reduce trade barriers. The World Trade Organization, European Union and NAFTA are examples of these types of organizations

60.

International organizations are limited in their effectiveness because membership is voluntary, as are any agreements among members. There is no world government to enforce international laws or agreements. What keeps countries somewhat in line is moral tradition.

Questions from Alternative Perspectives Austrian 1. The dangers of government intervention and support of activities is that once intervention begins, it is hard to limit. For example, if the state supports children 3

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the state will want control of those children, which will impinge upon individual’s freedoms.

2. If governments financially support families, they might attempt to limit the number of children that families can have, such as the People’s Republic of China did with the ―one child policy.‖ Alternatively, governments may want more children to increase the size of the military and will limit birth control to achieve these ends, just as Romania did in its socialist period.

61.

Religious He meant that strongly held religious beliefs can lead people to violate the law, because they hold the law of God above the law of the state. There is debate about whether he is correct, but as can be seen with some religious fundamentalists who incorporate violence into their belief system, the state may face serious problems when people rely on religion as their primary guide for action.

62.

Feminist Economists know relatively little about intra-household decision-making and have generally assumed that households have a single joint utility function. In one popular theory, those with power (parents) are assumed to be benevolent while those without power (children) are assumed to be selfish. Widespread spouse and child abuse and evidence of harmful unequal food distribution within families clearly undermine this simple notion of household decision-making.

3. Absolutely. Bargaining is likely to take place among individuals within a household. A child might agree to eat certain foods in exchange for getting a toy, for example.

4. The ability to walk away from the bargain is what gives someone power. Paying the bills also gives power. In families the individual with higher income is likely to have greater bargaining power.

5. Individuals are more likely to act cooperatively within a household because there are additional mechanisms besides money to maintain accountability. However, there may be unspoken competition within a family, such as when children compete for their parents' attention. There is also cooperation elsewhere, such as when employees work together to accomplish a task.

6. It makes sense within the theory of social behavior of groups of various sizes and strengths of relations.

4

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63.

Institutionalist The dilemma is obvious and represents an inherent conflict in a society whose values are greatly influenced by the Judeo-Christian ethic of charity towards all, and the free market ethic, which emphasizes the pursuit of self-interest. In thinking about ethics, there is a difference between intention and result, and in the Theory of Moral Sentiments, Adam Smith argued that all people have an inherent concern about others, but that often in trying to do good, the end result left things worse off. In some cases, he argued that the competitive market was the best way to blend the two goals together. In developing this idea, discussion can be used to delineate concepts of justice and the difficulty of universal application.

64.

Radical To some degree consumers’ desires influence what is produced, but with so much advertising, it is difficult to determine people’s true desires, and whether those desires are being created by businesses. The ability of firms to influence consumers’ behavior is increasing with the development of data science and the large amount of data generated by Internet activity. As firms better understand consumer psychology, they are in a better position to use it to their advantage.

Firms have a strong incentive to develop tastes for the products that they are selling, and they spend lots of money on advertising to shape tastes. But since we don’t know what people’s underlying tastes are, views on this issue can differ, and it is difficult to say which view is correct.

The other group that has some sovereignty is business. If business sovereignty holds, then the analysis based on consumer sovereignty is misleading, and should not necessarily be followed. What this tells us is that economic analysis is much more complicated than an introductory text can provide.

Issues to Ponder Markets have little role in most families. In most families decisions about who gets what are usually made by benevolent parents. Because families are small and social bonds are strong, this benevolence can work. Thus, a socialist organization seems more appropriate to a family and a market-based organization to a large economy where social bonds don’t hold the social unit together. The propensity to look after the common good is much stronger in a family than in an entire economy.

The benefits of a market-based economy in a family would be to provide incentives to all members of the family to contribute to family production, although this may undermine the social bonds of families.

5

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65. a. The fact that more money is spent on adults than on children in the family does not imply that the children are deprived or that the distribution is unfair. Children and adults have different needs. Adults, for example, eat more.

Yes, these percentages probably change with income. The lower the income, the larger the percent of total expenditures spent on children. The reason is that most families want to provide a basic level of needs for their children. Many families feel that luxuries should not be given to children until the children have learned how to work for themselves.

7. Our suspicion is that the allocation would not be significantly different in command economies as compared to capitalist economies. If, however, the average income in command economies were lower, the percentage of total expenditure spent on children might be higher, as described in part b.

66. a. Innovation requires a certain level of freedom of thought and a possibility of profit-making from the innovation. Neither existed in centrally-planned economies. Government planners directed production with income based on need, so workers had neither the freedom nor the incentive to innovate.

Both freedom and the possibility of making profits provide the means and incentives for innovation in capitalist countries.

Schumpeter’s argument was based on the idea that profit-making by innovators was necessary for innovation to occur. As firms become larger, however, the individual ceases to become the direct beneficiary of his or her innovations.

Since his predictions did not materialize, one must believe that firms have either been able to create incentive structures to foster innovation or that some other venue for innovation has arisen. Firms have large research and development departments designed to promote innovation. In addition, individual innovators have been able to raise enough capital to start their own companies to profit directly from their innovations. In the United States there has been enormous growth in the number of such firms. The U.S. government has been a large motivator of innovation through its strong patent and copyright system, as well as providing subsidies for research at universities and support of military innovations, both of which have large spillovers into private industry.

67. a. Such an idea could be expanded to include college courses, but that is unlikely to happen because the quantity of in-person college courses demanded would decline as people substitute toward recorded lectures. Substitution, however, is not perfect since DVDs cannot provide the interaction between student and instructor or among students that exists in the classroom. Social forces would act 6

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against the movement away from college classroom instruction even if the invisible hand pressed action toward it.

Technical problems are virtually nonexistent. Socially, the problems are substantial.

A diminishing role of the university would significantly change its role of providing a focal point for intellectual discussion and discovery, thus changing the nature of education. There would be great social pressures to maintain this role of American colleges. The economic issues are substantial as well. A course could be taught once and used over a period of years. This would reduce the demand for professors and create revenues for certifying agencies that would regulate the distribution and quality of the tapes. If these college-at-home courses became an accepted educational credential, the demand for traditional college education would fall, putting major competitive pressure on traditional colleges.

Even though the program is technically possible and cost efficient, it will not necessarily be a success because social forces will play a major role in limiting the market. Social forces are often strong enough to overcome economic forces.

(Note: Student answers may be more varied now that online college courses have become much more popular during COVID. Platforms like Coursera are now large and trading on the NYSE, so some students may discuss that.)

68.

Answers will vary. There are no ―correct‖ answers; it is more an exercise that asks you to gather information about the limitations on businesses of different types in their communities. You are then asked to make judgments as to whether the limitations were necessary (are you being clear about the goals involved?) and whether the number of limitations is correct. The information is linked to the text’s material in part d. Part e asks you to learn about business taxes in your community, and part f asks you to gather a sense of business satisfaction.

69.

Consumers decide what goods they want and demonstrate their decisions in their willingness to pay for the goods. Businesses decide what to produce, but their decisions reflect consumer desires. Thus, there is no contradiction. However, some types of advertising, in which businesses attempt to influence consumer behavior, can limit consumer sovereignty.

70.

Individuals might disagree as to the categorization of a good as a merit, demerit or public good or a good that involves an externality. In the case of an externality, they may believe that given sufficient property rights, the externality will be solved most efficiently by the market, not government.

71.

There is market failure only if people do not value operas as much as they should.

This normative statement is valid only if the ―should‖ can be measured against 7

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some absolute truth as to the value of operas, otherwise how would one decide who decides the value of operas? Because it is only through the market that value is revealed, we’d argue that government intervention in this case will likely lead to government failure—the failure of government to accurately value operas.

With government intervention, the value will likely reflect the preferences of those with political power, not necessarily those of the general population.

72.

People have made decisions based on the rules that were set up, so changing them after the game has been started may be more unfair than continuing to play by the original rules. There is a cost of loss of credibility to changing rules after the game has started. Such decisions must be made based on the marginal cost and benefit of changing the rules.

73.

When making such trade agreements, it is important for countries to realize that trade includes not only economic issues, but cultural and social ones as well.

While free and unregulated trade is generally the most economically beneficial (maximizes consumption possibilities), these economic benefits can be overpowered by the loss of cultural identity as a result of globalization. Taking into consideration such losses is a government’s responsibility when negotiating trade agreements. These losses must be weighed against the benefits of free trade.

CHAPTER 4: SUPPLY AND DEMAND Questions and Exercises 74.

The law of demand states that quantity demanded falls as price increases; or that quantity demanded rises as price falls. Price is inversely related to quantity demanded because as price rises, consumers substitute other goods whose price has not risen.

75. a.

Price $2 $4 $6 $8 $10 $12 $14 $16

Market Demand 64 56 44 36 28 20 12 8 8

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rr. See the accompanying graph of the table.

ss. At the market price of $4, the total market demand is 56. If the price rises to $10, the total market demand will fall to 28. tt. All of the curves will shift to the right by 50 percent. [(Note: The top part of Javier's demand curve will not shift to the right (an additional 50% of zero is still zero).]

76.

Four shift factors of demand are income, price of other goods, tastes, and expectations. A fifth shift factor is taxes and subsidies to consumers. As income rises, demand increases. As the prices of other substitute goods rise, demand increases. As tastes change to favor a particular good, the demand for that good increases. If people expect the price of a good to fall in the future, demand will fall now. Taxes reduce demand, while subsidies increase it.

77.

A change in the price causes a movement along the demand curve to a new point on the same curve. A shift in the demand curve means that the quantities will be different at all prices; the entire curve shifts.

78.

The law of supply states that quantity supplied rises as price increases or, alternatively, that quantity supplied falls as price decreases. Price is directly 9

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related to quantity supplied because, as price rises, people and firms rearrange their activities to supply more of that good in order to take advantage of the higher price.

79.

Saying that supply increases means that the curve has shifted to the right, which is not the result of a price change. The correct statement is that, normally, as price rises, the quantity supplied increases, other things constant.

80.

A shift in supply is the graphical representation of the effect of anything other than price on supply, and these shift factors shift the entire supply curve. Shift factors of supply include the price of inputs, technological advances, changes in expectations, and taxes and subsidies. As the price of inputs increases, the supply curve shifts to the left. As technological advances are made that reduce the cost of production, the supply curve shifts to the right. If a supplier expects the price of her good to rise, she may decrease supply now to save and sell later. Other expectational effects are also possible. Taxes paid by suppliers shift the supply curve to the left. Subsidies given to producers shift the supply curve to the right.

81.

When adding two supply curves, sum horizontally the two individual supply curves, as in the accompanying diagram. S3 is the market supply curve.

82. a. The market demand and market supply curves are shown in the accompanying graph. uu. Equilibrium price is $40. Equilibrium quantity is 25. vv. At a price of $30, quantity demanded is 35 and quantity supplied is 15. Excess demand is 20. At a price of $60, quantity demanded is 5 and quantity supplied is 45. Excess supply is 40.

10

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83.

In the accompanying graph, the demand curve has shifted to the left, causing a decrease in the market price and the market quantity.

84.

The price of airline tickets rises during the summer months because demand for airline travel increases as more people take vacations. This change in consumer tastes causes a shift of the demand curve to the right.

The equilibrium price increases as does the equilibrium quantity as is shown in the accompanying graph.

85.

Sales volume increases (equilibrium quantity rises) when the government suspends the tax on sales by retailers because the price to demanders falls and hence equilibrium quantity demanded rises. This occurs because the supply curve shifts to the right because suppliers do not have to pay taxes on their sales (cost of production declines).

86.

Increased security measures imposed by government will increase the cost of providing air travel. This will 2

shift the supply curve to the left,

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increase equilibrium price to P1 and decrease equilibrium quantity to Q1 as shown in the accompanying graph. They also might reduce demand (the hassles of the increased security and the additional time it takes to travel), further decreasing equilibrium quantity and offsetting the rise in price, in this case to P2 .

Some students might argue that increased security will increase demand because consumers will feel more comfortable flying (they don't have to worry about terrorists as much). If demand increased, the price would go up even higher and the equilibrium quantity would also increase.

87.

Customers will flock to stores demanding that funky ―economics professor‖ look, creating excess demand (the demand curve shifts right). This excess demand will soon catch the attention of suppliers, and prices will be pushed upward.

Eventually a new equilibrium is reached at an increased price and quantity.

88.

As substitutes for bottled water—clean tap water—decrease, demand for bottled water increases enormously, and there will be upward pressure on prices. Social and political forces will, however, likely work in the opposite direction—against ―profiteering‖ from people’s misery.

89.

Since the Organization of the Petroleum Exporting Countries (OPEC) is a dominant producer of oil, increasing oil production (not as a result of a price change) will shift the supply of oil out to the right. The price of oil will decline as shown in the accompanying graph.

90.

The results for each part are shown in the accompanying graphs. ww. The bad weather causes a decrease in supply. This is shown by a shift in supply from S0 to S1. Equilibrium price rises from P0 to P1, while equilibrium quantity falls from Q0 to Q1.

2

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xx. The medical report causes a decrease in demand. This is shown by a shift in demand from D0 to D1.

Equilibrium price falls from P0 to P1 and equilibrium quantity falls from Q0 to Q1.

yy. The innovation causes an increase in supply. This is shown as a shift in supply from S0 to S1. Equilibrium price falls from P0 to P1, while equilibrium quantity rises from Q0 to Q1.

zz. The drop in income causes a decrease in demand.

This is shown by a shift in demand from D0 to D1.

Equilibrium price falls from P0 to P1 and equilibrium quantity falls from Q0 to Q1.

91. a. I would expect wheat prices to decline since the supply of wheat is greater than expected. Wheat commodity markets are very competitive, so the initial 30 percent increase in output was already reflected in the current price of wheat. It is only the additional 10 percent increase that will push down the price of wheat. aaa. This is graphically represented by a shift to the right in the supply of wheat, as shown in the accompanying graph. Equilibrium price falls from P0 to P1, while equilibrium quantity rises from Q0 to Q1.

1

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92. a. The cars in Italy are most likely much smaller than those in the United States.

Italians would be likely to want to conserve gasoline and thus demand smaller cars that use less gasoline. bbb. As in (a), Italians will want to conserve gasoline more and thus use public transportation more than Americans use it. ccc. As in (a) and (b), Italians will be more concerned with fuel efficiency in their desire to conserve gasoline since it is relatively more expensive there. ddd. Raising the price of gasoline in the United States to $5 per gallon will decrease the size of cars driven in the U.S., increase the use of public transportation in the U.S., and increase the fuel efficiency of cars purchased in the U.S.

93. a. The tax shifts the supply curve to the left in the market for natural gas exports because it increases the cost of supplying the natural gas to other countries. Therefore, in the market for natural gas exports, equilibrium price rises while equilibrium quantity falls. eee. As it becomes more expensive to sell natural gas to other countries, more natural gas produced in Argentina will be sold in Argentina, causing the domestic price to fall.

94.

It suggests that the price is above the equilibrium price so that the quantity supplied exceeds the quantity demanded, as you can see in the accompanying graph. Including social and political forces in the analysis will provide a counter– pressure to the dynamic forces of supply and demand. The result would be an equilibrium with continual excess supply or excess demand. In this example, there must be a social or political force exerting upward pressure on the price, causing an excess supply of taxis at the airport.

1

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95.

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. It affects the supply/demand model by drawing our attention to the possibility that supply and demand are interdependent. Feedback effects must be taken into account to make the analysis complete. An understanding of the fallacy of composition is of central relevance to macroeconomics. In the aggregate, whenever firms produce (whenever they supply), they create income (demand for their goods).

96.

The greatest feedback effects are likely to occur in the markets that are the largest.

This is most likely to be true for housing and manufactured-goods markets.

97. a. Because the market for pencils is relatively small, supply/demand analysis would be appropriate without modification. Also, there are no significant political or social forces that would affect the analysis. fff. Because the labor market is very large, supply/demand analysis would not be appropriate without modification. For example, an increase in labor supply will likely lead to greater income and greater demand for goods, which will lead to an increase in quantity of goods produced and therefore an increase in the demand for labor. In this case there are significant feedback effects. ggg. Aggregate markets such as savings and expenditures include feedback (ripple) effects, so supply/demand analysis would not be appropriate without modification. hhh. The tire market is relatively small. Supply/demand analysis would be appropriate without modification.

Questions from Alternative Perspectives 98.

Austrian It is difficult to estimate supply and demand curves without a market. Consumers have an incentive to overstate demand, while suppliers have an incentive to overstate costs. Without the need to pay in a market, it is almost impossible to get individuals to reveal their true preferences. Central planners tried many incentive schemes to get around this problem and never completely succeeded. One thing that did abate this problem was to allow gray markets—semi-legal markets where individuals’ true supply and demand were revealed. Overall, the socialist experience suggests that central planning for a large country cannot adequately reveal consumers’ preferences.

99.

Religious 1

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iii. There is some truth to this saying; if people were only selfish, they would lose much that makes them human. jjj. Yes, there is a conflict, although how strong the conflict is a matter of debate.

There are different types of Christianity; some are more in conflict than others.

Where capitalism and Christianity most agree are in their views of human freedom; both see it as central to their ideology. kkk. No probably not, although, again, the answer is debatable. Markets would not work well if people were purely selfless. In many ways if there were more than enough to go around the society would simply not need markets. The market provides efficient ways of allocating scarce resources when individuals are selfish or somewhat selfish.

100. Feminist lll. Women and men have not always been equally free to choose the amount of education they receive. Established in 1833, Oberlin College was the first coeducational college. Over time, women have gained much better access to education, and better access has led to better educational attainment. By the 1880s, 30 percent of all undergraduates in the United States were women. Today, women receive 58 percent of all undergraduate degrees. mmm.

Women did not have the right to vote until 1920. Women today continue to face difficulties in reaching the higher levels of administration in commercial enterprises and studies have shown that they receive less compensation than men who are in similar positions. nnn. To the extent that women are not free to choose, they are not represented in the analysis of supply and demand. The questions that economists consider, and therefore the models economists use, are likely to have been affected by the fact that women have less representation in the field of economics. Thus, if economists base their conclusions on the models alone, they cannot be objective.

101.

Institutionalist You will want to examine the determinants of supply and demand, and the conditions under which they may or may not hold. There is also the problem of interdependency. Discussion of each should include problems of measurement since, ultimately, science requires any and all propositions to be tested. Many of the ideas from which economic analysis is derived are beyond direct systematic measurement. Thus, economic analysis is, in many respects, a belief system: we act as if it were true because we believe it to be true.

102.

Post-Keynesian 2

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ooo. Consumers follow rules of thumb for a variety of reasons, one being to save time. Given that much of our consumption is repetitive (that is, buying the same brand of soda, soap, toothpaste, and so on at the same grocery store), researchers have found that much of our consumption is based on routine habits that give us satisfactory outcomes that may or may not be optimal. ppp. Our decisions to buy goods are usually based on past behavior—habits that have been incorporated in our consumer behavior. This behavior could have come from family, friends or advertisements and may affect our consumption more than the desire to optimize. This analysis allows room for advertisements and social norms—in addition to prices— to influence our consumption rather than price.

This means that economists’ claims that the market efficiently meets consumer’s desires is questionable since the market may be creating superficial desires rather than ―true‖ desires. It is, however, extraordinarily difficult to determine what is superficial and what is true.

103.

Radical The hiring decisions of multinational corporations don’t appear to be very responsive to wages and working conditions, suggesting that few jobs are likely to be lost to better paying wages. In addition, labor demand is not fixed by public policy changes and can be augmented by public spending and tax policies.

Issues to Ponder 104.

It suggests that the job is being rationed, which means that the wage is above the equilibrium wage.

105.

a.

It increased the demand for housing and increased housing prices. The demand curve shifts out, while the supply curve remains constant.

qqq. It decreased the demand for housing and decreased housing prices. The demand curve shifts in while the supply curve remains constant. rrr. The price would increase more in San Francisco.

106.

a.

It would likely raise the value significantly – it was estimated that it would raise it to $50,000 a sheet. Demand shifts to the right as people realize the oddity of the stamp. Supply shifts to the left because of the recall.

sss. It would probably lower the value of the stamps – it was estimated that it would lower the price of the sheet to $100 a sheet. Graphically this would be shown with the supply curve shifting back to the left, resulting in a lower price. The demand curve could remain high, though it might shift back to the left. ttt. They would likely sue to stop the additional sheets from being issued; they did and they lost.

3

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107.

a.

The number of punitive awards would decline because the incentive for plaintiffs to pursue a case declines. The demand curve shifts down by the amount of the tax, lowering the equilibrium price of punitive awards.

uuu. The number of pre-trial settlements would rise because the plaintiff would be willing to accept a lower settlement that is not taxed and the defendant would get to pay a lower punitive award. The tax leads to an increase in the supply of settlements, without affecting the demand for settlements (because the tax is paid by the plaintiff), which accounts for the increase in the quantity of settlements.

108.

A supply/demand analysis that includes only economic forces will likely be incomplete because social and political forces will also impact equilibrium price and quantity. One example is that the prediction that a disaster that leads to loss of electricity will lead to higher prices for flashlights might be wrong if there are laws that prohibit such price gouging during emergencies. Social and political forces must be added to the supply/demand model.

CHAPTER 5: USING SUPPLY AND DEMAND Questions and Exercises 109.

If the equilibrium price and quantity both rose, the simplest cause would be a shift of the demand curve to the right.

110.

If price fell and quantity remained constant, a possible cause would be a shift out to the right of the supply curve and a shift of the demand curve in to the left.

Another possibility would be a shift of the demand curve in to the left with a vertical supply curve. Note that when both curves shift, the effect on either price or quantity depends on the relative size of the shifts.

111.

Computer pricing of roads could end bottlenecks and rush hour congestion by price rationing. Currently at zero price, at certain times, the quantity demanded greatly exceeds the quantity supplied, resulting in congestion. Raising prices, during those times, could eliminate excess demand and reduce the congestion.

This technological change will spread out congestion over wider geographic areas and over the day, as individuals with more flexibility with respect to route and timing, will choose to demand less of the current high demand route at rush hour.

112. a. This would represent a shift in demand to the left assuming the decline in Cookie Monster’s popularity represents a decline in the popularity of cookies. The 4

price and quantity of cookies would likely fall as shown in the accompanying graph.

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vvv. This is represented by a shift in demand for bread (high in carbohydrates) to the left. Equilibrium price and quantity falls as the graph shows. (Note: this is the same graph as for part a.)

Remember a shift factor of demand is anything other than its price that affects demand. It shifts the entire demand curve. A change in price causes a movement along the demand curve.

113.

a. Both the shift in demand to the right and the shift of supply to the left lead to a higher equilibrium price of oil. The effect on equilibrium quantity is indeterminate. While the shift in demand to the right would lead to a rise in equilibrium quantity, the shift in supply to the left would reduce it. Whether equilibrium quantity rises or falls depends on the relative size of the shifts. The accompanying graph shows a slight decline in equilibrium quantity and a significant increase in equilibrium price.

With an increase in production (supply shifts to the right), equilibrium price will decline and equilibrium quantity will rise as shown in the graph below. Because demand has increased in the meantime, the equilibrium price and quantity will be higher than before the original supply disruption.

2

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114.

a. This represents a shift of the supply curve to the left because the offended decide not to supply organs, increasing the legal price significantly and perhaps reducing the equilibrium quantity to a quantity that is below the amount currently provided at zero cost. This is shown in graph (a) below.

This represents a shift of the supply curve to the right. How responsive quantity supplied is to price affects the slope of the supply curve. If quantity supplied is very responsive to price, the equilibrium price might be quite low and legalizing organ sales would have significant benefits to society. In fact, the authors of the study estimate the equilibrium price of kidneys to be less than $1000. In graph (b) below, S1 is much more responsive to price than S0 .

(b)

(a)

Remember a shift factor of supply is anything other than its price that affects supply. It shifts the entire supply curve. A change in price causes a movement along the supply curve.

115.

The drought in the Midwest causes a decrease in supply, which shifts the supply curve for beef to the left. Equilibrium price rises from $3 to $4 a 2

pound and quantity falls as the accompanying graph shows.

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116.

See the accompanying graph. A price ceiling of PC below equilibrium price will cause a shortage shown by the difference between Q D and QS

117.

As you can see in the accompanying graph, the rent controls create a situation in which demanders are willing to pay much more than the controlled price and much more than the equilibrium price. These payments are sometimes known as key money. In this graph, landlords are willing to supply Qs at the current controlled rent,

PC . Consumers are willing to pay up to PB for the quantity QS . Key money can be an amount up to the difference between PB and PC .

118.

See the accompanying graph. A price floor of PF above equilibrium price will cause a surplus shown by the difference between QS and Q D .

4

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119.

A minimum wage is a price floor as in question 10. A Pmin , above the equilibrium wage will result in the quantity of laborers looking for work to increase to QS and the quantity of employers looking to hire to decrease to Q D . The difference between the two is a measure of the number of unemployed.

120.

a.

A $4 per unit tax on suppliers shifts the supply curve up by $4 shown as a shift in the supply curve from S0 to S1 . Equilibrium price will rise by $4 only if the demand curve is perfectly vertical. In the case of a vertical demand curve, quantity would not change. Otherwise, equilibrium price rises by less than $4 and equilibrium quantity falls as shown in the accompanying graph. In this example, the price increases by less than $4 to P1 and quantity declines to Q1 . The price that suppliers receive falls to P2 .

A $4 per unit tax on consumers shifts the demand curve down by $4 shown as a shift down in the demand curve from D 0 to D1 . Equilibrium price will fall by $4 only if the supply curve is perfectly vertical. In the case of a vertical supply curve, quantity would not change. Otherwise, equilibrium price will fall by less than $4 to P1 and equilibrium quantity falls to Q1 as shown in the accompanying graph.

The price paid by consumers, including the tax, is P2 .

3

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www.

The unit tax on the consumers and suppliers has the same effect on both equilibrium quantity and price. It doesn't matter who pays the tax. Because consumers demand less at every price, substituting other goods whose prices have not risen, the demand curve shifts up by the amount of the tax. The price of the good that suppliers receive rises until quantity supplied equals quantity demanded.

121.

a. The quantity supplied and demanded equal each other when the price is $1.00.

The equilibrium price is $1.00 and the equilibrium quantity is 150 units.

The tax shifts the supply curve up by $0.75 from S0 to S1 . Equilibrium price (the price consumers pay) is $1.50 and equilibrium quantity is 125. Suppliers receive the equilibrium price less the tax, or $0.75.

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xxx. The tax shifts the demand curve down by $0.75 from D 0 to D1 . The equilibrium price (the price suppliers receive) is $0.75 and equilibrium quantity is 125. Consumers pay ($0.75 + $0.75), or $1.50.

yyy. It doesn't matter upon whom the tax is levied. The result is the same. We can see this by considering what happens to demand when customers pay the tax.

Because consumers demand less at every price, substituting other goods whose prices have not risen, the demand curve shifts down by the amount of the tax. The price of the good that suppliers receive falls until quantity supplied equals quantity demanded.

122.

A quota places a quantity restriction on imports. Consumers are willing to pay a higher price for the lower quantity  Q Q  than the equilibrium price without a quota. Therefore, quotas lead to higher import prices as shown in the accompanying graph.

123.

a. As you can see in the graph below, consumers are willing to pay up to $50 for 100 fishing licenses, but pay only $20.

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At $20 per license, demand is 400 and supply 100. There is excess demand of 300. zzz. The maximum a person is willing to pay is $50. aaaa. If Pawnee keeps the number of licenses, it must charge $50. If it eliminates the quantity restriction, it will charge $30 and sell 300.

124.

Public postsecondary education is an example of a third-party payer market because it is heavily subsidized by state government and in most cases, a student’s parents. Those consuming the good, students, do not pay the entire cost of the education they receive. This likely leads to greater expenditures on postsecondary education than if students had to pay the entire cost of their education.

125.

a. Equilibrium price is $6 and equilibrium quantity is 500.

In third-party-payer markets, the person who demands the good differs from the person paying for the good. Here, with a co-payment of $4 quantity demanded will be 700 units. Sellers require payment of $8 per unit to supply that quantity. bbbb.Total spending in part a is $3, 000  $6  500  . Total spending in part b is

$5, 600  $8  700  .

Questions from Alternative Perspectives 1.

Austrian

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I might decide to hire my friends, or to hire those with whom I like to work—such as those from a preferred ethnic group or gender. Is doing so fair? Fairness is a judgment question and judgments differ. From most people’s perspective, such methods are not fair. The problem is that wage controls set an equal base wage level but leave open possibilities for other inequalities. Rather than helping the least skilled end of the labor pool it prices them out of the market, increasing their unemployment, and promoting other forms of discrimination. Austrians believe that these market distortions are not good for society and prefer little or no government intervention.

2.

Feminist There are likely a number of reasons why women are paid less than men. Part of the pay gap may be explained by differences in work experience, education, onthe-job training, and work interruptions for women. Economists typically measure discrimination as a residual – that part of the pay gap that remains ―unexplained‖ after accounting for these factors. The second part of the question is a judgment question and judgments differ. A law that requires firms to pay equal wages to those with comparable skills may be difficult to implement. How would the skills be assessed? Others argue that assessment itself would add costs to a firm’s production and increase product prices. However, if the reason for the pay gap is discrimination, the law can change values and make it more costly to discriminate. Since discrimination necessarily implies that hiring is on the basis of something other than productivity, reducing discrimination may promote efficiency. Feminists generally support such laws.

3.

Institutionalist a. We can see cultural evolution through history; the appendix to Chapter 3 can be used to trace the cultural evolution of the market system. Here it is important to stress that religious values and social relationships had to evolve to accommodate the needs of the new forms of economic organization that emerged. Markets change overnight and increasingly require rapid adaptation by individuals, which can cause shocks to social relationships. One might question the long-term (in)stability caused by market evolution. The outcomes of biological evolution are driven by natural selection: those organisms with traits giving them a competitive edge in the competition for limited energy propagate; others disappear. In this context, the only purpose is to successfully reproduce. Some economists believe that the purpose of cultural evolution is betterment of the human condition for all. b. In the U.S. market, evolution has elevated living standards for everyone relative to those of say 1775. We see access to fresh fruits and vegetables year-round; many diseases have been eliminated; life spans have increased greatly. Yet, we are social beings who are aware of our social position. One may be well fed, but 8

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one may still feel socially destitute because one’s level of welfare is low relative to one’s contemporaries. In this sense, market evolution has failed to contribute to betterment.

4.

Religious What is appropriate depends on one's normative judgments, and most normative systems see taking undue advantage of someone in a crisis as wrong. Early economists have examined a concept that they called the "just price," which is the price that should be charged in various situations. There are many interpretations of what the just price should be, but one is that it should be close to the normal market price that would be charged. During emergencies such as floods or hurricanes, most people believe that "price gouging" is inappropriate and there are social pressures and laws against it. That said, there is another view that points out that any restriction on price will prevent some people who really need water and are willing to pay for it, from getting it, since sellers cannot charge the price they are willing to pay. They have no incentive to provide the water to those most willing and able to pay for it.

5.

Radical a. Today’s rent controls are designed to be less invasive than the ones described in the book, and thus they do not have the strong effects described there. They still have some effects, and the policy question is whether the income redistribution effects they have are sufficiently desirable to warrant the costs of the policies. b. This is a judgment question; economics can tell one about what the costs and benefits of a mechanism are; not about what is an appropriate mechanism. c. This again is a judgment question that requires an integration of normative issues into the analysis. Most mainstream economists would argue that it is better to deal with the underlying income distribution issues, rather than specific ones, and that one must consider the problems of government intervention. Radical economists would argue that, while mainstream economists talk about "underlying issues", they seldom do deal with those problems. If one is going to direct spending toward housing, mainstream economists would prefer using generalized housing vouchers than using administrative means of allocation apartments, since housing vouchers offer individuals more flexibility.

Issues to Ponder 126.

a.

The graph on the left shows the primary market for tickets, assuming that all tickets that will be available for the game are offered by lottery. We know that 9

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there is excess demand because at $130 a seat, 110,000 tickets are demanded and only 10,000 are supplied resulting in an excess demand of 100,000.

The graph on the right represents the scalped ticket market, assuming that only 5,000 of the 10,000 ticket holders and only 50,000 of the 100,000 of those who didn't get tickets are willing to break the law and enter the scalped ticket market.

Assume that sellers will not accept any prices under $2000 and that they will sell for the best price they can get over $200. Given this assumption, no tickets are for sale at $130. At $130 a ticket, there are no tickets available, so excess supply is 50,000. Assuming buyers and sellers do not distinguish among the quality of seats, the market-clearing price is $2,000 per ticket. cccc. If scalping becomes legalized, more people would be willing to sell their tickets because there is no risk of being arrested and fined. Assuming all ticket holders are willing to sell their tickets, the supply of tickets shifts to the right to 10,000, reducing the scalped ticket price of Final-Four tickets to $1,000 a ticket.

127.

a. A weakly enforced anti-scalping law would add an additional cost to those selling scalped tickets and push up the resale cost of tickets to include the expected cost of being caught, which would be fairly small given weak enforcement. In the accompanying graph, this shifts the supply curve from S0 to S1 , raising the equilibrium price slightly from P0 to P1 .

(Note: This assumes that only selling, not buying, is illegal and that public (consumer) attitudes toward scalping are independent of its legal status.)

A strongly enforced anti-scalping law (against suppliers) would push up prices far more as the cost of supply rose and the supply curve shifted to the left. If enforcement were sufficiently strong, a two-tier price system would emerge with a low legal price at P0 and another very high price, P2 .

128.

a. Boards often exist not only to benefit the consumer, but also to benefit existing producers. Often those who are currently certified attempt to limit the number of new certifications so as to limit the supply and raise prices.

Possible changes include eliminating the board of certification, limiting its regulation to only those skills that it addresses directly, or requiring continual recertification so that skills of those already certified reflect the current demand for skills in that market. dddd.A political difficulty with implementing these changes is that a relatively small group of those currently certified will be hurt and will lobby hard for the status quo. Those currently certified may have more ―clout‖ with the board if the board 10

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is comprised of certified hairdressers. The benefits of the changes are also large, but they are spread out over large groups of consumers, with each consumer benefiting very little. Therefore, it will be easier for the small group, whose benefit per individual is large, to organize.

129.

a. The Oregon Health Plan includes a prioritized list of medical services that determine whether a service is covered. The list is based on comparative benefit to those covered as determined by the Health Care Board. Those services that this Board believed had the highest net benefit were ranked highest. Those they believed had a lower net benefit were not covered. The Health Care Board was made up of health professionals whose goal was hoped to be the ―greatest good for the greatest number.‖

Economists should not oppose the Oregon Plan because it involves rationing. The market involves rationing through the price mechanism. Economists might oppose the Oregon Plan because in general they support the market as the least-cost method of providing goods and services to those who actually need it, and because they believe the board’s rationing is less fair than market rationing.

Economists are open to the argument that the market may not distribute goods and services in the way that society wants, which may require government intervention. eeee. In the market, the interaction of demand and supply determines the equilibrium price and quantity that is bought and sold. Those who are able to pay the equilibrium price are the ones who receive the specified types of health care. The Oregon Plan uses its benefit-ranking system determined by their Board of Professionals, rather than price as the rationing mechanism.

130.

a. Frequent-flyer programs allow companies to lower their effective prices without lowering their reported prices. Companies also use them to get business travelers to choose their airline. Such programs are an example of a third-party-payer system: The business traveler gets the benefit (frequent-flyer miles), while their business pays for the current flight.

Other examples include points that hotels give to travelers, loyalty cards, and bonus checks based on charges that Discover gives those who use its credit card. ffff. Firms likely do not monitor these programs because it would be too costly to do so, and because the benefits of the program are not taxed, which makes them a type of tax-free income for their employees.

131.

a. An import quota will increase the price of imported sugar. The accompanying graph shows how a higher imported sugar price 12

increases the price that domestic producers can charge and

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increases the quantity they can supply to the market. For example, at world price P0 , domestic consumers demand the quantity E−B from importers and quantity B from domestic producers. After a quota represented by quantity D minus C is imposed, the import price is P1 . Domestic consumers demand the quantity D−C from importers and quantity C from domestic producers.

The government could have imposed a tariff on imported sugar. This would also have raised the price of imported sugar. gggg.A minimum required import level of 1.25 million will limit the ability of the United States to support domestic sugar prices. The increase in quantity supplied will put downward pressure on sugar prices.

132.

a. As shown in the accompanying graph, the controlled price  PC  is below equilibrium. At this price the quantity of apartments demanded  Q D  exceeds the quantity of apartments supplied  QS  .

Since there are more apartments demanded than supplied at this price, apartments are hard to find.

Since at the existing quantity supplied, QS , demanders would be willing to pay Pb , there is a strong incentive to make side payments to existing tenants to acquire the apartment. At Pb , more tenants are willing to supply their apartments than at Pc , so a side payment can induce a tenant to give up their apartments. This is one form of rationing. hhhh.Eliminating rent controls would most likely allow the market price of apartments to increase and eliminate side payments. The quantity supplied will rise until it equals the quantity demanded at the market price. The price, quantity combination is  Pe , Q e  in the graph. However, if there are few additional apartments available to be rented (the supply curve is almost vertical), then price will increase dramatically, and quantity supplied will only rise slightly.

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iiii. The political appeal of rent control is that it benefits those who currently rent apartments. Apartment renters who live in rent-controlled apartments are more likely to vote, and this is why it is maintained. There are other possible reasons as well.

133.

a. The government subsidy of mohair provided an enormous incentive for those who were allowed to sell mohair to sell large quantities at lower price than otherwise. The elimination of this subsidy shifted the supply curve to the left (shown below as a shift from Ssubsidy to Sno subsidy , increasing the market price for mohair from P0 to P1 and decreasing the quantity demanded and supplied from

Q 0 to Q1 .

This program was likely kept in existence because not many people knew about it (mohair is a relatively small market), and ranchers had no incentive to broadcast the subsidy. jjjj. A law that requires that suppliers receive $3.60 more than the market price is the same as a tax, but the revenue goes to the supplier. The demand curve would shift to the left (down) to include this tax. The quantity demanded would fall dramatically. Consumers would not support this law because they would have to pay an enormously high price. Suppliers would support this law only if they were guaranteed that they could sell at that high price.

134.

Excess supply in U.S. agricultural markets is caused by the government’s policy of agricultural price supports, or price floors on agricultural products. Political forces prevent the invisible hand from working.

135.

It would likely increase the number since it reduces the cost of having a car that you drive very little.

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136.

The demand for rolling machines went up enormously because loose tobacco became a cheaper substitute for the taxed cigarettes and rolling machines are a complement of loose tobacco; some companies more than quadrupled their sales of loose tobacco and rolling machines.

137.

a. Japan prescribed many more drugs than the U.S. because Japanese doctors had a financial incentive to do so.

It would lead to many more drugs being produced, even if they were not really innovative, as happened when Japan tried this. kkkk.Drug reps would likely provide free samples and other gifts to doctors and have lunches for them where they tout the advantages of their drugs.

138.

a. They would likely fall. In fact, they fell by 13 percent.

They also would likely fall. In fact, they fell by 22 percent. llll. The graphs below show the effect of increasing co-payments. The graph on the left has a co-payment of $15. Consumers demand Q1 and the shaded region shows the medical claim costs. In the accompanying graph on the right, consumers must pay the first $1,500 of medical costs, demonstrated by the lowershaded region. (For simplicity, we assume that consumers end up purchasing 50 units at a cost of $30 per unit.) As you can see, however, the medical cost to the firm (upper shaded area) is much smaller. In addition, the units of medical services demanded are lower, illustrating the answer to the second question – hospital admissions declined.

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APPENDIX: ALGEBRAIC REPRESENTATION OF SUPPLY, DEMAND, AND EQUILIBRIUM 139.

a. The tables are shown below:

Price (Dollars per gallon) 0 1 2 3 4 5 6

Quantity Demanded (Gallons per year)

Quantity supplied (Gallons per year

600 500 400 300 200 100 0

−150 0 150 300 450 600 750

See the accompanying graph. Equilibrium price is 3 and equilibrium quantity is 300. mmmm.

P = 3; Q = 300

140.

a. The following are the demand and supply tables after the hormone is introduced: Quantity Quantity Price Demanded Supplied (dollars per (gallons per (gallons gallon) year) per year) 16

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0.00 1.00 2.00 2.50 3.00 4.00 5.00 6.00

600 500 400 350 300 200 100 0

−25 125 275 350 425 575 725 875

The hormone (a technological advance) shifts the supply curve to the right by 125,000 gallons, The demand curve is unchanged.

17

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The original supply curve is S 0 . The growth hormone shifts the supply curve to S1 (to the right by 125). Equilibrium price falls to $2.50 a gallon, and equilibrium quantity rises to 350 million gallons (point B). nnnn.The demand curve remains the same at QD  600 100 P . The supply curve becomes QS  25  150 P . To solve the two equations, set them equal to one another: 600 − 100P = -25 + 150P and solve for P. Doing so, we get P = 2.5.

Substituting this value for P into either the demand or supply equation gives us equilibrium quantity of 350. oooo.Quantity supplied would be 425 (25  150  3) and quantity demanded would be 300 (600  100  3) . There would be excess supply of 125. The price floor is shown in the accompanying graph.

141.

a. The demand curve is QD  10  P ; the supply curve is QS  2 P  5 . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $5, Q = 5.

The new demand curve is QD  13  P . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $6, Q = 7.

1

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pppp.The new supply curve is QS  2 P  8 . To solve for equilibrium price and quantity, set the two equations equal and solve for P. Substitute P into either to find equilibrium quantity. The solution is P = $7, Q = 6.

142.

a. A demand curve follows the formula QD  a  bP , where a is the quantity-axis intercept and b is the slope of the curve. A shift in demand is reflected in a change in a. An increase in demand increases a and a decrease in demand reduces a.

A supply curve follows the formula, QS  a  bP , where a is the quantity – axis intercept and b is the slope of the curve. A shift in supply is reflected in a change in a. An increase in supply increases a and a decrease in supply decreases a. qqqq.A movement in supply or demand is reflected in the effect of a change in P on either QS or QD . The equations themselves do not change.

143.

a. P = 4; Q = 6

Since the government set price is above the equilibrium price, it is a price floor. Thus, it would create a surplus. Solving the equations, we see the surplus would be 2 million bushels.

144.

a. The new supply equation is QS  150  150( P  1) where P is the equilibrium price, or QS  300  150 P .

P = 3.60; Q = 240. rrrr. Farmers receive $2.60 per gallon, while demanders pay $3.60 per gallon.

145.

a. The new demand equation is QD  600  100  P  1 where P is the price suppliers receive, or QD  500  100 P .

P = 3.60; Q = 240. ssss. Farmers receive $2.60 per gallon. It doesn’t matter who pays the tax, the market outcome is the same.

146.

a. The new supply equation is QS  150  150  P  1 where P is the equilibrium price, or QS 150 P .

2

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P = 2.40; Q = 360. tttt. Farmers receive $3.40 per gallon.

147.

Equilibrium price is $2.

a. P = $3.00 is above equilibrium price, so it is a price floor. There is a surplus of 8.

P = $1.50 is below equilibrium price, so it is a price ceiling. There is a shortage of 4. uuuu.P = $2.25 is above equilibrium price, so it is a price floor. There is a surplus of 2. vvvv.P = $2.50 is above equilibrium price, so it is a price floor. There is a surplus of 4.

CHAPTER 6: DESCRIBING SUPPLY AND DEMAND: ELASTICITIES Questions and Exercises 148.

ED = percentage change in quantity/percentage change in price  20 / 10  2 . The percentage change in quantity is greater than the percentage change in price, so demand is elastic.

149.

a.

Price elasticity of demand if quantity is constant, is 0.

wwww.

ED = percentage change in quantity demanded/percentage change in price = 0 / 5  0 . xxxx.I would check to see if other things (besides price) remained constant.

150.

The price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price =

Q2  Q1 1 / 2  Q1  Q2    5, 000 / 18,500    0.25 / 1.375   0.270 / 0.182  1.49.

P2  P1 1 / 2  P1  P2  3

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151.

Price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price. Pizzas went from $8 to $2 and quantity from 1 to 100. The price elasticity of demand is Q2  Q1 1 / 2  Q1  Q2    99 / 50.5  /  6 / 5   1.63.

P2  P1 1 / 2  P1  P2 

152.

They both have the same elasticity. Any supply curve that goes through the origin has an elasticity of 1.

153.

The price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price = Q2  Q1 1 / 2  Q1  Q2  P2  P1 1 / 2  P1  P2 

A to B:  20 / 30  /  5 / 22.50   0.667 / 0.222  3.00 C to D:  20 / 90  /  5 / 7.50   0.222 / 0.667  0.33 The price elasticity of supply equals percentage change in quantity supplied divided by the percentage change in price = Q2  Q1 1 / 2  Q1  Q2  P2  P1 1 / 2  P1  P2 

E to F:  20 / 20  / 10 / 5   1 / 2  0.50 G to H:  20 / 70  / 10 / 30   0.286 / 0.333  0.86 154.

a.

Cars: The broader the category, the less elastic the demand.

yyyy.Leisure travel: It is more of a luxury. zzzz. Rubber during the entire 20th century: There are more substitutes over a longer period of time.

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155.

a.

Peak hour travelers are likely to be commuters who have little choice but to go to work and therefore have lower demand elasticity than those who ride buses during off-peak hours and are more likely using buses for errands or other more discretionary activities.

aaaaa.

Demand tends to be less elastic in the short run because there are fewer substitutes. If fares rose enough, in the long run people could find alternative modes of transportation – purchase a car, find someone to share rides with, etc. bbbbb.

Tolls are likely a much smaller portion of high-income commuter’s total income, contributing to a less-elastic demand.

156.

a.

Price elasticity of demand is equal to the percentage change in quantity demanded divided by the percentage change in price. The elasticity of demand for drinking is .28; the elasticity of binge drinking is .51.

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ccccc.

Binge drinking is more elastic. One possible explanation is that binge drinking (drinking 5 or more drinks on one occasion) is a larger percent of one’s income and has a close substitute—drinking less. It is easier for students to decrease the amount they drink rather than to quit altogether.

Source: ―Alcohol Advertising and Alcohol Consumption by Adolescents,‖ NBER Working Paper 9482.

157.

a.

The price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price =

Q2  Q1 1 / 2  Q1  Q2    40, 000 / 260, 000  /  2.00 / 4.00   0.15 / 0.50  0.31.

P2  P1 1 / 2  P1  P2  ddddd.

Since the demand is inelastic, it doesn’t make sense to lower the price because it would reduce the total revenue. eeeee.

It would make sense to lower the price as long as the demand for advertising is elastic and the increased revenue more than compensates for the loss of revenue due to circulation.

158.

If the author is profit maximizing, he or she would prefer to raise the book’s price.

Raising prices when the demand is inelastic increases revenue. Because the author’s cost is a sunk cost, profit also rises.

159.

a.

Neither state is maximizing revenue. Maximum revenue is collected when elasticity is one. Both are collecting less than the maximum revenue: in California elasticity is less than one and in Massachusetts elasticity is greater than one.

fffff. You should recommend that Massachusetts lower its price and California raise its price. ggggg.

Massachusetts, because not only is it not collecting maximum revenue, it is also charging a higher price than is optimal. It could simultaneously lower price and

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increase revenues, which would please both those who buy vanity plates and the treasury. hhhhh.

Elasticity of demand equals one at price P* in the accompanying graph.

California is below E=1, at a price such as P1 , where demand is inelastic. So, you can see that raising the price from prices below P* will result in greater revenue gained (BC) than lost (F). Massachusetts is at a price above P*, such as P0 , where demand is elastic. So, you can see that lowering the price to P* will result in greater revenue gained (CE) than lost (A).

160.

The more elastic the supply or demand is, the less revenue will come from a tax. With elastic supply and demand, increasing tax rates can decrease quantity supplied and quantity demanded enough to cause a decrease in tax revenue. With inelastic supply and demand, quantity changes little, which means that revenue from a tax is greater than it would be with an elastic supply or demand.

161.

a.

Total revenue = Price × Quantity. Total revenue rises from $10.2 billion to $13.3 billion.

iiiii. Using the midpoint method of calculating elasticity, the price elasticity of demand equals percentage change in quantity demanded divided by the percentage change in price  (0.2 / 1.3) / (1 / 9)  0.154 / 0.111  1.39 . Since we have calculated a positive number for elasticity, assuming other things are equal, this is an upward sloping demand curve, which is suspicious. See part c. jjjjj. The major proviso is that this is an unexpected result and suggests that something else has likely changed such as income, marketing, etc. You are likely not estimating elasticity at all.

162.

a.

Liquor producers would not support a tax on beer because the cross-price elasticity between beer and hard liquor is negative (beer and liquor are complements). The beer tax would also reduce liquor consumption.

kkkkk.

Wine producers would support a tax on beer because the cross-price elasticity between beer and wine is positive. The beer tax would increase wine consumption (beer and wine are substitutes).

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163.

Normal goods are goods whose consumption increases with an increase in income. For a normal good, income elasticity > 0. Normal goods are divided into luxuries and necessities. Luxuries are goods that have an income elasticity > 1.

Necessities are goods that have an income elasticity that is positive but < 1.

Inferior goods are goods whose consumption decreases when income increases.

For an inferior good, income elasticity < 0.

lllll. Vodka: normal and luxury (except in Russia). Individuals tend to drink more hard liquor as their income rises. (It depends on the type: Absolut vodka is more of a luxury than store brands.) mmmmm. Table salt: normal and necessity. It is a small portion of people’s income, and its consumption doesn’t increase much with income. nnnnn.

Furniture: Normal and luxury. Everyone needs some furniture, but as income goes up, people buy much more and much nicer furniture (elasticity is positive and greater than 1 in the short run). ooooo.

Perfume: normal and luxury (depends on the type). The rich blow money on perfume; the rest of us get by with toilet water (a less concentrated form of perfume), or we smell a bit. ppppp.

Beer: normal. Income elasticity is positive but less than one.

qqqqq.

Sugar: normal and necessity. It is not used significantly more by rich than by poor.

164.

a.

It depends. They are complements to the extent that one puts carrots in salads. They are substitutes to the extent that a person wants a vegetable and is choosing between the two.

rrrrr. Negative. They are complements. sssss. Positive. They are close substitutes. ttttt. Close to zero. They are at best distant substitutes, otherwise unrelated.

165.

a.

Cross-price elasticity of demand = (percent change in demand)/(percent change in price of a related good)  2 / 18  0.11 .

uuuuu.

Hot dogs and ketchup are complements because the cross-price elasticity of demand is negative.

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166.

a.

Income elasticity of demand = (percent change in demand)/ (percent change in income)  10 / 20  0.50

vvvvv.

Income elasticity of demand = (percent change in demand)/ (percent change in income) =

Q2  Q1 1 / 2  Q1  Q2    3 / 18.5  / 10, 000 / 35, 000    0.162  /  0.286   0.57 P2  P1 1 / 2  P1  P2  167.

In the short-run there tend to be fewer substitutes, so demand is fairly inelastic. In the long-run there are more substitutes, so demand is more elastic. Therefore, there is a greater effect on equilibrium quantity in the long run.

168.

If supply interests the price axis it will be elastic. If the supply curve intersects the quantity axis it will be inelastic. This means that a shift in demand would have a greater effect on the change in equilibrium quantity on the supply curve that intersects with the price axis. (The answer to this question requires reading the Added Dimension box ‖Geometric Tricks for Estimating Price Elasticity.‖)

169.

a.

The supply curve shifts to the right, causing the equilibrium quantity to increase. Since the price remains nearly constant and quantity changes enormously, the demand curve is very elastic.

wwwww.

The supply curve shifts to the right, causing the equilibrium price to fall. Since equilibrium quantity did not change, demand is perfectly inelastic. xxxxx.

The supply curve shifts to the left, causing the equilibrium price to rise.

Since equilibrium quantity changes very little, demand is inelastic.

Questions from Alternative Perspectives 170. Austrian yyyyy.

There is no hard and fast rule about how to distinguish the short from the long run. A good off-the-cuff answer would be that the long run is a period of time in which sufficient substitutes for the good arise. The question then becomes: What is a sufficient number of substitutes? zzzzz.

The concepts have far less meaning; all individual decisions are made as forward-looking decisions, and such forward looking decisions do not fit nicely into the time frames in the models. The elasticity measure is more an exercise for students than an actual number that firms use.

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171. Feminist aaaaaa.

This likely happens because white men are perceived by car salespeople (generally, men) as having greater bargaining power and more information about costs and the market than women or blacks. These highly stereotypical representations reflect cultural bias and may explain why women prefer to buy automobiles for a fixed price online rather than to bargain at dealerships. bbbbbb.

To the extent that the perceived elasticities are accurate, differences in elasticities would facilitate car dealerships’ practice of differing sales tactics by race and gender. Men's demand curve would be more elastic; men would be less likely to buy the car unless the price is kept low, and thus there might be an economic foundation to the discrimination. Regardless of the reasons for the differences, the actions represent a type of racial and gender discrimination.

The fact that discrimination is grounded in economic realities doesn't change that.

It does, however, make the actions more difficult to prevent.

172. Religious cccccc.

It may be a useful distinction, but it integrates positive and normative issues, and mainstream economists generally attempt to avoid such issues. Many religions incorporate stewardship of the earth and low consumption. For these religions, this distinction is important to using resources wisely. dddddd.

Yes, it would fundamentally change the nature of economic analysis.

For example, it would decrease the focus on GDP and focus much more on the distribution of that GDP. It would also lead to economists explicitly recognizing the normative aspects of economics are more than they do now. eeeeee.

Mainstream economists would argue that it does not, because normative issues can be added later; some religious economists would argue that it does because the normative issues are generally not added later. The bias is that elasticities are given, not pliable or potentially impacted by calls toward virtuous behavior.

173. Institutionalist ffffff.It suggests that there are few job alternatives. gggggg.

It suggests that while the supply/demand discussion presented in the book makes it look as if the minimum wage will cause problems, a more nuanced view of the problem suggests that these problems may be quite small, and that there may well be a role for the minimum wage in policy.

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174.

Post-Keynesian The fact that price elasticities are constantly changing over time and are also very difficult to measure means that managers rarely use elasticities to determine prices. It is much more likely that managers use a "mark-up" strategy in which they set price at some level above production costs. Depending upon a firm's degree of market power, the firm might also manipulate its prices to increase its markup.

175. Radical hhhhhh.

Elasticities reflect power, and one’s bargaining power is related to elasticity. When one group has more elastic supply or demand they hold disproportionate bargaining power over the other group. For example, if employers have an elastic demand for labor and workers have an inelastic supply of labor, the employers will have more power to determine wages because workers will not change the quantity of labor they supply by very much when wages fall. If there are social or political forces that discourage using such power to reduce wages, employers might use their power to deny health benefits or provide less vacation time for workers. iiiiii. This is a normative question for which mainstream economics provides little guidance. Radical economists believe that something should be done.

Issues to Ponder 176.

Keep in mind that the definition of elasticity is percent change in quantity divided by percent change in price. We want to show that the elasticity of supply is less than one. Elasticity of supply can be written as (% change in Q / % change in P) , or (change in Q / Q) / (change in P / P) . Arranging terms, we have: (change in Q / change in P)  ( P / Q) . Since (change in Q / change in P) = 1 / slope , this can be rewritten as (1 / slope)( P / Q) . The slope of a line crossing the quantity axis is given by P / (Q  a) , where a is the quantity supplied at zero price (a > 0).

Substituting into the equation for the elasticity, we have {1 / [ P / (Q  a)]}( P / Q)  (Q  a) / Q  Q / Q  a / Q  1  a / Q  E . Since a > 0 and Q  0, a / Q  0 and 1  a / Q  1 so that E < 1 and the curves are inelastic.

177.

a.

Using standard reasoning, we would answer that firms decreased the size of the coffee cans to hide price increases from consumers. However, in reality people often react differently to changes in the size of packages compared to the equivalent change in price.

jjjjjj. Examples include candy bars, soap, and canned tuna fish.

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178.

In real life elasticities are difficult to measure. A 1% rise in price would probably be swamped by other effects.

179.

a.

Since the price falls by 0.60 / 3.30 (about 18%) the price elasticity would be approximately one.

kkkkkk.

Elasticity would be about the same (one), since price per ounce decreases by nearly 18% from $0.24 to $0.20.

180.

a.

A price rise of 10 percent will reduce fuel consumption anywhere from 4 to 8.5 percent. Quantity demanded would range from 9.85 to 9.6 million gallons.

llllll. This suggests that there are other forces besides price at work here; making adjustments to higher prices is much easier than adjusting lower prices. This may be due to learning the true cost of substitutes when those substitutes are consumed. One can imagine a scenario in which a price hike significantly changes driving behavior—commuters may switch to ride sharing or public transportation, to which there may be perceived social barriers (costs). Once those barriers are overcome and the perceived costs are lowered after those alternatives are used, a larger decline in the price of gasoline is required to induce those who switched to return to driving their own cars.

181.

To the degree that colleges are trying to get as much revenue as possible, they will keep raising tuition until the demand is no longer inelastic. Colleges don’t raise their tuition by more than what they currently do because they are not profitmaximizers, and because social pressures such as student protests would result if they raised tuition too much.

182.

a.

Supply-side measures shift the supply curve to the left, raising the price of drugs and reducing quantity demanded as shown in the accompanying graph.

mmmmmm. If the demand for drugs is inelastic, a reduction in supply will increase total revenue going to the drug industry. Since less is being produced, total cost also decreases so that total profit also increases. nnnnnn.

Demand-side measures shift the demand curve to the left, reducing the demand of drugs and 9

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revenue to the drug industry declines. oooooo.

Profits will fall since there is a decrease in demand.

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183.

If demand is elastic, reducing price will increase revenue, which is good, but it will also increase costs (since you’ll be producing more), which is bad. The sum of these two effects is not clear.

184.

More eager students will agree to go to a school even if they don’t get much financial aid. That is, they have an inelastic demand to attend the school. If the school has some way of determining that—for example, did they agree to early acceptance, they can take advantage of that information and offer them less financial aid (the student’s effective tuition rises). Whether this practice is justified is a difficult normative issue, with many alternative views.

185.

If there were only two goods in the world (assuming no saving), the goods must be substitutes because if a person doesn’t consume one, he or she would have to consume the other.

CHAPTER 7: TAXATION AND GOVERNMENT INTERVENTION Questions and Exercises 186.

With either excess supply or excess demand, the number of trades will be lower than if price were allowed to move to its equilibrium price. That means there is a loss of surplus.

187.

Decision making based on costs and benefits means you make purchases if the marginal benefits are greater than the price. Thus, when you decide to make a purchase, you are likely receiving something worth more to you than what you had to spend to buy it, or else you wouldn’t have bought it. That net benefit is consumer surplus.

188.

If demand is inelastic, raising a tax rate increases tax revenue paid by consumers, similarly with supply. If demand is elastic, however, raising a tax rate decreases revenue paid by consumers. Thus, what happens to total tax revenue depends on the elasticity of both supply and demand.

189.

Because labor supply is elastic, raising the tax rate will reduce the percent of hours worked by more than the percent decrease in wages paid. That is, total income will decline as will total tax revenue. Social Security cannot be financed 1

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by increasing tax rates. Source: ―Why Do Americans Work So Much More than Europeans?‖ Quarterly Review, July 2004.

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190. Welfare loss is shown by the bolded triangles in the figures below. pppppp. qqqqqq.

rrrrrr.

191.

ssssss.

a.

Before the tax, equilibrium price is $6 and equilibrium quantity is 200.

After the tax, equilibrium price is $8 and equilibrium quantity is 100.

tttttt. Producer surplus before the tax is the area above the supply curve and below price. This is a triangle with base 200 and height 4 (Areas E,F, and G). So, producer surplus is (1/ 2)(200)(4)  400 .

After the tax, the triangle representing producer surplus has a height of 2 and base of 100 (Area G). So producer surplus is 1/ 2(100)(2)  100 .

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uuuuuu.

Consumer surplus before the tax is the area below the demand curve and above equilibrium price (Areas A, B, C, and D). This is a triangle with base 200 and height 4. So consumer surplus is (1 / 2)(200)(4)  400 . After the tax, the triangle representing consumer surplus has a height of 2 and base of 100 (Area A). So consumer surplus is 1/ 2(100)(2)  100 . vvvvvv.

Total tax revenue is $4 times equilibrium quantity, 100, or $400(Area B, C, and E).

192.

If suppliers were strong lobbyists, the government would prefer demand to be more inelastic than supply, because then consumers will bear the larger portion of the tax (producers would bear a smaller portion). Suppliers would not lobby against the tax as hard than if the suppliers had to bear the greater burden (supply is more inelastic than demand).

193.

Inelastic goods with a price elasticity of demand and supply as close to zero as possible. Examples would be cigarettes, salt, required medications, a per capita tax, and a land tax. (Other examples are possible.)

194.

The consumer. The more inelastic the demand curve, the larger the percentage of the burden is borne by the consumer (or demander).

195.

With a perfectly elastic demand, suppliers will pay the entire cost of the tax regardless of how elastic supply is—unless supply is also perfectly elastic, in which case no goods will be bought or sold after the tax, so no one will bear the burden. The answer would be the same if the tax were levied on suppliers.

196.

The demander will pay 30 percent of the tax [0.3 / (0.3  0.7) 100] and the supplier will pay the remaining 70 percent [0.7 / (0.3  0.7) 100] .

197.

If the economist wanted to get as much revenue as possible from as little output reduction (welfare loss) as possible, he would suggest taxing goods with inelastic supply because with an inelastic supply, equilibrium quantity would not change much. (Pretty similar to Question 8)

198.

No. Tenants shouldn’t worry too much. In the short run, the supply of apartments is highly inelastic so the owner will bear the majority of the tax burden; it will not be passed on to tenants. In the long run supply is more elastic so the renter will pay some of the tax. Thus, in the long run, tenants should worry more.

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199.

The demander will pay the percent of the tax equal to [ ES / ( ES  ED )  100] , and

the supplier will pay the remaining percent of the tax equal to [ ED /  ES  ED  100] . wwwwww.

Percent borne by demander = 80; percent borne by supplier = 20.

xxxxxx.

Percent borne by demander = 40; percent borne by supplier = 60.

yyyyyy.

Percent borne by demander = 67; percent borne by supplier = 33.

zzzzzz.

Percent borne by demander = 50; percent borne by supplier = 50.

aaaaaaa.

Consumers with relatively more elastic demand curves bear a smaller percent of the tax. The same is true for producers. If the elasticities of demand curves and supply curves are equal, consumers and producers will share the tax burden equally.

200.

For an equivalent percentage reduction in price due to the price ceiling, a more elastic demand and supply results in a greater shortage. The reason is that the response in quantity supplied and demanded is greater when price elasticity is greater.

201.

See the accompanying graph. Given the demand curve shown and supply curve S0 , the price floor Pf is above the

to the suppliers who still supply the good.

equilibrium price, Pe . The ―tax‖ paid by consumers is areas A and B. Area A represents surplus transferred to producers. Welfare loss is shown by area C. bbbbbbb.

In the case of a tax with an equivalent effect on equilibrium price, the revenue (rectangles A and B) goes to the government. ccccccc.

In the case of a price floor, Pf, the ―revenue‖ (areas A and B) goes 202.

a.

At first there will be an excess supply of workers, but with time, the newly unemployed will get discouraged and drop out of the labor force, disguising the unemployment. Another possibility is that firms invest in machinery to replace labor, increasing the long-term job shortage.

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ddddddd.

It is likely to decrease because demand for minimum wage earners becomes more elastic over time, which means that more low-wage workers will lose their jobs.

203.

a.

The equilibrium price is $8, the equilibrium quantity is 4.

eeeeeee.

Producer surplus is the area below equilibrium price and above the supply curve (Areas D, E, and F). The numerical value is ½ 4 4  8 . fffffff.

Consumer surplus is the area above equilibrium price and below the demand curve (Areas A, B and C). The numerical value is ½  4  8  16 .

Producer surplus is the area above the supply curve below $12 up to 2 (areas B, D and F). Numerically this is equal to 14, 1/ 2(2  2)  (2 6) . Consumer surplus is the area below the demand curve above $12 up to 2 (Area A).

Numerically this is 4(1/ 2  2  4) .

ggggggg.

204.

a.

Consumers will likely complain the most because they have fewer alternatives.

There will, however, be more suppliers who are kept out of the market.

hhhhhhh.

In the accompanying graph, you can see that the suppliers decrease output significantly, but the opportunity cost of their doing so is not great. Those fewer demanders who are hurt are hurt a lot; they will likely scream loudly. The actual number of complaints will depend on the costs and expected benefits of complaining.

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205.

Rent seeking is attempting to transfer surplus from one group to another; for firms it usually involves restricting supply in order to increase price. Firms have a greater incentive to rent seek when demand is inelastic because as price rises, total revenue rises.

206.

The general rule of political of political economy is that when small groups are helped by a government action and large groups are hurt by that same action, the small group tends to lobby far more effectively than the large group; thus, policies tend to reflect the small group’s interest rather than the interest of the large group.

An example from the real world is that farmers lobby the government to create a price floor or restrict the supply for their farm products.

207.

Without the restriction, Q 0 suppliers earn areas A and B in producer surplus. After the restriction, Q1 suppliers earn areas A and C. Suppliers would be willing to pay at most the difference (C − B) to restrict supply.

Questions from Alternative Perspectives 208. Austrian iiiiiii. Taxation without representation can be seen as robbery because it is not a tax that was chosen by elected representation. To the extent that our elected representatives follow the will of their constituents, taxes are not robbery because those taxes will be used to fund projects supported by society. jjjjjjj. Many Austrians would support a voluntary approach to government finance.

This would lead to a much smaller government and much more freedom for individuals. Austrians are not against collective action per se, but they are against involuntary transactions.

209. Feminist kkkkkkk.

The issue of taxation leaves out the fact that, to the extent that women do not make buying decisions, their surpluses are not accounted for in the model.

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Also, to the extent that women are not as frequently in government positions that decide taxation, their desires regarding taxes are not represented fairly. lllllll. One could frame the question so that it involves normative consideration. mmmmmmm. Yes, women would get less weight than men in the model of consumer surplus.

210.

Institutionalist People with the least money to spend necessarily—for example, a single dollar— receive less surplus. Those with the most money, who are willing and able to pay more for each unit, yet need not do so, receive a great deal of surplus. Thus, the distribution of income, which is itself a function of access to and control of the production process, determines whose welfare is maximized.

211.

Radical Econometric evidence suggests that the Social Security taxes are highly regressive in both competitive and non-competitive labor markets. Empirical studies find that in competitive markets with an inelastic labor supply and little bargaining power, workers bear the burden of their share of the payroll tax and much of the employers’ share in the form of wages that are lower than they would be in the absence of the tax. If supply is perfectly inelastic, the demand curve for labor shifts down by the amount of the tax ( P1  P0 in the graph shown below on the left). Wages fall by the entire amount of the tax, so employees bear the entire burden of the tax. In non-competitive markets, workers have a more elastic supply and more bargaining power, and the employers are unable to shift as much of their share of the payroll tax back, towards labor. If supply and demand are equally elastic, employees and employers share the burden of the tax equally as shown in the graph below on the right. The demand curve shifts by the amount of the tax (P1  P2 ) , but wages fall by ½ of the tax, P1  P0 .

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212.

Religious Economists’ surplus approach weights people’s views by their income, and thus is not directly consistent with this view. Although, for some types of questions, where individuals have similar tastes regardless of income, the difference is not that important.

Issues to Ponder 213.

a.

The tax structure that would bring about Mansard roofs is a tax that is based on the number of stories a building has, which is the type of tax they had in Paris when this roof was popular.

nnnnnnn.

If a story were interpreted as including living space created in the attic, or if the tax were based on square-footage of living-space, then the Mansard roof would decline in importance. ooooooo.

There are many. One example is if taxes are based on outside appearance, then the inside of a building would tend to be more elaborate than the outside. Another example is taxes on the number of windows in Quebec. In Quebec City, taxes at one point were based on the number of windows, so you see a lot of buildings where windows have been filled in. (Other answers are possible.)

214.

a.

A poll tax would have no incentive effect, since there is no way to avoid paying it. A tax on property, where supply is somewhat elastic, will reduce the quantity of property supplied (negative incentive effect), resulting in a loss of consumer and producer surplus.

ppppppp.

Margaret Thatcher was almost thrown out of office because of this tax, and her successor, John Major, returned to a property tax. Citizens were far more concerned with the distributional consequences associated with a poll tax than they were with the loss of efficiency associated with a property tax.

215.

If the tax were based on street frontage or area of the ground floor/foundation rather than square feet of living space, individuals would have an incentive to build in this style.

216.

a.

The regulations of Dr. Wiley's Law were likely the result of strong lobbying by the food industry to protect their own interests from competition under the guise of consumer protection.

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qqqqqqq.

A skeptical economist would likely look at the effects of this law on prices and competition to determine the motives behind passage of the law. rrrrrrr.

This is very significant because it suggests that it was the lobbying of existing producers that supported the law to protect their interests, not the consumers' interests.

217.

a.

Because the elasticity of demand among the top students was greater than one, lowering tuition would lead to a proportionally greater percentage increase in enrollment. Total revenue would rise for the college.

sssssss.

The program distinguished among top students because their elasticities likely differed. The top 10 percent were likely being offered scholarships at other academic institutions, giving them greater choices, which made their elasticities greater. ttttttt. It could be that the President did not reduce tuition for all students because the overall elasticity of demand for students was less than one. This scheme allowed them to take advantage of differing elasticities with price discrimination. Another reason is that price is sometimes an indicator for quality. By lowering tuition across the board, the President could be sending a signal that the college has lost relative academic standing. In using this scheme, he is sending a signal that he desires to increase their relative standing.

218.

a.

Because there were students that were asked to defer enrollment, there was excess demand as shown by the distance between Q 0 and Q1 in the accompanying graph.

uuuuuuu.

The market solution for excess demand is to raise tuition until excess demand is eliminated. vvvvvvv.

The state may have decided not to increase tuition in fear that lower-income students might not be able to afford the tuition. Another solution, however, would be to price discriminate − subsidizing education of those with lower income by charging higher prices to higher-income students.

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CHAPTER 8: MARKET FAILURE VERSUS GOVERNMENT FAILURE Questions and Exercises 219.

Reasons for a potentially beneficial role of government intervention include: to provide for public goods, to correct for externalities, and to address imperfect information.

220.

The marginal social benefit of a good that exhibits positive externalities is greater than the private social benefit because the trade results in a benefit to people outside the trade. This positive externality results in a market price that will be too low to maximize social welfare.

221.

An economist might argue about the word "acceptable." While not many people would argue that any pollution is good, an economist who realizes that eliminating pollution completely is probably an impossible costly goal would find pollution acceptable if it could be reduced to a cost-efficient level.

222.

This oil tax is an example of a tax incentive program that attempts to make the price of oil reflect the negative externality. If it works, it should provide an incentive for the users with the lowest cost of reduction to decrease their consumption of oil. If those with the lowest costs are significant users, then there will be a significant reduction. The effect depends on how high the tax is and the alternatives available to oil consumers.

223.

a.

Assuming perfect competition, the price and quantity will be set where demand crosses marginal cost with equilibrium price, P1 , and equilibrium quantity, Q1 .

wwwwwww. The socially efficient price and quantity would be where demand crosses marginal social cost, a higher price and a smaller output (P0 , Q0 ) .

224.

A market incentive program is more efficient because it makes use of the powerful force of the invisible hand, and unlike the direct regulation approach, it 1

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gets people to equate the marginal costs with the marginal benefit of their choices.

This results in the costs of a policy being distributed in the most efficient way.

225.

a.

Proposal A would force a downward shift in each demand curve by reducing quantity at every price. Proposal B would raise the price at each quantity, also shifting the demand curves down.

xxxxxxx.

The consumers with more elastic demand can more easily adjust their usage and would therefore favor Proposal A. yyyyyyy.

Those with inelastic demand are more likely to favor the tax because changing their usage is more difficult. Their inelasticity can be interpreted to mean that they are more willing to pay a higher price than to consume less oil.

226.

a.

The price of getting rid of garbage rose while the price of getting rid of recyclables did not. People substituted recycling for disposing.

zzzzzzz.

The weight of garbage fell by less than volume because the fee was based on volume; people stuffed their bags fuller, placing more garbage into a 32-gallon bag. aaaaaaaa.

With a flat fee, the marginal cost of disposing of more garbage was essentially zero, so in the accompanying graph, Q 0 garbage pick-up was demanded. With volume pricing, the price rose to P1 , and quantity demanded fell to Q1 .

227.

(1) Safety: The public aspect of safety is that if safety provides a safe environment, it is provided for all people and one person enjoying safety does not preclude others from benefiting from that safety.

(2) Street Names: Naming streets allows people to orient themselves in towns and facilitates communication. Once a street is named, it benefits all people. No one can be excluded from referring to that name. In addition, one person using that street name does not preclude others from referring to that street with its name.

Before the street is named, however, if a particular name is used to refer to more than one street, the value of that name in providing geographic orientation will be diminished.

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(3) Steak Dinner: A steak dinner has no public good aspects, since it is both rival and excludable.

228.

Non-excludability and non-rivalry both increase the ability of free riders to enjoy the benefit of the product, without paying for it.

229.

City parks are examples of public goods. Use by one person does not deplete its use to others; in other words, city parks are nonexcludable. Asking for voluntary contributions to sustain city parks will result in too few parks because of the free rider problem. Once built, it would be difficult to exclude the people who did not voluntarily contribute to its building from using it. Thus no individuals have a monetary incentive to pay for the park. (They may have non-monetary incentives such as wanting to support green spaces in their neighborhoods.)

230.

a.

The graph of the market demand curve is shown in the accompanying graph. The market curve and the demand curve for A are the same from quantity 4 and up. Remember that with public goods, the market demand curve is created by summing the individual demand curves vertically.

bbbbbbbb. Because people do not actually purchase public goods, their true preferences are not revealed. Since people will not directly pay for those goods, they will tend to overstate the value they receive from public goods.

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cccccccc. units.

The socially optimal amount of the public good at a price of $2 is 4

dddddddd. Given the free rider problem, the answer to c is most likely an overestimate.

231.

You might offer the average, $3,000. If sellers of cherries want $4,000, your $3,000 would buy you only lemons. If you had this information, you'd know that you had no chance of buying a cherry. The problem is that even though all cherries are priced higher than $3,000 there are also lemons priced higher than $3,000. You would likely lower your asking price to reflect the fact that there are only lemons available in the market.

232.

Signaling refers to an action taken by an informed party that reveals information to an uninformed party and thereby partially offsets adverse selection. The adverse selection problem occurs when buyers and sellers have different amounts of information about the good for sale and potentially use that information to the detriment of the other. Three examples of signaling are (1) car warrantees, (2) 90day return policies, and (3) academic credentials. (Other answers are possible.)

233.

Automobile insurance companies don’t have complete information about a person’s choice whether to take risks while driving. The screen is the two options.

People who drive safely will choose the high deductible because they have a low probability of getting in an accident. The person who is more likely to expect to get in an accident will choose the low deductible.

234.

In a market where buyers and sellers have different amounts of information about the good for sale, a problem occurs called the adverse selection problem. The problem is that the market for quality products disappears. While the question doesn't ask for an example, here's one: In commercial dating services, the seller certainly has more information about the negative (and positive) aspects of the product than the buyer. We suspect that the market has fewer ―acceptable‖ dates than the general population.

235.

Neither buyers nor sellers would have any information about the quality of the cars, so the mix would become a potluck and the distribution of problems would reflect the quality and natural aging of cars.

236.

To keep rates to a minimum, insurance companies estimate information about individuals by categorizing them according to risk by looking for variables that 1

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are related to risk. If everyone paid the same amount, low-cost customers would be paying for high-cost customers and eventually change companies, leaving only high-cost customers. Because studies have shown that, statistically, married drivers are safer drivers, they are often charged a lower rate for insurance.

Whether this practice is fair is a normative issue.

237.

The advanced degree serves the same purpose as a license. It reduces the supply and increases the wage of the one with the license.

238.

If the informational alternative were introduced, existing doctors, on average, would likely lose, as their monopoly would be reduced. Individuals seeking medical help will gain because they will have wider options. Individuals just starting careers in medicine, who have more options about what type of study to pursue, will also gain. Some individuals seeking medical help who have less ability to shop around may lose if they end up going to inadequate doctors who were previously excluded from practicing medicine.

239.

The moral hazard problem in insurance will lead to higher premiums because those who are covered will be less careful with whatever behavior is being covered and behave in a way that is more risky. Both raise the cost of providing insurance for the provider.

240.

a.

Not necessarily. The ―right‖ number of regulations is a normative issue.

One could argue that the right number of regulations is the number that equates the marginal cost to the marginal benefit of those regulations. Since we don't know the marginal benefit of the regulations, just the total, we can't tell whether these regulations are optimal.

eeeeeeee.

To the extent that the marginal costs and marginal benefits of regulations are known, economists would use a cost/benefit analysis to decide each regulation.

241.

Whether government ought to forbid Jayden from wearing a red shirt depends on how much you support a free market and whether you believe government should correct all externalities. One opinion is that no, even though Ciara might dislike the color red, she is not physically harmed in any way. Besides, Jayden should also have the freedom to wear the clothes that he wants as a freedom of expression.

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242.

False. While placing a tax on burning fossil fuels would be a reasonable policy to consider, since it would tend to decrease the amount of carbon dioxide emissions, the statement is too strongly worded to be unambiguously true. The ―tax fossil fuel‖ policy needs to pass a cost/benefit test before it is the policy that should be implemented. If the statement had been that the government should consider such a tax policy, I would have classified it as true. An example of where one might not want to use a tax policy would be if other countries are not using such taxes, which could cause problems for the country’s competitiveness. Another would be if the needed tax was so high to sufficiently discourage the use of fossil fuels that it would undermine support for possibly more effective policies, which might change people’s tastes so that they would simply not want to drive a fossil-based automobile. Policies involve complex interrelationships, making strong statements portraying one policy as the correct policy highly suspect.

Questions from Alternative Perspectives 243. Austrian ffffffff.

Yes, it could. gggggggg. According to Austrian economists, the structure of the microeconomics course is slanted towards government action, and government failure is not given sufficient focus.

244. Religious hhhhhhhh. There is some truth to this saying; if people were only selfless, they would lose much that makes them human. iiiiiiii. debate.

Yes, there is a conflict, although how strong the conflict is a matter of

jjjjjjjj.

No probably not, although, again, the answer is debatable. Markets would not work well if people were purely selfless. In many ways the society would simply not need markets.

245.

Institutionalist Using this institutionalist definition of economics, a prima facie case for any government intervention exists. It is simply people using institutions to achieve ends. That makes the decision about government intervention a moral decision about what are legitimate goals. Most institutionalist economists believe that intervention is acceptable if it improves the capacity of the provisioning system to better the human condition. Since most institutionalists believe that individuals have basic rights to services such as healthcare, they believe that debates about policies such as universal healthcare are not questions of if, but of how.

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246. Post-Keynesian kkkkkkkk. A number of examples are possible. Here is one: Asymmetric information is likely to exist in the used automobile market. llllllll.

The seller of the car could offer a warranty for the car. (There are other possibilities.) mmmmmmmm. It could, since there are no barriers to entry, but it seems to be very expensive for small firms to create such warranties, leaving a potential for government action. In a broader sense, however, they could not since the very process of contracting requires a dependable legal system that government provides.

247. Radical nnnnnnnn. Providing safe drinking water has public goods aspects to it; it benefits the entire community, not just the individual, and many of the costs are joint.

Clean water has a positive externality associated with it, such as preventing diseases such as cholera. Water will be underprovided by a private market. oooooooo. This is a judgment question, and judgments differ. Most Radical economists believe that private provision of water is a bad policy. pppppppp. From a Radical perspective, public provision of basic services makes the most sense, since private provisioning would provide too little clean water.

Issues to Ponder 248.

If economists support a tax on a specific good, it is usually because of a suspected externality. In the case of gasoline, the likely externality involves carbon emissions. The higher tax would encourage individuals to use less gasoline and to switch to less polluting alternatives.

249.

a.

One advantage of such fees is that they reduce the quantity of animal trophies demanded (assuming poaching can be prevented). This reduces the damage to the stock of animals. Further, the revenue could be used to raise more animals or meet other needs of African nations. This also provides an incentive for the local people to preserve sufficient big game to meet the demand for the permits.

qqqqqqqq. One argument against it is that condoning such slaughter at any price is immoral and by removing the stigma of illegal killing may even result in a greater demand for animal trophies. A second argument is that, by the time the optimal price is found, the animals may well be extinct.

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250.

a. well.

Most likely the price of all cars will rise; air quality would likely rise as

rrrrrrrr.

This law could possibly increase pollution if consumers hold onto their older, less efficient but lower-cost, higher-performance gasoline-fueled vehicles and delay purchase of an electric car. This would increase the average age of cars on the road, increasing pollution. Furthermore, if electric cars (the most likely candidates) were designed to meet the no-pollution requirement, it could be that the process of generating sufficient electricity to run the cars would produce even more pollution, at which point even more regulation might be imposed. ssssssss.

Economists generally favor market incentive programs over direct regulation. A market incentive program that reduces pollution by a certain percent might be to tax drivers of older, high-pollution cars and use the tax revenue to subsidize those who purchase the new, no-pollution cars. This approach will more likely equate marginal cost with marginal benefit. Another market incentive program would be to increase taxes on gasoline, causing the demand for gasoline to decrease as people switch to more efficient vehicles.

251.

Three market failures that possibly justify national parks are: (1) National parks are possibly public goods. Use by one does not deplete their use by others, and it is difficult to exclude people from using them. National parks are not pure public goods because they can be gated with toll booths at their entrances, requiring fees to enter. However, one aspect of national parks – existence value – is not excludable. Existence value is the value a citizen of a country derives from the knowledge that the country has national parks. National parks create national pride and identity. This value is both non-rival and non-excludable, leading to underproduction of national parks by the private market. (2) National parks create positive externalities. People who visit national parks learn about taking care of the environment, our national heritage, and the complexity of nature – education that can be brought into other parts of economic life. Another positive externality is that they provide resources for a variety of research that provides benefits to society. (3) National parks may experience increasing returns to scale. That is, the larger the park, the lower the per-unit cost of maintaining it. Thus, national parks can be seen as a natural monopoly of sorts, justifying government intervention.

Source: ―Market Failures and the Rationale for National Parks,‖ Journal of Economic Education, Fall 2002. (Natural monopolies are covered in Chapter 14 but can be introduced by the instructor facilitating the class discussion.)

252.

The FDA protects us from unsafe pharmaceuticals, but in doing so it creates enormous bureaucratic hassles for the manufacturers of pharmaceuticals. In some cases, by the time the FDA has approved a pharmaceutical, many potential users are already dead. This question requires weighing the costs against the benefits.

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253.

While there are benefits of licensing, it is often used as a way to restrict entry into the profession and thwart competition. Thus, while some type of certification program may be warranted, licensing is probably not warranted.

254.

Pro: People should undergo testing before getting life insurance because the person who is more likely to seek thrills is a greater risk to the insurance company, and should bear these higher costs themselves, rather than having them passed on to non-risk seekers.

Con: People should not undergo testing before getting life insurance because whether a person is a greater risk depends on revealed behavior rather than proclivity towards a particular behavior. We, not our genes, decide our behavior.

Undergoing such testing would result in people who have the gene but who avoid such behavior having to unnecessarily pay a higher premium.

255.

Many answers are possible, beginning with (1) the label on breakfast cereal, (2) the roads used to get to school, (3) either the school they go to (if it is public) or the federal funds their school receives (if it is private), (4) the taxes paid on the snack at the snack bar, and (5) the laws that are enforced on the roadways. The benefits of labeling are that consumers can better plan nutritional balance and are better informed about the product they are buying. Whether this is justified is unclear. If consumers wanted such labeling, there would be market pressure to include that information on cereal boxes. Some labeling, such as whether the product is genetically modified (GMO), could unnecessarily alarm consumers.

This would hurt those companies that use genetically modified food and help others that don’t. To date, genetically modified food has not been shown to be harmful.

256.

The tax on oil will probably affect the pollution coming from oil, but it is possible that users could switch to other fuel sources that result in other and greater forms of pollution. Moreover, some types of pollution would be unaffected. Thus, the net impact on the environment is difficult to predict.

257.

a.

Some dairy farmers would probably argue that labeling is unnecessary since the drugs they administer have been certified by the FDA. Dairy farmers who do not use BST would support BST labeling because consumers may perceive their milk as better for their health.

tttttttt.

If BST were to be listed on milk containers, one could argue that all drugs and antibiotics should be listed. However, such listing (without more information) may cause unnecessary consumer concern. To support BST labeling but not other labeling, one must argue that BST is different.

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uuuuuuuu. One would suspect that dairy farmers who support BST labeling would not support the broader law that might include drugs that they do use. Only those few farmers who use wholly organic farming would support full labeling.

CHAPTER 9: COMPARATIVE ADVANTAGE, EXCHANGE RATES AND GLOBALIZATION Questions and Exercises 258.

A country does better exporting a good for which it has a comparative advantage and importing goods for which other countries have comparative advantages.

259.

There is a basis for trade because Wadgetland can produce wadgets at a lower opportunity cost than Widgetland. Wadgetland gives up 1/ 4 of a widget for every wadget it makes, while Widgetland gives up 1 widget for every wadget it makes.

So Widgetland has a lower opportunity cost of producing widgets. They give up 1 wadget while Wadgetland gives up 4 wadgets to make a widget. Wadgetland has a comparative advantage in producing wadgets and Widgetland has a comparative advantage in producing widgets.

If each specializes in their respective comparative advantage, Wadgetland ought to produce 720 wadgets and 0 widgets and Widgetland ought to produce 240 widgets and 0 wadgets.

With this production combination, a possible deal in which each can consume more than before is for Widgetland to trade 120 widgets for 240 wadgets. It could then consume 120 widgets and 240 wadgets, doubling the amount of wadgets they are now able to consume. Wadgetland would then consume 480 wadgets and 120 widgets, doubling the amount of widgets they were previously able to consume.

Both countries will be better off than before.

260.

a.

Iowa has a comparative advantage in bushels of corn (gives up 1/ 3 bushels of wheat for every bushel of corn). Nebraska has a comparative advantage in wheat (gives up 1/ 3 bushels of corn for every bushel of wheat). It would be recommended that Iowa produce 180 bushels of corn [120  (3  20)] and 0 bushels of wheat and Nebraska produce 0 bushels of corn and 180 bushels of wheat [120  (3  20)] .

With this combination, Nebraska can trade 120 bushels of wheat for 60 bushels of corn. With this trade, Nebraska will end up with 120 bushels of corn and 60 bushels of wheat and Iowa will end up with 60 bushels of corn and 120 bushels of wheat. Nebraska ends up with 20 more bushels of corn and Iowa ends up with 20 7

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more bushels of wheat than required by the question. Thus, each can achieve at least the consumption combination required by the question. The excess must go somewhere, and part b tells us where—the trader. vvvvvvvv. The states together produce 180 million bushels of both corn and wheat but consume 160 million bushels of each leaving the trader 20 million bushels of corn and 20 million bushels of wheat.

261.

a.

The countries must realize that the only way to get to the new consumption combinations is if they specialize and then trade. Machineland has the comparative advantage in machines and should specialize in them and trade them for food from Farmland. Doing so, Machineland produces 200 machines and Farmland produces 200 units of food. They can then end up at points B and D with a one-to-one trade with Machineland trading 50 machines for 50 units of food.

wwwwwwww. At points A and C, the total production of machines is 110 and the total production of food is 170. By specialization, the total production of each would increase to 200, so production of machines increases by 90 and production of food increases by 30. xxxxxxxx. There is no set amount that a trader should receive, but the trader's share should compensate him and still allow for the two nations to gain from trade. Eventually, the above-normal returns will be competed away. yyyyyyyy. If costs fell as production rose, the argument for specialization is even stronger. The recommendation doesn’t change, but the economic case behind it becomes stronger.

262.

a.

The production possibility curves are shown in the accompanying graph.

zzzzzzzz.

Busytown has a comparative advantage in producing cars and Lazyasiwannabe has a comparative advantage in gourmet meals. aaaaaaaaa. Busytown should produce 60,000 cars and Lazyasiwannabe should produce 50,000 meals.

Lazyasiwannabe then offers Busytown 22,000 meals for 24,000 cars.

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Lazyasiwannabe ends up with 28,000 meals (50,000 − 22,000) and 24,000 cars. If it had produced 24,000 cars on its own, it would have had only 24,000 meals.

Busytown ends up with 36,000 cars. If it had produced 22,000 meals on its own, it would be left with only 33,600 cars (60,000 − 26,400).

263.

Traders get bigger gains from trade in newly opened markets where strong competition among traders has yet to develop. The more competition that exists in international trade, the more the traders will compete with one another and will offer to arrange the trade for less and less. With more competition, gains to traders will be reduced, leaving more gains for citizens of the countries involved in the trade.

264.

Smaller countries tend to get more of the gains from trade because more opportunities are opened up for them. This is true only under the condition that competition among traders prevails.

265.

International traders in small countries often have little competition and so keep larger shares of the gains from trade for themselves; hence, the people of the small country may not get the gains from trade.

266.

a.

No. Both countries’ opportunity cost of producing pickles is 2 (they must give up 2 olives to get 1 pickle). Neither has a comparative advantage, so there is no basis for trade.

bbbbbbbbb. If per-unit cost of producing pickles and olives falls as more of each is produced, it definitely pays for both countries to specialize in either olives or pickles since doing so would lower total costs. Which country should specialize in which good is an open question since neither has a comparative advantage and we do not know how much per-unit costs fall for each’s production.

267.

Four reasons are: (1) Economists can identify both the costs and benefits of trade.

Laypeople often do not recognize that the decline in product prices is the result of trade, while they can readily identify that lost jobs are the costs. (2) Economists know that comparative advantage implies that each country is better at producing at least one good. Laypeople worry that since wages are lower in China, it has a comparative advantage in all goods and the U.S. will lose all its jobs. Economists admit that because the U.S. has a trade deficit, the U.S. will face difficult economic forces to restore a more nearly equal division of comparative advantage. (3) Economists recognize that trade occurs in more sectors than manufacturing. They see the comparative advantage that the U.S. has in trading services. Laypeople tend to see trade as trade in manufactured goods only. (4) Economists' models do not take into account the effect of trade on the distribution 1

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of income. A change in a country's comparative advantage will affect the distribution of income. Laypeople do take this into account.

268.

False. According to the theory of comparative advantage, if one country has a comparative advantage in one good, the other country must have a comparative advantage in another good.

269.

While the loss of a comparative advantage in the manufacturing sector might have hurt the United States’ economy in some ways, it has freed resources for the sectors in which the United States does have a comparative advantage. Today that comparative advantage is facilitating international trade. This change creates a demand for U.S. advertising, management, and distribution of goods. This creates jobs and income in those sectors.

270.

Outsourcing has reduced the demand for manufactured jobs, reducing employment and income in that industry. Manufacturing supported the middle class for a number of years. Globalization has also created demand for technology, finance, and trade, which all require specialized skills, and ultimately pay higher salaries. Because globalization increases the market for their skills, income in these sectors has increased enormously. The overall result is a greater disparity in income.

271.

Any three of the following ten would be correct: (1) Skills of the U.S. labor force, (2) U.S. governmental institutions, (3) U.S. physical and technological infrastructure, (4) English as the international language of business, (5) wealth from past production, (6) U.S. natural resources, (7) cachet, (8) inertia, (9) U.S. intellectual property rights, and (10) relatively open immigration policy.

272.

Inherent comparative advantages are those that are based on factors that are relatively unchangeable, while transferable comparative advantages are those based on factors that can change relatively easily.

273.

A country would prefer to have an inherent comparative advantage because it would not lose that comparative advantage or face the adjustment costs that accompany the change of comparative advantages.

274.

The depreciation of a currency means that it takes fewer foreign currency units to buy one domestic currency unit. In the case of the United States and China where the dollar depreciates, the price of U.S. exports to China declines and the price of 2

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U.S. imports from China increases as more U.S. dollars would be needed to buy a Chinese import.

275.

Domestic production is shown by Q 0 . Domestic consumption is Q1 . The difference, Q1  Q0 , represents imports.

ccccccccc. The United States would like to raise world supply since it would increase domestic production and reduce imports.

Price

ddddddddd. This might happen in a variety of ways. The United States could gain a comparative advantage in the good by increasing productivity, relative U.S. wages could fall, or the U.S. dollar could depreciate.

S

SW

PW

D

Q0

276.

Q1

Quantity

The resource curse would worsen the distribution because it would cause an appreciation in the value of the currency, lowering the world price level, making the trade position for tradable goods worse. That is, a country’s exports would cost more, and imports would cost less. The resource sector benefits because by definition, foreign countries demand the resource. Tradable goods sectors tend to employ a large number of workers as compared to natural resource sectors.

Resource sectors tend to have fewer employees, concentrating the rise of income among a few, as compared to other tradable goods sectors.

Questions from Alternative Perspectives 277.

Austrian An Austrian would tend to agree with this statement because they believe that people tend to know what is good for them much better than government does.

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278.

Religious This is a judgment question in which answers will differ. A religiously oriented economist is more likely to give weight to such issues--maintaining cultural identity--than is a mainstream economist.

279. Post-Keynesian eeeeeeeee. Outsourcing tends to undermine the bargaining power of U.S. workers and increase the bargaining power of U.S. employers. fffffffff.

It will likely lead to lower U.S. wages than otherwise would have been the case. ggggggggg. Since lawyers need to be certified by state boards, they do not face as much competition from outsourcing, so outsourcing will not tend to lower lawyers’ wages. hhhhhhhhh. Yes, given that lawyers tend to have more influence in government, they would likely institute policies to limit outsourcing law services that have the potential to be outsourced.

280. Radical iiiiiiiii.

This is a judgment call, but an argument could be made that since there are economies to scale in the production of cloth and the production of cloth has linkages to other important industries (for example, chemical and machine making) that are key to an initiating industrial revolution that are missing in the production of wine, Ricardo’s advice was self-serving for England. jjjjjjjjj.

No, I probably would have advised them not to specialize in wine making.

281.

Austrian and Post-Keynesian Smith’s is a moral claim that is difficult to support or dispute. It depends on sensibilities of people. Most people’s sensibilities would be similar to Smith’s.

Individuals care about others, especially the poor. Not only do they say this, but they also demonstrate it by politically supporting programs that assist the poor and provide basic needs for people. But those programs have not been very successful at reducing income inequality, and the distribution of income is becoming less equal in the United States due in part to the adjustments caused by a decline in the comparative advantage for manufactured goods in the United States. Lower-income workers in the tradable sectors are seeing their income fall, while others at the top of the trading pyramid are gaining enormously.

Whether this increase in inequality undermines Smith’s claim that all people care about the poor is unclear. Society today is much richer than it was in Smith’s 4

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time, and there are many different judgments about whether low-income individuals in U.S. society should be classified as poor and miserable. Some would argue yes, they should be classified as such, and the fact that we haven’t done anything to stop the increase in inequality shows that people don’t care about society. Others would argue no, low-income individuals in the United States do not meet Smith’s conception of ―poor and miserable‖ and thus the fact that income inequality is increasing should not be of concern, nor does it demonstrate that society doesn’t care about the poor. They believe that the best way to help society is to allow market trade to ―lift all boats.‖ Programs designed specifically to help the poor will likely backfire, and not help the poor, but instead help those who design the programs. Smith also made this argument when he explained why most proposed government programs ―ought never to be adopted, till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention.‖ The problem is that the proposals to help the poor ―come… from an order of men, whose interest is never exactly the same with that of the public, who generally have an interest to deceive and even oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.‖

Issues to Ponder 282.

Outsourcing to China and India today differs from outsourcing in the past in two ways: (1) the potential size of outsourcing is much larger today (those countries have combined population of about 3 billion) and (2) China and India are able to compete on a larger number of production levels than in the past (China and India have adopted more technological advances).

283.

The law of one price states that the price of equivalent goods will cost the same across countries. Reasons why the law of one price might not hold include different social institutions, laws, and transportation costs. Another reason is that while two products might be equivalent, consumers might not perceive them as equivalent. American goods currently have cache in some countries that will keep their prices higher than "equivalent" goods in other countries.

284.

The normal textbook presentation might not include the international trader because it complicates the model. How much of the gains go to the trader depends on the cost of facilitating the trade, the competition among traders, and the bargaining power of the country relative to the trader. There is no simple model to reflect these complications. Including the trader in the model recognizes that traders are a necessary component of trading. This allows one to acknowledge the comparative advantage the United States currently has in facilitating trade.

Including traders provides a more comprehensive view of how the benefits of trade are distributed.

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285.

a. zero.

Since the trade would be balanced, the price of the certificates would be

kkkkkkkkk. In order to import, the price would be very high. lllllllll.

Since the United States has a trade deficit with China. Chinese companies that wanted to export to the United States would pay a high price to American exports for the license to do so. In China, the price of certificates to export would be highly positive, which means that the price of certificates to import would be highly negative. Exporters would have to pay importers to import. mmmmmmmmm. Such a law would make exchange rate fluctuations less likely because it would equalize the current account balance.

286.

The subgroup of workers that would likely be most helped are low-wage manufacturing workers in tradable sectors. They would have their industries supported in order to encourage exports, and they would face fewer imports. The subgroup of workers that would likely be most hurt are the international traders who would have to give up some of their gains from importing to create offsetting exports.

CHAPTER 10: INTERNATIONAL TRADE POLICY Questions and Exercises 287.

Because U.S. trade is a relatively small percent of total output, trade is less important to the United States compared to other countries. Considering all goods and services produced, U.S. producers face less competition, this suggests that trade policies are less important.

288.

The two greatest U.S. trading partners are Canada and Mexico. Trade with China and India is rising rapidly. (The Pacific Rim and the European Union are collections of, not single, countries.)

289.

Tariffs and quotas have similar effects on limiting trade. A quota restricts the quantity of imports. A tariff results in the same quantity of imports by raising the world price by the amount of the tariff. The resulting domestic price and quantity are the same in both cases. Domestic producers face less competition in both. The difference is who gets the revenue from the resulting increase in the price of imports. With a tariff, the domestic government gets the revenue, shown by the shaded region. With a quota, the revenues accrue to the foreign producers.

6

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290.

Both voluntary restraint agreements and tariffs increase the price of the imported good paid by consumers and reduce total quantity demanded. The two, however, impact the government and foreign firms differently. In the case of the tariff, the domestic government collects tax revenue. In the case of voluntary restraint agreement, foreign firms receive higher prices for the products they sell and the government receives no tax revenue.

291.

a.

The gains to domestic producers are shown in the accompanying graph.

Domestic producers now produce B at Pt instead of A at Pw . Domestic producers gain additional revenue shown by areas FHKG and ABKE.

7

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nnnnnnnnn. The revenue to the government is the quantity supplied by foreign producers, BC, multiplied by the tariff. This is shown in the accompanying graph as HIJK. ooooooooo. The cost to domestic producers to produce additional units is shown by area ABKHE. ppppppppp. The gain to domestic producers is greater than the cost to domestic producers by area FHEG because the cost of producing the additional output is less than the revenue gained from the additional output, specifically, area GEHF.

292.

a.

It might be good or bad for the United States government. To the extent that it produced tariff revenue, it was good. To the extent that it strained U.S – German relations, the trade war was bad.

qqqqqqqqq. A tariff by Germany on the U.S. produced chickens would lead to higher chicken prices in Germany since the supply of imported chicken would shift up by the amount of the tariff, increasing their price. German producers would also sell their chickens at the higher price because they face less competition. German consumers would be hurt by the tariff. rrrrrrrrr.

U.S. chicken producers would be hurt because the quantity of chickens demanded falls and they have to pay a tariff on those chickens that they do sell to Germans. The net price they receive is lower.

8

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sssssssss.

U.S. light-truck producers would gain because light trucks imported from Germany would rise in price and be less competitive. U.S. producers of light trucks could raise their prices. ttttttttt.

Economists, in general, do not support any trade restrictions because they reduce world output and raise prices.

293.

a.

With the quota, the quantity of clothes sold was fixed. Suppliers charged the price (P0 ) consumers were willing to pay for that quantity. With the removal of the quota, as the accompanying graph demonstrates, equilibrium quantity rose (to Q1 ) and equilibrium price fell (to P1 ).

uuuuuuuuu. Consumers benefited because they were able to buy a greater quantity at a lower price. This is represented by an increase in consumer surplus shown by the shaded region in the accompanying graph. vvvvvvvvv. The short-run effect of the removal of the quota is that profits declined because the equilibrium price declined (this assumes demand is inelastic in the short run). Revenue falls when supply increases and demand is inelastic). If economies of scale lower average total costs by more than the decline in equilibrium price, in the long run profits might increase with the removal of the quotas.

294. Countries restrict trade for many reasons. Any three of the following are correct answers: a. Unequal internal distribution of the gains from trade. b. Companies that feel they are not getting a good deal from trades will lobby government to restrict trade. c. Countries want to make threats of trade restrictions for the purpose of negotiating credible. d. Learning by doing and economies of scale may reduce the cost of producing a domestic good, making those goods more competitive in the future. This may be particularly true for infant industries. e. Sales of goods to foreign goods may threaten national security. f. Countries may want to use trade restrictions as an international political tool.

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g. Governments earn revenue from the tariffs that can be used to support government spending.

295.

A country would have trade adjustment assistance programs in an effort to facilitate free trade by compensating domestic producers who lose as a result of reductions in trade restrictions. They are difficult to implement because losses from free trade become exaggerated and magnified—often causing the costs of the assistance programs to outweigh the gains.

296.

A credible threat of trade restrictions would lead to lower trade restrictions because the other bargainer's belief that a country would implant trade restrictions gives the country the upper hand in strategic bargaining and enables the country to extract larger gains from trade. These gains could be lower trade restrictions.

297.

Economies of scale refer to the situation in which costs per unit of output fall as output increases. If per unit costs fall sufficiently, the country that increases the production of that good may gain a comparative advantage in that good. Trade restrictions would reduce competition, allowing domestic firms to sell and produce more goods and realize the economies of scale.

298.

From a global perspective, free trade increases total output. International trade provides competition for domestic companies, which forces domestic companies to remain competitive and efficient. By fostering international cooperation, international trade makes war less likely which is a significant contribution to national security.

299.

The WTO is the World Trade Organization. It generally supports multilateral free trade policies.

Questions from Alternative Perspectives 300.

Austrian It depends. In some ways it is true; a tariff protects the income of people who produce goods protected by the tariff. As such, the tariff transfers income from others to that group. In other ways it is more complicated. Government is also a way that people deal with collective problems that have to be solved collectively.

This can involve implicit social contracts among people in a society to compete, and a tariff can also be seen as a way of maintaining a social contract to take into account new issues.

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301.

Radical The view that liberty is the only solution to problems of human relationships does not deal with the fact that one person’s liberty often infringes on the liberty of another person. Where that infringement occurs, liberty does not, in turn, provide an answer, even if one has a great deal of belief in it.

302.

Religious When there is trade there is a blending of economies that creates better understanding among cultures and mutual dependence. A greater understanding and mutual dependence can reduce the chances of war. But trade also introduces new areas of contention among countries, which can lead to conflict.

303.

Post-Keynesian The group that has been most helped by free trade are international traders and those associated with them. International traders have become wealthy by engaging in trade. The group that has been most hurt by trade are low-skilled laborers. Economists side with the traders.

304. Radical wwwwwwwww.Some radical economists would argue that they did not follow that strategy because they were protecting their infant industries. xxxxxxxxx. Some radical economists would argue that it suggests that economists’ calls for free trade might be self-serving for developed economies because free trade allows them greater access to the markets of developing economies.

Issues to Ponder 305.

306.

While trade may increase output and income, trade will change the culture of that country. The impact is considerably larger for developing countries with unique and rich cultural practices and production. It often takes the form of exporting the dominant country's culture and goods. a.

Three assumptions are that the good is tradable, that transportation costs are minimal, and that taxes between the two countries do not differ significantly.

yyyyyyyyy. To the degree that production facilities and labor can move easily, the law of one price should hold for labor, too. Given the wage differentials that exist among countries with seemingly equivalent productivity, it seems that these 5

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conditions do not hold for labor. Barriers such as language and family ties likely explain this observation. zzzzzzzzz. Since capital is more mobile than labor, the law of one price should have a greater tendency to hold for capital. Financial capital is a great example.

Interest rates among countries tend to reach an equilibrium much faster than wages.

307.

An equitable method might be to tax those who gain from the trade liberalization and give the proceeds to those who are hurt by it.

aaaaaaaaaa. Assuming the original distribution is equitable, and the government is not trying to change income distribution, this method is equitable because the combined policies make everyone better off. bbbbbbbbbb. The political problems with implementation include: (1) Everyone will try to exaggerate the amount they are hurt and understate the amount they are helped. Thus, actually finding a tax that accomplishes the goal will be difficult.

(2) Once the taxes and subsidies are in place, they may not be removed after the adjustment of displaced workers is complete. Losers will be overcompensated, and gainers will be taxed too much. (3) Those who have big gains (big business) may have more political power and may be able to prevent the implementation of this policy.

308.

With a price floor, there is a loss of consumer surplus, higher prices and lower quantities.

309.

There is no ―right‖ answer to this question. To the extent that the chemicals present a health problem, the government may want to restrict tomatoes imported from Mexico. Doing so, however, will raise the price of tomatoes for American consumers. Domestic producers will lobby for such restrictions because they will be able to sell more tomatoes at higher prices.

310.

a.

Yes, if the deductions in lost taxes exceed the amount collected. This is indeed the case. Congressional tax experts have estimated that the deductions exceed the amount that corporations pay in taxes by over $6 billion a year.

cccccccccc. The natural suggestion would be to eliminate the tax, including the accompanying deductions from corporate taxable income. This would have the added benefit of eliminating the administrative costs associated with the tax.

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dddddddddd. It is likely that the companies want the tax because they benefit from it—in other words, because the tax results in lower taxable corporate income, it is an implicit subsidy, and they will lobby strongly to keep it. The government may keep the tax because it wants to encourage exports.

311.

a.

Economists opposed the tariff because it creates deadweight loss as shown by the shaded region in the accompanying graph and hurts the welfare of the whole society.

eeeeeeeeee. The tariff shifts the supply curve of imports up, which increases equilibrium price to P1 and lowers equilibrium quantity to Q1 as shown in the accompanying graph. ffffffffff.

The tariff would help the economy by increasing the price of imported goods, making domestic goods relatively more competitive and allowing domestic producers to raise their prices if they chose to do so. It would also provide revenue for government that it could spend on consumption or investment, further stimulating the domestic economy. gggggggggg. The macroeconomy would be worsened because a retaliatory tariff reduces the trade between countries, which hurts both of them. The countries do not benefit from the full extent of their comparative advantages.

Price

S1 S0 tariff

P1

P0

D0

Q1

Q0

Quantity

7

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312.

The answer, in part, will depend on what advice is being given. Most economists would argue that some trade restrictions might benefit a country, but almost no country can limit its restrictions to the beneficial ones. Trade restrictions are addictive; most economists would not recommend them, even in a recession.

CHAPTER 11: PRODUCTION AND COST ANALYSIS I Questions and Exercises 313.

314.

Economists include all opportunity costs as costs. This includes not only explicit costs but also implicit costs such as the opportunity costs of factors of production provided by the owners of the business. Accountants don’t include this second item as a cost. Economists include changes in the value of any assets owned by the firm in revenue (implicit revenue) as well as total sales. Accountants include only total sales. An example of implicit revenue is changes in the value of any assets owned by the firm, such as the building and equipment that it owns.

a.

Explicit costs: Labor $40,000 Rent 10,000 Ingredients 35,000 Utilities 5,000 Total $90,000 Implicit costs: Opportunity cost of labor Opportunity cost of capital (= $400,000 × 0.01) 4,000 Total

$125,000

$129,000

Explicit plus implicit costs

$219,000

Revenue

$260,000

Her accounting profit is explicit revenue minus explicit costs: $260,000 − $90,000 = $170,000. Her economic profit is revenue minus explicit and implicit costs: $260,000 − $219,000 = $41,000. hhhhhhhhhh. Peggy-Sue is earning positive economic profit with her current business, which means that she should continue with her current business.

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315.

a.

By the accounting definition of cost and profit, Economan is making a profit equal to $120,000   $5, 000  $45, 000  $6, 000  = $64, 000 .

iiiiiiiiii.

By the economists' definition of cost and profit, where explicit and implicit costs are included, Economan has a loss of $120,000  ($5,000  $45,000  $6,000  $60,000  $5,000) .

Explicit costs: Labor Rent Utilities Total

45,000 5,000 6,000 56,000

Implicit costs: Opportunity cost of labor 60,000 Opportunity cost of capital 5,000 Total 65,000 Explicit plus Implicit costs

121,000

Revenue

120,000

Economic Profit Accounting Profit

−1,000 (a loss) 64,000

316.

The terms short run and long run do not necessarily refer to specific periods of time but rather to the degree of flexibility a firm has in changing the level of output. In the long run a firm can vary its inputs as much as it wants, while in the short run these variations can be so costly that we consider them as fixed. Simply stated, in the short run some inputs are fixed while in the long run all inputs are variable.

317.

Whenever you see the term "marginal," it implies "additional." Thus, marginal productivity is the additional output that a firm will receive with one additional variable input (workers), assuming all other inputs are constant. Whenever you see "average," you divide by the quantity. Thus, average product is the output divided by the number of workers.

318.

Assuming you organize your studying reasonably, initially you focus on content that is most likely to show up on the exam and is most likely to raise your grade.

Then you study material that will raise your grade, but by less than the original material you studied. At some point, additional studying can have a negative return.

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319.

Total cost is the sum of the fixed and variable costs: TC = FC + VC. Average total cost (often called average cost) equals total cost divided by the quantity produced: ATC = TC ∕ Q. Average total cost also can be thought of as the sum of average fixed cost and average variable cost: ATC = AFC + AVC. Average fixed cost equals fixed cost divided by the quantity produced: AFC = FC∕Q. Average variable cost equals variable cost divided by the quantity produced: AVC = VC∕Q. Marginal cost is the increase (decrease) in total cost from increasing (decreasing) the level of output by one unit: MC = Change in TC ∕ Change in Q. From the data given: Q 0 1 2 3 4 5

FC 200 200 200 200 200 200

VC 0 20 30 35 50 80

TC 200 220 230 235 250 280

AVC inf 20.00 15.00 11.67 12.50 16.00

ATC inf 220.00 115.00 78.33 62.50 56.00

MC inf 20 10 5 15 30

AFC inf 200.00 100.00 66.67 50.00 40.00

(Note: Marginal costs should be interpreted as between levels of output. Inf = infinite for values that are divided by 0)

320.

a. Total cost jjjjjjjjjj.

Average total cost

kkkkkkkkkk. Average fixed cost llllllllll.

Average variable cost

mmmmmmmmmm. Average total cost

321.

a.

To the extent that the firm has a contract with the payroll services company in which the cost of the services is independent of the number of workers (and therefore output), it is a fixed cost. To the extent that payroll 3

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services company charges by the number of workers (and therefore output), it is a variable cost. nnnnnnnnnn. To the extent that the lease is for a fixed amount of office space regardless of the number of workers working at the office (and therefore output), leased offices are a fixed cost. oooooooooo. Company-owned buildings are an example of a fixed cost. The buildings have already been bought; they do not vary with the number of employees hired or level of output. pppppppppp. Payroll taxes are an example of a variable cost; they vary with the number of employees hired, which, in turn, varies with the level of output.

322.

Of all the costs discussed in this chapter, marginal cost—the increase in total cost from increasing the level of output by one unit—is the most important for a firm deciding how much to produce. Remember the economic decision rule: If the marginal cost exceeds the marginal benefit, don't do it. If the marginal benefit exceeds the marginal cost, do it.

323.

a.

The increase in hourly pay affects wages is a type of variable cost. It will affect each in the following way: Average fixed cost curve: no change Average variable cost curve: shift up Average total cost curve: shift up Marginal cost curve: shift up qqqqqqqqqq. The lump-sum tax must be paid no matter the firm’s level of output, therefore it is a fixed cost. It will affect each in the following way: Average fixed cost curve: shift up Average variable cost curve: no change Average total cost curve: shift up Marginal cost curve: no change rrrrrrrrrr.

Because the ―stack-tax‖ varies with the degree of air pollutant emissions, it changes based on a firm’s level of output and is a type of variable cost. It will affect each in the following way: Average fixed cost curve: no change Average variable cost curve: shift up Average total cost curve: shift up Marginal cost curve: shift up

4

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ssssssssss. The increase in productivity of every worker as a result of the new technology increases output for every worker, and therefore affects costs in the following way: Average fixed cost curve: no change Average variable cost curve: shift down Average total cost curve: shift down Marginal cost curve: shift down 324.

See the graph below for the graph of total output.

tttttttttt.

See the table below. Marginal product is between values. For example, the increase in output from 20 to 60 is 40.

Output

MC 0 20 60 150 260 350 420 455 420 375 300

AP

20.00 40.00 90.00 110.00 90.00 70.00 35.00 −35.00 −45.00 −75.00

20.00 30.00 50.00 65.00 70.00 70.00 65.00 52.50 42.00 30.00 5

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uuuuuuuuuu. See the graph below. vvvvvvvvvv. See the graph below.

325.

In the short run, output can be raised only by increasing the variable input. But as more and more of a variable input is added to a fixed input, the law of diminishing marginal productivity enters in. Marginal and average productivities fall. The key insight here is that when marginal productivity falls, marginal cost must rise, and when average productivity falls, average variable cost must rise. So to say that productivity falls is equivalent to saying that cost rises.

326.

If marginal cost is increasing, average costs could be rising, falling, or constant.

The direction of average costs depends upon whether marginal cost is higher or lower than average cost. If marginal cost is lower than average cost, average cost is falling. If marginal cost is higher than average cost, average cost is rising.

327.

a.

Output VC AFC ATC AVC MC 1 35 100.00 135.00 35.00 35 2 75 50.00 87.50 37.50 40 3 110 33.33 70.00 36.67 35 4 140 25.00 60.00 35.00 30 5 175 20.00 55.00 35.00 35 6 215 16.67 52.50 35.83 40 6

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7 8 9

260 315 390

14.29 12.50 11.11

51.43 51.88 54.44

37.14 39.38 43.33

45 55 75

wwwwwwwwww. See the accompanying graph. xxxxxxxxxx. The marginal cost curve intersects the AVC curve at the minimum of the AVC curve. As long as the MC curve is below the AVC curve, the AVC curve is falling. As long as the MC curve is above the AVC curve, the AVC curve is rising.

The marginal cost curve intersects the ATC curve at the minimum of the ATC curve. As long as the MC curve is below the ATC curve, the ATC curve is falling. As long as the MC curve is above the ATC curve, the ATC curve is rising.

The MC curve intersects the AVC curve at a lower output than at the output it intersects the ATC curve. yyyyyyyyyy. The ATC and AFC curves shift down because they are the only two of the four that include fixed costs. The MC and AVC curves do not shift because they include only variable costs.

328.

Average cost will not necessarily rise. The general relationships are: If average productivity is falling, average costs must be rising; if marginal productivity is falling, marginal cost must be rising, and marginal cost intersects the average cost curve at the same level of output that the marginal product curve intersects the average product curve.

329.

a.

Given the price of labor at $15 per hour, and the data in the total product table, the following table shows average variable costs Labor

TP 1 2 3 4 5

5 15 30 36 40

Total cost AVC AP MP MC 15.00 3.00 5.00 5.00 3.00 30.00 2.00 7.50 10.00 1.50 45.00 1.50 10.0 15.00 1.00 60.00 1.67 9.00 6.00 2.50 75.00 1.88 8.00 4.00 3.75

7

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zzzzzzzzzz. The AVC curve is shown in the accompanying graph, and the AP curve is shown below it. You can see that the AVC curve and AP curve are mirror images of each other.

aaaaaaaaaaa. The MP curve is shown in the graph above. bbbbbbbbbbb. As you can see from the graph on the left, the MC curve and the MP curve are approximate mirror images of each other.

330.

a.

See the table below:

Fixed Variable Average Average Average Marginal Q Cost Cost Fixed Cost Total Cost Variable Cost Cost 1 100 25 100 125 25 25 2 100 50 50 75 25 25 3 100 75 33 58 25 25 4 100 100 25 50 25 25 5 100 125 20 45 25 25 6 100 150 17 42 25 25 7 100 175 14 39 25 25 8 100 200 13 38 25 25 9 100 225 11 36 25 25 ccccccccccc. The AFC, ATC, AVC, and MC curves are would have to be shown in the accompanying graph. decreasing marginal productivity (a Uddddddddddd. The AFC curve has its normal shape. shaped MC curve) Because average variable costs do not change, the for the curves to marginal cost curve is coincident with the average have their variable cost as shown. The ATC curve is always "normal" shapes. falling since the costs are always above the MC curve.

The ATC curve asymptotically approaches $25. There 8

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eeeeeeeeeee. The law of diminishing marginal productivity is not operative.

331.

a.

See the table below.

Average Average Average Marg Fixed Variable Fixed Total Variable inal Output Cost Cost Cost Cost Cost Cost 1 100 25 100 125 25 25 2 100 60 50 80 30 35 3 100 105 33 68 35 45 4 100 160 25 65 40 55 5 100 225 20 65 45 65 6 100 300 17 67 50 75 7 100 385 14 69 55 85 8 100 480 13 73 60 95 9 100 585 11 76 65 105 fffffffffff.

See the accompanying graph.

140 120

ATC MC

100

Cost

Marginal costs would have to decline at first and then rise for the curves to have their ―normal‖ shapes.

ggggggggggg.

80 60 AVC

40

AFC

20 0 1

2

3

4

5

6

7

8

9

Total Output

10

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Questions from Alternative Perspectives 332. Austrian hhhhhhhhhhh. Entrepreneurs generally develop broadly defined business plans, which include expected costs and expected market conditions, before entering a business. These costs and market conditions, however, are highly uncertain; the tables should be seen as simply an exercise. They do not reflect the uncertainty under which real-world decisions are made. iiiiiiiiiii.

Ultimately businesses must make decisions based upon highly imperfect knowledge, knowledge that they get by entering the business itself.

Models do not show the uncertainty and risk of business, missing an important element of real-world markets. jjjjjjjjjjj.

Governments have even less information than businesses in making decisions, and government does not gain information by running businesses. The implication is that government should be very hesitant to intervene in the market.

333. Religious kkkkkkkkkkk. This is an empirical question and can only be answered by empirical evidence. Assuming no prosecution is possible, the standard model would suggest that firms would do so, although doing so would create negative publicity for them, which would limit the amount that they do. lllllllllll.

From most religious perspectives, they should not do this because it is unethical. They should do what is good for society.

334. Feminist mmmmmmmmmmm.

Probably not. There seems to be no objective reason for this. It is possible that women sell men’s underwear because men prefer to buy underwear from women and men sell refrigerators because women perceive men as knowing more about gadgets and therefore trust men (or at least firms believe this to be true). It is also possible that men tend to be given the higher paying jobs, and refrigerator sales come with commissions, because they are perceived as the primary ―bread-winner‖, whereas women’s income is perceived as supplemental. nnnnnnnnnnn. It is possible that because of traditional roles of women and men, women indeed know more about clothing, including underwear, and men know more about appliances, such as refrigerators.

335.

Institutionalist 1

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To the extent that consumer preferences are shaped by firms, people are maximizing the welfare of the owners of businesses when they make consumption decisions. If consumers, however, perceive their preferences to be real, is there really any difference between maximizing their own welfare and the welfare of the firm?

336.

Radical The just-in-time competitive strategy lowers overall costs, which is why Walmart uses it. To some degree, it shifts the fixed costs to Walmart’s suppliers, making them variable costs for Walmart. This allows Walmart to reduce production saving more variable cost than it otherwise would.

Issues to Ponder 337.

The terms long run and short run do not necessarily refer to specific periods of time independent of the production process. The long run, by definition, is a period in which the firm can vary the inputs as much as it wants; in the long run, all inputs are variable. The question is whether a firm ever really gets this degree of flexibility. It may be true that firms are always constrained with regard to what production decisions they can make, in which case this statement is probably true.

338.

This is true because the fixed cost will be spread over such a large quantity of output that the average fixed cost, the difference between average variable cost and average total cost, will approach zero.

339.

a.

The marginal cost was zero initially and 35 cents if you were over the allotted minutes. See graph below.

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ooooooooooo. Zero for minutes 1 to 350 and then rises until it approaches, but never reaches, 35 cents per minute. ppppppppppp. You wouldn’t. It is too difficult. You would guess at it. Companies were expecting that, which is why they offered such plans. qqqqqqqqqqq. They were relying on people’s gullibility and bringing them in as customers on the expectation of lower prices than they were getting, then relying on the difficult cost of changing phone companies to keep them customers. rrrrrrrrrrr.

They were against the portability of phone numbers because portability reduces the cost of change, and thus discourages the practice of offering confusing plans. sssssssssss. Bandwidth has expanded tremendously, driving the marginal cost of additional minutes to nearly zero.

340.

If neither factor is fixed, there is no diminishing marginal productivity. However, the quick order premium means that short-run marginal costs are 50% higher than long-run average costs. Assuming constant returns, then both the long run and short-run marginal cost curves are flat. Thus, once you have determined an initial production level, to change in the short run you must use the short-run marginal costs. The average total cost curve will initially be U-shaped, but then it will become asymptotic to the short run marginal cost curve.

341.

The shapes of the short-run average cost curve and marginal cost curve would be the same as in the more usual case where machines are the fixed factor. Either way you are still adding more and more of a variable factor to a fixed factor and encountering diminishing marginal productivity as a result. The marginal cost and average cost curves would be U-shaped.

CHAPTER 12: PRODUCTION AND COST ANALYSIS II Questions and Exercises 342.

Technical efficiency in production means that as few inputs as possible are used to produce a given output. Economic efficiency means using the method that produces a given level of output at the lowest possible cost.

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343.

a.

Because the second farmer can produce the same amount of corn with fewer hours of labor and less seed, both methods cannot be technically efficient.

Only the second farmer is technically efficient.

ttttttttttt.

All economically efficient methods are also technically efficient.

However, the first method is not technically efficient. So, it is not possible for both methods to be economically efficient.

344.

a.

It is possible that both methods are technically efficient because neither dressmaker is using more of both inputs to produce the same number of garments.

uuuuuuuuuuu. The economically efficient method is the least-cost method. The cost of 800 garments for the first dressmaker is $42,800[(160  $80)+(3,000  $10)] .

The cost of the same number of garments for the second dressmaker is $36,000 [(200  $80)  (2,000  $10)] . Therefore, the second method is the economically efficient method.

345.

It is incorrect because in the long run, there would be no fixed cost—all costs would be variable. The shape of the long-run average total cost curve is determined by economies of scale.

346.

If production relationships were only technical relationships, diseconomies of scale would never occur because the same technical process could be used over and over again at the same cost. In reality, however, the social dimensions of production relationships among workers introduce the potential for diseconomies of scale because, as the firm size increases, monitoring costs increase, and team spirit or morale generally decreases.

347. a. Carmakers were taking advantage of both economies of scope (combining production of different models to lower the cost of production for both) and economies of scale (increasing production of cars on one assembly line to lower average cost per unit).

vvvvvvvvvvv.

348.

The plan shifted the average total cost curve down.

a.

The long-run cost curve is shown in the accompanying graph. Initially it will fall because of economies of scale.

wwwwwwwwwww.

It will later rise due to diseconomies of scale.

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xxxxxxxxxxx. The average cost curves in the short run are also U-shaped. Their shape is due initially to increasing marginal productivity and eventually to decreasing marginal productivity. yyyyyyyyyyy. long run.

There is no fixed component since there are no fixed costs in the

zzzzzzzzzzz. The long-run cost curve would be a horizontal line equivalent to the constant costs.

349.

a.

Units 1 2 3 4 5 6 7 8 9 10

Total Cost $16,000 $21,000 $26,000 $31,000 $36,000 $41,000 $46,000 $51,000 $56,000 $61,000

Average Total Cost $16,000 $10,500 $8,667 $7,750 $7,200 $6,833 $6,571 $6,375 $6,222 $6,100

aaaaaaaaaaaa. It exhibits economies of scale because average total costs are declining. bbbbbbbbbbbb. The fixed cost of producing whales is the cost of the mold, or $11,000. cccccccccccc. The variable cost of producing whales is the materials used to make a new whale, or $5,000 per whale.

350.

Long-run costs are always lower than or equal to short run costs because in the long run all factors of production are variable. A firm can lower costs in the long 5

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run by adjusting what are fixed costs in the short run. Constraints to production always raise production costs.

351.

The long-run average total cost (LRATC) curve is an envelope of the short run average total cost (SRATC) curves. The short run marginal costs (SRMC) curve cuts the SRATC at its lowest point.

352.

A firm will produce along the segment where there are constant returns to scale.

A firm producing where there are increasing returns to scale has an incentive to increase production to lower costs. A firm producing where there are decreasing returns to scale has an incentive to decrease production to lower costs.

353.

An entrepreneur is an individual who sees an opportunity to sell an item at a price higher than the average total cost of producing it. He or she creates supply by organizing production as efficiently as possible and fully taking advantage of any potential economies of scale or economies of scope.

354.

No, not in the long run. In the long run, you should not continue to produce at a loss, and because all inputs are variable, you can go out of business. In the short run, the decision whether or not to produce depends on what portion of your costs are fixed.

355.

False. Financial reward plays a role in entrepreneurial effort, but it is not the only role. Entrepreneurs can also be motivated by providing social goods such as clean air. Recently a new type of firm has emerged called a for-benefit firm that includes both profit and social good in its charter.

356.

Cost curves are defined within a period of time. In the short run, technology is assumed constant. In the long run, technological change shifts the cost curves down. It does not explain the downward-sloping portion of cost curves.

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357.

Learning by doing lowers average total costs (shifts the curve down) because workers become better at their jobs—producing more in the same time period or producing the same with fewer inputs to production.

358.

The long-run average total cost curve is shifting down. Learning by doing means that workers can produce more with fewer inputs, shifting the short-run average total cost curve down. If the short-run average total cost curve shifts down so will the long-run average total cost curve

Questions from Alternative Perspectives 359. Austrian dddddddddddd. True costs are revealed through the workings of the market process.

Without the market, one has little sense of the true costs. eeeeeeeeeeee. There is probably no one optimal method of finding costs, but experience in an actual competitive marketplace is probably the best that firms can do.

360. Feminist ffffffffffff. To the extent that women provide less detail about their jobs in surveys and applications, they lead employers to believe that they know less than men and therefore have less experience. gggggggggggg. Women who have completed their formal education may have periodically withdrawn from the labor force. Working without pay in volunteer work for non-profits as well as years of experience as a household executive provide women with the experience of multitasking, delegating, managing schedules, and carrying out complicated tasks required on PTAs and other volunteer positions.

361.

Religious It suggests that differences in productivity are not inherent but are matters of luck and circumstance such as having fewer opportunities to learn, and it thereby undermines some aspects of the moral arguments for paying more productive people more. A possible policy implication is to provide opportunities for increasing productivity to those who have fewer opportunities.

362. Institutionalist hhhhhhhhhhhh. An example is large-scale hog farming. The environmental consequences of large-scale hog farming are enormous: two are contamination of groundwater and destruction of freshwater lakes, streams and rivers (deadly algae blooms in tidal ecosystems). There are also problems with airborne pollutants, not 7

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the least of which is ammonia. The presence of a large-scale hog farm will reduce property values in the associated area. iiiiiiiiiiii.

The implication for policy is that a system should be set up that requires firms to internalize all of their costs. One way to do this is to tax producers based on the costs that they externalize. Another option is to regulate the production process to reduce or eliminate the environmental consequences.

363.

Radical If the empirical work that shop floor participation improves productivity is true, one would expect that firms that adopt it would out-compete firms that do not.

One reason why firms may not adopt floor shop participation is that giving workers a larger voice in the work process might undermine employers’ control of the production process and reduce some of the prerogatives of bosses, which the firm may find ideologically unacceptable.

Issues to Ponder 364.

a.

Variable costs would likely include manufacturing labor, materials, and possibly sales costs (to the extent that they are for the sale of additional production). Certain other costs have a variable component to them, but they will unlikely vary directly with production.

jjjjjjjjjjjj.

Fixed costs would likely include factory overhead, operating expenses and profit, research and development, interest, and, to some extent, advertising. In the real world, the division between fixed and variable costs is not as clear-cut as it is in the textbooks. kkkkkkkkkkkk. If output were to rise, average total cost would likely fall because fixed costs are spread over a higher level of production. This is the case for many real-world firms.

365.

The inputs used in studying would certainly be labor, probably energy (i.e., lighting and temperature control), and a place (desk, bed, etc.), which would represent the "plant." Pens or pencils and paper to take notes and a highlighter to mark the text are also likely inputs to be mentioned, as well as study snacks (food for thought?). The shapes of the long-run average total cost curve and the marginal cost curve will depend on whether or not there are economies or diseconomies of scale in studying, and that will be determined by the relationship between how resources are used and the study time.

366.

The marginal costs of an additional car driving on a road would be the added costs of the road's usage. This includes the added wear and tear to the road surface, which is minimal for every car. There could also be a congestion cost, 8

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which at certain times can be substantial. Most likely the marginal cost curve would be a straight line at close to zero with a quickly rising slope as the highway becomes congested. Because of congestion, marginal costs increase as more and more cars use the road.

367.

a.

In the short run, the college is probably right. However, it depends on how short the short run is. To the extent that fewer laborers could be hired to prepare less food and to the extent that the empty dining halls could be used for other purposes, these are variable costs and could be rebated as saved variable costs. In reality, labor contracts are somewhat fixed, and the opportunity cost of college dining halls (or the additional seats available) is minimal. One less meal does not allow fewer laborers or alternative uses of the space because they are indivisible costs.

llllllllllll.

At the planning stage, the argument can be made that they are all variable costs, and that the college could plan for a percentage of off-board students and consequently build fewer dining halls and hire fewer laborers. In fact, some dining halls allow a set number of off-board students and do not charge board. However, colleges must accommodate visitors and all students who would like board and must build a too-large hall. Thus, the variability of demand also plays a role. However, the longer the time period, the higher the relevant marginal cost. mmmmmmmmmmmm. Administration at these schools would probably argue that the $6.00 cost is justified because it is the expectation of occasional guests that led to the building of larger dining halls. Therefore, some of the cost of building the space should be assigned to them. However, if that is correct, it is difficult to see why that higher marginal cost should not be used for determining rebates.

Furthermore, it could be argued that too low a price would lead to too many ―guests,‖ which the dining halls cannot accommodate.

368.

The draftsman was right because marginal cost curves pass through the minimum points of their short-run average cost curves, and short-run average cost curves are not all tangent to the long-run average total cost curve at these minimum points (except at that output where short-run average total cost curve is at the minimum of the long-run average cost curve). Thus, that Viner really wanted many of the marginal cost curves to pass through two different points on a single short-run average cost curve is not possible.

369.

Producing steel in this fashion involves an enormous fixed cost. These fixed costs must be spread out over sufficient production to lower average total costs and make the average total production costs (which includes fixed costs) less than the price.

APPENDIX: ISOCOST/ISOQUANT ANALYSIS 9

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370.

Due to diminishing marginal productivity, the marginal rate of substitution falls as the firm adds more of the variable input.

371.

See the accompanying graph. The dotted line is the original isocost curve. Each of the following is shown with respect to the dotted line.

nnnnnnnnnnnn. This is line A in the graph. oooooooooooo. The isocost curve rotates in along the machinery axis as shown in the graph to line B. pppppppppppp. The isocost curve shifts in along both axes as shown to line C. 372.

As shown in the accompanying graph, land is cheaper in the United States than in Japan and labor is cheaper in Japan than in the United States. This accounts for the differing isocost lines. For each country to produce efficiently, it must equate the marginal rate of substitution to the relative costs of inputs. Then, they will choose different combinations of labor and land.

Japan will choose more labor and less land as shown by point A. The U.S. will choose more land and less labor as shown by point B.

373.

Technical efficiency in production means that as few inputs as possible are used to produce a given output.

On the accompanying graph, this would be anywhere on the isoquant curve, including points A and B. Economic efficiency means using that method that produces a given level of output at the lowest possible cost. Given the cost of inputs, the efficient point to produce that level of output corresponding to the isoquant curve is point B, where the isocost curve lies tangent to the isoquant curve.

374.

See the accompanying graph. The efficient combination of inputs for isocost line A is point A. 10

qqqqqqqqqqqq. T echnological innovation

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that makes land and labor equally more productive will increase the output that corresponds to Isoquant A. rrrrrrrrrrrr. The isocost curve rotates in along the x-axis to Isocost B. The firm cannot produce as much as before. The efficient combination of inputs is now point B on a lower isoquant curve.

375.

If the price of labor falls to $3, the isocost curve shifts out along the labor axis, intersecting at 20 units of labor. Producing 60 earrings with the new labor costs is now inefficient. The firm can now produce more than 60 earrings, shown by point D, which is on a new isoquant curve to the right of the isoquant curve that corresponds to 60 earrings.

376.

A rise in the cost of machines shifts the isocost curve in along the machine axis to intersect at 12 machines. The firm can no longer produce 60 earrings. It must produce fewer at a point such as E.

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CHAPTER 13: PERFECT COMPETITION Questions and Exercises 377.

Buyers and sellers must be price takers because if sellers set prices, they would be able to raise them to make a profit and their demand curve would not be horizontal. In a perfectly competitive market, market supply and demand determine the price; both firms and consumers take the market price as given.

378.

A perfectly competitive market is a market in which economic forces operate unimpeded. For a market to be called perfectly competitive, it must meet some stringent conditions. Some of these conditions include: 379. Both buyers and sellers are price takers.

380. There are no barriers to entry.

381. Firms’ products are identical.

3.

In perfect competition, the invisible hand of the market is assumed to operate unimpeded, so this model provides a useful reference point and can be used as a starting point for looking at real-world markets. Although perfect competition conditions are generally not met, recent technological developments are making the perfectly competitive model more directly relevant to our economy.

4.

If both firms are producing where MR = MC and you could buy either for the same amount, you should buy the one with the highest total profit. In other words, you can't know which firm to buy from the information given. Remember, it is total profit, not profit per unit, that is maximized by a firm. If they are perfectly competitive firms, however, eventually both will earn zero economic profits regardless of which you buy.

5.

Assuming perfect competition, the firm should produce where MR = MC. If the price is $24, then MR is also $24. If MC is three times the quantity, produce 8 units  MR = P = MC = 3 × 8 = 24  .

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6.

Typical marginal cost, marginal revenue, and average total cost curves are shown in the accompanying graph. The profit-maximizing level of output is Q*, where MC = MR. As drawn here the firm is earning profit shown by the shaded rectangle. The firm is not in long-run equilibrium since it is earning a profit. Other answers are possible.

Specifically, the ATC curve could equal the price at the equilibrium quantity and price in which case it is not earning profits, but it is in long-term equilibrium. Another possibility is that the ATC curve is above the price at the equilibrium quantity and price in which case it is incurring a profit loss and not in longterm equilibrium.

7. a. There are two mistakes in this graph: The average total cost curve is mislabeled as the average fixed cost curve. The profit maximizing output level is not where MC = ATC as indicated, but rather where MC = MR. ssssssssssss. The demand curve facing a single firm in a competitive market is perfectly elastic (horizontal) instead of upward sloping. Also, the marginal cost curve is typically upward sloping at the levels of output where the firm would choose to produce. tttttttttttt.

As with (b), the demand curve facing a single firm in a competitive market is horizontal instead of downward sloping. Secondly, the profit maximizing level of output is not where MC = AVC, but where MC = P = MR. Third, the MC curve should go through the minimum point of the ATC curve. It currently doesn’t. uuuuuuuuuuuu. This graph would never represent any real firm since the firm would have shut down if P is below AVC. Output should be zero. Also, the ATC curve cannot be below the AVC curve.

8.

A technological development shifts the MC curve down and to the right for each firm. Since each firm increases quantity produced, the market supply curve shifts to the right. Market price will fall, and output will rise. Profit for each firm will still be zero because the price will decline sufficiently so that each firm earns zero profit. (Remember, perfectly competitive firms earn no profit.)

2

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9.

The typical MC, MR, and ATC curves for a firm in long-run equilibrium are shown in the accompanying graph.

Because the firm is in long-run equilibrium, it does not earn any economic profit. With no economic profit, average total costs equal equilibrium price.

10. a. In perfect competition, the price each firm gets for its product is the market price.

Because the perfect competitor takes the market price as given, its marginal revenue is also the market price. The market equilibrium price, the price that each firm gets for its product, in this case is $8. b. The market equilibrium quantity is 40 units, where MR = MC ($8 = $8).

(Remember that in perfect competition, MR = Market Price.) Since there are 10 firms, each firm produces 1/10 of the quantity, or 4 units. c. Each firm is making a total profit of -$7 (a negative profit is a loss)

 Profit per unit  Quantity = (Market price - Average Total Cost)  Q = $8 -  $39  4   × 4 = -$7.00 d. Firms will begin to exit the market when the price falls below the minimum average total costs, or $9.75  = $39/4  .

11.

Output Q*, shown in the accompanying graph, is the profit-maximizing level of output. The price is P. e. A slightly larger quantity would not be preferred because the marginal cost of the additional output exceeds marginal revenue. Increasing output would lower total profit.

3

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f. A slightly smaller quantity would not be preferred because the marginal revenue of the additional output exceeds marginal cost. Increasing output would raise total profit. g. The shutdown point is at the minimum of the AVC curve (where MC = AVC), at point A in the accompanying graph. h. The fact that the permit would be lost if the firm shuts down shifts the AVC curve down because the permit now must be counted as a marginal benefit of remaining in business. Its value will be lost if the firm shuts down. This lowers the price of the shutdown point.

12.

The sum of all individual firms’ marginal cost curves (above the minimum AVC curve) is the market supply curve.

13.

The typical ATC, AVC, and MC curves are shown in the accompanying graph.

The price at which the firm shuts down temporarily is PA , the minimum of the AVC curve. The price at which the firm exits the market in the long run is higher at PB , the minimum of the ATC curve

14.

The shutdown point is the same as the point at which a firm exits a market in the long run when there are no fixed costs—that is, when AVC is the same as ATC.

15. a. If this is a profit-maximizing firm in short-run equilibrium, its marginal cost equals price, or $2. Since ATC is $5, it is making a loss, at least in the short run. It is unknown if P > AVC, but you do know that P < ATC. So, the firm should shut down in the long run and would shut down in the short run if P < AVC. The best recommendation you can give is to try to lower its costs to minimize losses and perhaps earn no profit (except normal profit). i. If we now know that AVC = $4, we know that price is less than the average variable cost. If AVC cannot be reduced, the firm should stop producing since it loses more by producing than it would if it shuts down.

16.

If this situation refers to the output level at which MR = MC, the price covers the AVC of $4, but only half of the AFC; therefore, in the short run, the farmer should still grow wheat. By producing he will lose $2 per unit, but if he did not 4

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produce, he would lose $4 per unit. In the long run the farmer will go out of business.

17. a. To maximize profits, a competitive firm should produce where MR = MC. This is between 5 and 6. b. The firm is earning losses so the market price will rise in the long run because firms will exit the market, shifting the market supply to the left, which causes market price to rise.

18.

The long-run market supply curve is upward sloping for an increasing cost industry because as output rises, average total costs shift up. Higher marginal costs increase the price at which firms make zero profit and increase the long-run equilibrium price. As output rises, so does equilibrium price. Thus, the long-run supply curve is upward sloping.

19. a. Equilibrium price is where MR = MC, or $70 a pair. At $70 a pair, Zapateria will produce 500 pairs of shoes. b. The total profit that Zapateria will earn is $20 times 500 pairs of shoes, or $10,000. c. Since Zapateria is making an economic profit, it should expect other shoe stores to be enticed to enter the market. d. The long-run equilibrium price is $40 a pair because at $40 a pair price equals average total cost, and all firms earn zero profit.

20. a. In the short run, the demand curve shifts to the left. Equilibrium price and quantity decline as shown in the accompanying graph.

j. In the short run, this firm operates at a loss shown by the shaded region in the accompanying graph, though not below the shutdown point (minimum of the AVC curve). In the long run, price is lower than 5

average variable costs and this firm will go out of business.

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k. In the long run, some firms exit the industry, and the supply curve shifts to the left.

Because it is a constant-cost industry, a sufficient number of firms exit so that price returns to its previous level (so that MR-MC) at an even smaller equilibrium quantity ( Q2 ) as shown in the accompanying graph.

Questions from Alternative Perspectives 6.

Austrian d. The theory of perfect competition does not reflect the real world, at least not to the satisfaction of Austrians. In fact, the theory’s assumptions of product homogeneity and perfect knowledge preclude much of what actual competition in the real world does. Also, innovation, which is a central aspect of real-world competition, is unexplained by this model. e. If the government has any role at all, it might have a role in establishing and protecting property rights and enforcing contracts. f. The danger of government intervention in the market is that it will likely undermine competition. Individuals will have an incentive to lobby the government to establish and enforce rights to their advantage and the government will have the incentive to serve itself and not the market.

7.

Feminist Given the assumptions of the model, if it costs the firm to discriminate in the form of higher wages or lower productivity, it is difficult for discrimination to persist in a perfectly competitive industry because firms that do so will have higher costs and will not be able to offer their goods at the same low price as their competitors (unless all firms are equally discriminatory). However, if all firms discriminate 7

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against African Americans, for example, then the market would not punish those firms that discriminate. That, however, would not be a perfectly competitive industry since characteristics of the buyers and sellers matter, and in perfect competition, they do not. g. In some ways, eliminating discrimination, by reducing costs, will increase economic efficiency because firms that will be better able to assign jobs according to comparative advantage will have a competitive advantage.

8.

Institutionalist As a market structure, perfect competition is only a small percentage (possibly almost zero) of the real-world economy. Most economists believe that the perfectly competitive model serves as a useful reference point to analyze real-world economies, but some see it as making it easy for students to be taught a belief system that free markets are the best of all possible worlds. h. The text spends so much time on perfect competition because the model provides a useful starting point for understanding firm behavior. Students need to be reminded, however, that it is only a starting point and that all the issues that are not brought into the analysis must, at some point, be considered.

9.

Post-Keynesian It is possible that the firm could arrive at that level through trial and error, intuition or luck. Generally, though, unless the firm has complete knowledge of its marginal cost and marginal revenue, it will not produce at the optimum profit-maximizing level of output. i. Firms might follow a strategy based on instrumental or bounded rationality. Once a sustainable outcome is found, even though it might not be the maximum profit outcome, the firm will deem it acceptable.

10.

Radical The Internet has made the economy more competitive in some ways since it has lowered set up and sales more sellers are possible. But the overall marketplace is controlled by large firms, such as Amazon, that take a share of the profits of those firms who sell through Amazon, and who gather information on sales, and decide to enter into the market in those goods themselves when it is beneficial to do so.

This disparate access to information means that the Internet itself is not competitive, but is highly oligopolistic. Because of network effects and the advantages to firms who enter the market first, free entry is far from the reality in Internet sales. j. It would be difficult. The need for agreed-upon rules needed to conduct business requires a level of conscious planning that is difficult to organize in industries with many providers and low marginal costs. This makes marginal cost pricing (the equilibrium of a competitive model) unlikely.

7

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Issues to Ponder 21.

If a perfectly competitive firm is owned by its workers, its output decisions will differ from those of any other perfectly competitive firm because its goal will be to maximize some combination of wages and profit, not profit alone. This will likely cause its decisions to differ from the non-worker-owned firm.

22. a. Reconstituted milk can be shipped from low-cost production areas to high-cost production areas, threatening local dairy monopolies through competition. Local dairies are a strong lobby group that keep this from happening through marketing to consumers and political pressure. l. This probably resulted from strong regional lobbies to protect regional markets from other lower-cost regions. m. He is most likely incorrect economically but correct politically. Price supports cause overproduction of milk, and its elimination would most likely cut production. He made this statement because he wanted to get reelected, and his supporters are dairy farmers who benefit from the price supports.

23. a. Once the new tomato is generally available, it will likely reduce the price of equal-quality tomatoes in the off-season. The new, higher-quality tomato may well sell for more than the bland ones normally bought in winter but will still put downward pressure even on the price of the bland tomatoes. n. Its effects on farmers depend on what the biotechnology firm charges for its seeds. If the prices for the seeds are high enough to extract the benefit of the better tomato, farmers will be no better off. Further, because the demand for tomatoes is fairly inelastic (quantity demanded is relatively unresponsive to changes in price), the increased supply of good tomatoes (reducing their price) in the off-season will reduce revenues of farmers. o. Tomatoes will likely be grown in areas much farther from their point of sale. p. To the degree that the price of tomatoes falls, tomatoes in the winter will more likely be moved from the rear to the front of the salad bar because they won’t be as expensive for the restaurant to supply.

24. a. If the older retail stores had higher costs than the new stores, they would be forced to cut prices below their costs. If that happened, they might stay in business in the short run, assuming they were covering their average variable costs. In the long run, they wouldn’t stay in business.

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q. If the market remains perfectly competitive, equilibrium price will fall.

25. a. Price is at the minimum of the average variable cost curve, as shown in the accompanying graph.

r. Assuming the market is perfectly competitive, when The Children’s Place shops closed, the supply curve shifted to the left. This raised the market equilibrium price to a level at which firms in the market no longer earn losses, but rather earn normal profit (zero economic profit). The market supply and demand curves are in the accompanying graph. Because this is a constant-cost industry, the new equilibrium price equals the equilibrium price before conditions led the firms to exit the market.

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CHAPTER 14: MONOPOLY AND MONOPOLISTIC COMPETITION Questions and Exercises 1. The key difference between a monopolist and a perfect competitor is that a competitive firm is too small to affect market price, so it takes market prices as a given.

Monopoly is a market structure in which there is only one seller in the entire market. It is the polar opposite to perfect competition where there are many sellers. In this market structure the firm faces no competitive pressure from other firms. This means that a monopolist takes into account how its output affects price; its marginal revenue does not equal price. In order for more output to be sold the firm must lower its price unlike the firms in a perfectly competitive market where there are many firms, and each firm takes the price determined in the market.

2.

A monopolist does not take price as given because it faces a downward sloping demand curve. As it increases production, consumers' willingness to pay falls, which means it will receive less per unit for the additional units produced along with all previous units produced.

3.

To sell an additional unit, the monopolist has to reduce the price not just to the marginal buyer, but to all buyers. Because an increase in output lowers the price on all previous units, a monopolist’s marginal revenue is always below its price.

4.

This is what is wrong in the graphs shown: s. The marginal revenue curve is too steep. It should cut the x-axis at Q. In addition, quantity should be determined where MR = MC. t. The curve labeled ATC is really the MC curve. Correctly labeled, the profitmaximizing level of output is determined where MC = MR. u. Quantity should be determined by where MR = MC, not where MC = ATC. Also, the MC curve should intersect the ATC curve at the minimum point of the ATC curve. Lastly, profit is drawn incorrectly. The rectangle cannot extend past the quantity sold.

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v. Quantity should be determined where MR = MC, not where MC=ATC. 5.

A lump-sum tax on a monopolist would change her fixed costs but not the variable costs (or marginal costs). Consequently, the output and pricing decisions would not be affected.

6.

A monopolist will tend to sell at a point on the demand curve where demand is elastic, but as the fish gets older (and smelly) the monopolist will wish to lower its price. The price will not likely be in the inelastic range, but it may if the fish are rotting, and the monopolist needs to sell its entire inventory.

7.

As shown in the accompanying graph, the profit maximizing condition MR = MC holds for both a perfect competitor and a monopolist. The difference is that for a perfect competitor, MR = PC and so the perfect competitor chooses to produce where PC = MC, which determines the profit-maximizing level of output, QC . In the case of a monopolist, MR < P, and so P > MC at the profit-maximizing level of output. The monopolist produces Q M and charges a price of

PM .

8.

This is not necessarily true. Monopolists may or may not make pure economic profit. It depends on average total costs, which may be above the price the monopolist chooses. In long-run equilibrium, perfectly competitive firms break even, which means they make only a normal profit. So, profit is not the distinguishing factor. Instead, the distinguishing characteristic is that the monopolist can restrict output to hold up the market price; a perfect competitor cannot affect the market price.

9.

Given the information in the problem, we can calculate: Q

P

TR

MR

FC

VC

TC

ATC

2 3 4 5 6 7 8

12 11 10 9 8 7 6

24 33 40 45 48 49 48

11 9 7 5 3 1 -1

20 20 20 20 20 20 20

6 9 12 15 18 21 24

26 29 32 35 38 41 44

13.00 9.67 8.00 7.00 6.33 5.86 5.50

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-3 -5 -7 -9

20 20 20 20

27 30 33 36

47 50 53 56

5.22 5.00 4.82 4.67

Price

9 5 45 10 4 40 11 3 33 12 2 24 1. See accompanying graph.

$20

The monopolist would produce where MR1918 17 = MC, between 5 and 6 units of 16 15 output.

14 w. A perfectly competitive firm would produce where P = MC, shown on the graph where the MC curve crosses the market demand curve—at 11 units of output.

13 12 11 10 9 8 7 6 5 ATC 4 MC 3 2 MR 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity

10.

In the accompanying graph, the welfare loss is shown as the shaded triangle. The welfare loss triangle is represented by the horizontal distance between the monopoly output and the perfectly competitive output and the vertical distance above the marginal cost curve and below the demand curve. This welfare cost of a monopoly is one of the reasons economists oppose monopolies.

11.

A perfectly elastic marginal cost curve is shown in the accompanying graph as the horizontal straight line MC 0 . Because the opportunity cost of providing additional units does not increase, welfare loss is greatest with constant marginal costs—shown as the large, shaded triangle. One can see that welfare loss falls with increasing marginal costs by rotating the marginal cost curve up. An example, MC1 , is shown. Welfare loss is bounded by the MC curve, the demand curve, and the Q M quantity line.

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12.

It must be able to (1) identify groups with different elasticities, (2) separate the groups, and (3) limit the ability to resell the good among groups.

13. a. Blocking entry raises fares and reduces the number of flights.

2. Airlines would be willing to spend up to the additional rent they will gain by blocking entry.

14.

In industries with strong economies of scale, efficiency tends to increase as the number of firms decreases. With economies of scale, as each firm increases its output, its costs per unit fall. This means that fewer firms, each producing higher output, can produce more efficiently than more firms each producing lower output. A natural monopoly is an example of an industry in which a single firm can produce at lower costs than can two or more firms.

15.

One cost is the lost profit to Bayer, which will likely lead to lower investment in drug research. If drug makers believe that government will ignore patents on future drugs, thereby lowering future profits, they will spend less on developing new drugs. So, the cost to society of a policy of disregarding a patent is the potential of having fewer drugs to fight disease in the future.

Price

16. a. Since MC is falling and always below ATC, the firm will not cover its costs if price equals marginal cost. In the graph, it would chargeP PC and incur a per unit cost of CC .

The loss shown in the graph is shaded area B. To stay in business, firms must at least cover costs.

M

A

2. It would set quantity where MR = C MC, in the graph Q M , and then C charge a price that consumers areP willing to pay for that quantity- PM .

It would earn a profit shown by the shaded area A.

M

C

AC MC

B

C

Demand

MR QM

QC

Quantity

At a minimum, it must be allowed to charge its average cost. Alternatively, if the government subsidized all fixed costs, it could price at its marginal cost.

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17.

The first mover advantage are the benefits gained from being the first to gain a significant share of a market. It creates a virtuous cycle where, as the size of the network grows, so do its benefits. This provides benefits to monopolists.

18.

The benefits of platform monopolies are that it creates networks that connect people to one another. As the monopoly grows in size, so does the total value and the benefit of the network to each individual user. The cost is the concentration of market power in the hands of a small number of firms and the significant amount of user data harvested by the platform monopolies that can be sold.

19.

Firms can differentiate products through advertising. The overriding objective of product differentiation is to maintain or increase market share by creating a small monopolistic niche which increases demand, making it more inelastic.

20.

Monopolistic competition gets its competitive aspect from having many sellers and making zero economic profit in the long run. Monopolistic competition gets its monopolistic aspect from product differentiation that allows for monopolistic niches within markets. This means that the firm faces a downward-sloping demand curve, allowing the firm to restrict output and increase price in the short run, which also means the firm is charging a higher price than MR.

21. a. Given this table, the monopolistic competitor would produce where MC = MR, which is at about Q = 4. (We are rounding to whole numbers and calculating marginal revenue as the increase in revenue of one unit.)

2. To calculate the firm’s average fixed cost at that level of output, we first need to calculate total fixed costs. Total fixed cost = total cost – total variable cost. First, we calculate total cost. Because in the long run a monopolistic competitor earns no profit at the profit-maximizing level of output, its total cost at that level equals total revenue. Since total revenue = $72  Q  P  4  $18  , total cost = $72.

Given that information we can calculate total variable cost, which since the firm's marginal costs are constant at $6, is $24  Q  MC  4  $6  . Total fixed cost is then $48  $72  $24  . Average fixed costs at an output of 4 units are $12  FC / Q  $48 / 4  .

22.

The monopolistic competitor does not earn economic profits in the long run because of free entry and exit. If there’s profit, a new competitor will enter the market, decreasing the existing firms’ demand.

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23. a. See the accompanying graph. The profit maximizing quantity is 150, the price will be $9. Assuming there are no fixed costs, profit will be $3 per unit or $450.

2. In the long run, with entry, costs would rise (advertising would increase) and the demand curve would shift in until production for each firm asymptotically approached zero.

24. a. This is likely monopolistic competition. There are many firms, and their products are differentiated.

This behavior is a type of advertising that is intended to increase demand and reduce elasticity of demand. This advertising attempts to differentiate one product from the other products for sale. It also provides a barrier to entry for competitors.

Monopolistic competitors earn no profit in the long run. P = ATC as shown in the accompanying graph. x. Their argument is likely that the high cost of shelf space is a barrier to entry for them and is therefore unfair competitive practice. The retailer is using its monopolistic power over shelf space to extract profit from the supplier.

5. An argument from the other side is that firms that produce better products have the profit available to afford to pay the slotting fee and therefore the willingness to pay a high slotting fee is an indication to consumers of a better-quality product.

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25.

As shown in the accompanying graph, the profit maximizing condition MR = MC holds for both a perfect competitor and a monopolistic competitor.

The monopolistic competitor, however, does have some market control and thus, P > MR, and so P > MC at the profit-maximizing level of output.

However, to maintain that market share it must advertise, which raises its ATC until it earns no profit. The monopolistic competitor produces QM and charges a price of PM . At Q M , average total cost is PM , and it earns no profit. The monopolistic competitor faces some competition.

The perfect competitor produces QC and accepts a price of PC . It also makes no profit because there are no barriers to entry and new entrants into the market eliminate any profit.

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Questions from Alternative Perspectives 1.

Austrian 11. An Austrian would say that this suggests that governments should have only a minimal amount of power. Power should reside in the mechanism of the marketplace.

2.

Feminist 12. Men tend to have a monopoly of the best jobs, if by best jobs, one means the highest-paying jobs. The monopoly is protected by limiting entry—the ―old boys’ club‖ for hiring employees. As more women become entrepreneurs and can underprice firms that discriminate against women, the monopoly may erode. Additionally, through the 3rd wave of feminist activism, women are continually advocating for greater opportunities and equal wages in the workplace.

3.

Institutionalist 1. As neither the rules of the game nor the goals of its players have changed, Veblen’s analysis remains pertinent from Rockefeller to Gates. A good class exercise would be to summarize Rockefeller’s techniques, then have students find parallels in the Microsoft trial summarized in the text.

2. The implication is that government has a role to play in enforcing fair business practices.

4.

Radical 1. This is a normative question that has different answers depending on one’s normative views. Radical economists generally believe that the length of patents should be reduced.

2. Arguments can be made to this effect; it depends on the characteristics of each industry.

3. Research in areas where there are no patents could be publicly funded, or funded by non-profit foundations.

5.

Religious 1. This is a debatable question that the courts will have to answer. Currently, they have allowed life forms to be patented.

2. Most religiously oriented economists would argue that life forms should not be patented because life is created by the Divine. No one has the right to usurp that position.

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3. It might undermine some people’s conception of God, but it need not since one still has to deal with the problem of who created life and the existence of matter itself.

6.

Austrian 1. Firms differentiate their products in many ways, for example, through innovative packaging and advertising.

2. There are very few examples of exactly homogenous products. Some vegetables might be homogeneous, but even here differences such as the difference between Vidalia onions and just plain sweet onions exist.

3. It suggests that very few real-world markets are perfectly competitive.

4. It is difficult to say whether this market structure is fair or not; it just ―is.‖ Some may believe that packaging and marketing expenditures do not benefit society, but that is a value judgment upon which people reasonably disagree. Nothing should be done about it because such product differentiation is at the core of competition among firms. It leads to innovative products that will benefit society.

7.

Institutionalist 1. The distinction between real and unreal is one of perception. Perceptions depend upon interpretation of information flows. These flows are engineered to create a perception that a difference is important, thus real.

2. Because perceptions are inherently subjective, there is no objective universal answer to a.

3. To the extent that our preferences are based on advertising and society, there aren’t even objective individual answers to a or b. Economists assume preferences are given, but preferences are social constructs purposefully constructed to advance vested interests.

4. My answer suggests that the benefits of the market may themselves be an illusion and not objective.

Issues to Ponder 1.

The development of such a machine would probably reduce the demand for college education to the extent that it would be a lower-priced substitute. (But remember, gaining knowledge is not the only aspect of college—what about the social experiences, the sports, and so on?) If one college could monopolize the 2

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production of this machine, it could probably charge close to the current price of college and hire professors to do pure research with the proceeds.

2.

Q 0 1 2 3 4 5 6

P 4.20 3.80 3.40 3.00 2.60 2.20 1.90

TR 0.00 3.80 6.80 9.00 10.40 11.00 11.40

MR 3.80 3.00 2.20 1.40 0.60 0.40

TC 3.20 4.20 5.60 7.80 10.40 13.40 16.80

MC

ATC

1.00 1.40 2.20 2.60 3.00 3.40

4.20 2.80 2.60 2.60 2.68 2.80

1. Fixed cost is $3.20 per month per resident.

MC = MR at 3 collections per month. The price charged is $3 per pickup. Profit is $0.40 per pickup per person, or $1.20 per person. y. P = MC at 4 collections per month. The price charged would be $2.60 per pickup.

There would be only normal profits. Economic profit would be zero. z. The city government should prefer competitive bidding unless there is a natural monopoly. The quality of the pickup would be expected to be greater for the competitive industry because monopolists do not face competitors.

3.

Computer printers require, but don’t come with, ink cartridges. If these cartridges are specific to the machine, the company will have a monopoly in them, and can charge a high price relative to the cost. So, what the firm is doing is buying a monopoly in cartridges by giving them away for free. (I recently paid $40 for a color ink cartridge for a printer that initially was given away for free.)

4. a. A possible reason is price discrimination. Individuals in Palo Alto may have a less elastic demand than individuals in Pleasanton if there were different zoning regulations that limited the number of gas stations in Palo Alto compared to Pleasanton. There are other possible reasons that relate to the elasticity of demand, but without more specific information it is difficult to choose one.

2. One possible policy is the following: They might suggest ruling that firms must charge the same price at all stations. The problem with this policy is one of enforcement. It would require enormous amounts of data and a large bureaucracy to enforce, as does any type of price control. Also, gas stations in places with higher real estate prices and wages have higher costs to cover and therefore may need to charge higher prices to remain in business.

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Probably not. What the policy suggested in b would do is to equalize prices, which would tend to help richer communities where gas prices now tend to be higher and hurt poorer communities where gas prices tend now to be lower.

5. a. This is partly an example of price discrimination; the offers are limited to specific groups such as students or educators, who have more elastic demands.

2. If most subscribers get the discount, the reason is less likely to be price discrimination, although the publisher is still price discriminating because people who buy a single issue are still paying $3.95 per magazine. The other reason why Time might offer the magazine at such a low cost is that they have an incentive to have a large subscriber base.

The reason they can afford not to have subscription revenue cover costs is that a magazine gets most of their revenue from advertising. The higher the subscription base, the more advertisers are willing to pay, and the higher the magazine’s advertising revenue.

6. a. Removing copyrights would cause the price of textbooks to fall and output to rise.

2. The argument for copyrights is that without some guarantee of profits from their ideas, people would be unlikely to engage in the effort associated with generating new ideas, products, etc. If that is the case, then copyrights may be justified. If people would write good books anyway, then society would probably be better off without copyrights, because more books would be sold at a lower price.

7.

Colleges price discriminate by charging different prices to different students through financial aid and scholarships. A student whose elasticity is greater-perhaps because she has a better financial aid packed elsewhere--may be able to negotiate a higher financial aid package at another school. Whether this should be lawful is a normative question. To the extent that financial aid allows those with less income to attend college and a social goal is to make higher education available to all, one would support this. To the extent that financial aid raises tuition for everyone else, some may argue that this practice is unfair.

8.

The first thing to note is that publishers have pricing power. Therefore, they are able to price discriminate—charge buyers with different elasticities of demand different prices. The publisher charges a higher price to those who are eagerly awaiting the next book in a series and buy the book upon first release; their demand is less elastic. The publisher prints the book in hardcover to give the customer the feeling that they are buying a higher quality book. Publishers charge a lower price to those who are willing to wait a year (have more elastic demand).

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9.

Whether product differentiation makes us better or worse off is a matter of opinion. To the extent that differences result in no greater pleasure on the part of consumers or limit future innovation, one can argue that funds spent to differentiate make society worse off. There are many other possible arguments.

APPENDIX:

THE ALGEBRA OF COMPETITIVE AND MONOPOLISTIC FIRMS

1. a. For a competitive industry, the profit maximizing output is 8.8 and the price is 41.2.

2. For a monopolist, the profit maximizing output is 7.33 and price is 42.66.

The quantity is lower, and the price is higher for the monopolist.

2. a. Q = 2, P = $39.50 2. ATC = $52 Profit = −$25

3. a. The profit-maximizing level of output does not change as fixed costs change.

2. ATC = $78.

Profit = −$77.

4. a. Q = 6, P = $18 2. Q = 12, P = 0

CHAPTER 15: OLIGOPOLY AND ANTITRUST POLICY Questions and Exercises 5.

In an oligopolistic market, firms make interdependent strategic pricing and output decisions while in monopolistic competition each firm acts independently. This is 5

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because there are only a few firms in an oligopolistic market while there are many firms in a monopolistic competition market.

6.

Strategic decision making is the central characteristic of oligopoly. In monopolistic competition, there are so many firms that the individual firms tend not to explicitly take into account responses of rival firms. Monopolistic competitors face too many competitors to price strategically.

7.

The two extremes of an oligopoly model are the cartel model, which is equivalent to a monopoly with all firms colluding, and the contestable market model, which, if there are no barriers to entry, is equivalent to a competitive industry. In both models, firms react to other firms when setting their prices.

8.

The two extremes of an oligopoly model are the cartel model, which is equivalent to a monopoly, and the contestable market model, which, if there are no barriers to entry, is equivalent to a competitive industry. In both models, the number of firms is small, and firms react to other firms when setting their prices.

9. a. This is an example of colluding, trying to raise price or restrict quantity to increase joint profits. b. If you were the Braniff chief executive officer, you would not have gone along because such an action would be subject to a lawsuit and heavy fines. There are other ways to implicitly collude and arrive at the same solution that would not attract government scrutiny.

Crandell should not have been so direct in his attempt to collude with Braniff. There are a number of ways to collude indirectly.

10.

The breakfast cereal market is oligopolistic because the firms made interdependent strategic pricing decisions.

11. a.

In the toy industry, the four-firm concentration ratio is 35 = (11 + 4 + 5 + 15).

The Herfindahl index is about 452 = 121 + 225 + 25 + 16 + 65. This value assumes there are 69 firms, 65 of which have one percent of the market apiece. In the infant/preschool market the four-firm concentration ratio is 72 = (8 + 27 + 12 +25). The Herfindahl index is about 1,590 = 64 + 144 + 729 + 625 + 28. This value assumes there are 32 firms, 28 of which have one percent of the market apiece.

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3. Mattel would prefer the more broadly defined market (such as the toy industry) because Mattel would have a lower market share after the merger as opposed to a more narrowly-defined market.

The increased market share allows Mattel to limit output and increase prices or create significant barriers to entry by controlling distribution. aa. A combined Mattel and Fisher Price (15 percent market share) might be in a better financial position to compete against Hasbro in the overall toy industry, which already enjoys a 15 percent market share.

12.

A Herfindahl index of 1,200 means that the sum of the squared market shares of all the firms in the industry is 1,200. The related concentration ratios vary widely.

Thus, it is impossible to say which industry is more concentrated.

13. a. This market is most likely characterized by oligopoly or possibly monopolistic competition. I say oligopoly because the largest firm will consider the response of its rivals in its decisions. I say monopolistic competition because there are many firms, and their products are differentiated. There is some label recognition and loyalty.

4. The Herfindahl index is the sum of the squares of each market share: 428.49 + 289 + 44.89 + 4.84 + 4 + 51.4 = 822.62.

The four-firm concentration ratio is 46.6%  20.7  17  6.7  2.2.

14.

As an economist for the firm, you would want the broader definition of the market to make the firm’s share a smaller proportion. Thus, you would argue for the three-digit industry as the definition of the market.

15. a. As Mattel, you would want the regulatory boards to see more competition, so you would argue that the relevant market was all toys including video games, which is as broad as possible. This would make it less likely that the merger would violate the merger guidelines.

5. Since the offer is unsolicited, you would assume that Hasbro does not want to be taken over. Thus, if you were a lawyer for Hasbro, you would argue for the narrowest definition of market (i.e., dolls) so Mattel would appear to have a very large market share.

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16.

Judgment by performance judges the competitiveness of a market by the behavior of firms in that market. Judgment by structure evaluates the competitiveness of a market by looking at the market share of firms in the industry.

17.

A cartel model is more likely to judge an industry based on performance. A cartel is recognizable in that the firms in the cartel act like a single monopolist and restrict output to raise price, and therefore a cartel model is likely to judge an industry based on performance. A contestable market model is more likely to judge by structure, that is, by the number of firms. Under the contestable market model, an oligopoly could perform exactly the same way that a perfectly competitive market does as long as there is no entry or exit barriers.

18.

In the Standard Oil case, the Court determined that the company was a structural monopoly (it controlled 90 percent of its market), but that alone was not a violation of the Sherman Act. Rather, it was the firm’s behavior that brought it into violation. Thus, the firm was found guilty of unfair business practices. In the ALCOA case, the key issue was the determination of the firm’s market, and hence its share of that market. Determining that ALCOA had 90 percent of the aluminum market, the Court declared it a monopoly, and ALCOA was broken up.

Standard Oil was judged by its performance; ALCOA was judged by its structure.

19. a. Regulating the price of a monopolist makes the relevant demand curve perfectly elastic. In this example, regulators set price where MC intersects demand. The demand curve would be the marginal revenue curve, and the monopolist would produce where MC = MR = P, just as a competitor would, as shown in the accompanying graph. In the graph, the regulated monopolist charges PR and produces Q R . The quantity produced is

higher than the monopolist  Q NR  and the price charged is lower than the monopolist  PNR  .

6. Regulation in a contestable market is far less likely to have the effect shown in the diagram because in contestable markets, with fewer barriers to entry, the oligopoly will set prices closer to the competitive price, thus eliminating the need for regulation. There would not be much room for regulation to reduce price and increase output.

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If one follows the cartel view, the argument for regulation is much stronger since the stronger the cartel, the closer it can restrict supply and increase price. As the cartel or cartels become stronger, regulation becomes more effective in reducing price and increasing output, as in the graph above.

20. a. In a monopolistic competition model, the firms have only a small share of the market and make no profit, so antitrust policy would have little effect.

7. In a cartel model, firms get together and allocate market share. Antitrust policy would prevent that, holding prices down and increasing quantity supplied. The effect of price controls or other regulation leads to higher output and lower price.

In a contestable market model, potential competition, not market structure, determines equilibrium, so antitrust would have little effect unless it influenced barriers to entry and exit.

21.

Three reasons fewer antitrust cases have been brought before the courts are (1) antitrust laws are known and prevent monopoly actions from occurring, (2) globalization has changed American ideology, and (3) the rate of technological change has increased, making it difficult for the courts to determine remedies that are relevant to the market.

22.

Platform monopolies complicate antitrust policy for a number of reasons. Two of those reasons are: (1) Since platform monopolies are the result of network externalities, courts are less likely to break up firms since doing so would harm consumers. (2) Technology is changing quickly, which means antitrust policy will have to be considered within a dynamic framework and the remedy be quickly established. Courts typically cannot operate that quickly.

Questions from Alternative Perspectives 1.

Institutionalist They use power any and every way they can, including supporting election campaigns, lobbying efforts, and running public information campaigns. They do it using patent laws and through ―competitive‖—read that as ―predatory‖— pricing strategies. They do it by forcing suppliers to give them scale discounts; they do it by forcing retailers to exclusively carry their product line. Only the imagination is the limit here.

2.

Feminist 5. Tocqueville was describing what feminist economists call the dual sphere notion– the notion popular throughout much of American history that a woman’s place is in the home and a man’s place is in the workplace. The division of labor was 5

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justified because it was assumed that there were inherent differences between men and women. Increasingly, those ―inherent‖ differences between men and women are seen as culturally derived.

6. Feminists believe that dividing the work of women and men in society is not specialization based on comparative advantage, but instead based on sociallydetermined types of appropriate work.

3.

Feminist Women would likely do best in perfect competition because it allows the least scope for discrimination. Because of competitive pressures, businesses will look for the most capable person, rather than choose friends and family. Because the other market structures have profits, those profits allow more leeway for firms to discriminate.

4.

Post-Keynesian The analysis in the text makes it seem as though firms base their production strategies on whatever market structure they happen to be in. In reality, market structures may emerge by the strategic competitive behavior of firms. As firms work through different kinds of strategies of competition, collusion and cooperation, they might be creating their own market structure though not necessarily aware of what they are doing.

5.

Radical 7. They likely occur because they are in the interest of the managers who make the decisions to merge. It is also possible that managers in firms that are close to failing will participate in a merger as a last effort to save part of the business (especially their own job).

8. This is a question that would take much research to answer. Arguments can be made on both sides.

9. Radical economists would, at a minimum, favor stronger antitrust laws and more antitrust enforcement. They would also be likely to call for a total revamping of business structures to focus less on profit and more on achieving social benefits.

This progressive view of antitrust policy would make it difficult to keep up with firms like Google and Facebook that are rapidly evolving in nature and business models.

6

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Issues to Ponder 23.

a.

The perceived demand curve is kinked at an output of 4 and a price of $8.

The elasticity of demand curve above price 8 is less than the demand curve below price 8. In the graph on the right, the marginal revenue curve is discontinuous at an output of 4. There are two places where MC = MR, at quantities 4 and 8, which suggests there are two output equilibria—4 and 8. Since the current price is $8 the current quantity is 4.

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Since MC is flat, (assuming no fixed cost) ATC is also flat at a cost of $4. If the firm lowers its price to $7, increasing output to 8, it will increase its profits. At an output of 8, its profits would be $3 per unit giving us $3  8  $24 . At the original output of 4, its profits would be $4  4  16 . As long as other firms did not follow suit (which is the assumption in the model) doing so would increase its profits.

The assumption is, however, highly unlikely to hold. bb. As long as the assumptions of the model hold, if marginal cost falls, the level of firm’s output will rise. cc. As soon as the issue changes to raising price, the analysis changes since other firms are expected to follow suit. The answer would depend on the elasticity of the original demand curve. A kinked demand curve analysis depends on what the past price was. dd. This part asks students to survey firms in their area about pricing strategies. The kinked demand model presented in the book is more likely.

24.

Since colleges are not profit maximizers, it is difficult to characterize them as a cartel type of oligopoly. There certainly has been collusion, but the goals of that collusion are complicated and not simply with the goal of profit maximization.

25. a. Mattel might want to buy Fisher Price (1) to increase market share to 35 percent and increase its ability to set prices and increase profit, (2) to enjoy economies of scope that would decrease their joint average total costs, and (3) to get a good buy if they believe that Fisher Price is undervalued.

Since entry is relatively easy in this market, judging the market by performance would suggest that the merger would not add to the monopolistic nature of the market. ee. Arguments against allowing such a large concentration would include Mattel's new ability to control the distribution routes of toys in general, thus creating barriers to entry and moving the market to a monopoly position. ff. The four-firm concentration ratio for the entire toy industry would most likely be much lower because markets with broader definitions have lower concentration ratios.

26.

Whether a particular company, even one as important as Standard Oil, was or was not broken up, would probably not have much impact on the economy. However, if the populist forces that led to the breakup of Standard Oil had not existed, our entire industrial structure could have been different. Exactly how different is tough to say: Maybe the United States would have had a Communist revolution; 1

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maybe the firms and the United States would have been stronger. The possibilities are endless.

27. a. The lawsuit probably charged that American Airlines’ move was predatory pricing: pricing in a way to drive American Airlines’ competitors out of business so that the company would enjoy a monopoly position and gain the ability to raise prices.

Knowledge of their financial instability only strengthens the argument. It suggests that American Airlines would not have to hold prices down for too long before its competitors folded.

28. a. Since 1982, the Department of Justice has looked at mergers that would result in a Herfindahl index of over 1,000. There is no Ecofame guideline that exactly corresponds to a Herfindahl index of 1,000 since the Ecofame index places more weight on large market shares than does the Herfindahl index. One might consider a hypothetical industry where the four top firms each have 16 percent of the market and all other firms are very small. Such an industry would have a Herfindahl index of about 1,000 and an Ecofame index of about 16,000. However, for an industry with 10 equally sized firms, the Herfindahl index would be 1,000 while the Ecofame index would be 10,000.

The result of using the cubes instead of the squares is that the effect of large market shares is magnified. Consequently, uneven market shares would be more strongly discouraged. The biggest advantage would be more government pressure to maximize competition. The biggest disadvantage would be that natural monopolies might be unwisely discouraged.

29.

Smith meant that such discussions could lead to collusion, meaning that the firms act in harmony rather than competition. Generally, this results in higher prices for consumers.

CHAPTER 15W: POLITICS AND ECONOMICS: THE CASE OF AGRICULTURAL MARKETS Questions and Exercises 30.

The agriculture market in the United States is an example of a perfectly competitive market in that there are many independent sellers who are generally price takers, there are many buyers, and products are interchangeable. In other ways the agriculture market is far from perfectly competitive because government programs interfere in the market through price support and price stabilization 2

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programs.

31.

The good/bad paradox is the phenomenon of doing poorly because you're doing well. The increase in supply as the result of a good harvest lowers the price and results in less income to the farmers. If demand were perfectly elastic (a horizontal line) the shift in supply would have no effect on price. Thus the more elastic the demand, the less the effect on price and the less likelihood of the paradox. It's important to emphasize that the good/bad paradox refers to the entire market. The worst of all possible cases is where you have a poor year, but other producers have a good year. In this case you receive a low price and have a low output.

32.

The general rule of political economy is that when small groups are helped by a government action and large groups are hurt by that same action, the small group tends to lobby far more effectively than the large group. Because farmers who are helped by agriculture price support and stabilization programs are a relatively small group and consumers who are hurt are a relatively large group, farmers are more effective in lobbying for those government programs.

33. a. The graphs below illustrate the effect of a supply increase in each of the four situations presented in the question. When supply is inelastic and demand is elastic, the increase in supply causes a small change in price and a larger change in quantity.

When supply is elastic and demand is inelastic, there is a larger change in price and a smaller change in quantity.

When both are elastic, there is a small change in price and a larger change in quantity.

When both are inelastic, there is a large change in price and a smaller change in quantity.

3

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8. The effect of a government price guarantee in each case is illustrated in the graphs below. In each graph, 1 is the increase in farmers' revenue, 2 and 3 is the decrease in their revenue, and 3 and 4are the excess burden, the loss to society that results.

4

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9. Farmers prefer the situation with the inelastic demand and elastic supply. In each graph, 1 is the increase in farmer's revenue, 2 and 3 is the decrease in revenue, 3 and 4 are the excess burden, and the loss to society.

34.

A price support system achieved through acreage restriction is illustrated below.

The graph shows that under this system, the farmers gain rectangle A as income from the government in the form of payments not to grow wheat, and rectangle B from consumers who pay more for the wheat the farmers do grow.

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35.

The taxpayers' group would prefer the economic incentives for not producing because it costs less; in the example in the text, buying the surplus means the government pays the farmers $5 a bushel as shown in Figure 8W-(d), rather than $2.20 with the incentives program as shown in Figure 8W-3(b).

36.

As shown in Figure 8W-3(c) in the textbook, the method of price support that is most costly to the taxpayer is the subsidies on sales to keep prices down; taxpayers must finance the subsidy payments on all subsidized farm products.

Consumers get more goods at a lower price. As shown in Figure 8W-3(c), they benefit by area A. Suppliers get a higher price and can supply all they want. They benefit by area B. While consumers and suppliers benefit from the program, 6

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taxpayers foot the entire bill, paying the difference between the $5 and the $1.75 ($3.25) for each bushel sold. The cost to taxpayers is represented by areas A, B, and C. This option costs taxpayers the most of any of the four options.

37.

As shown in Figure 8W-3(a) in the textbook, the method of price support that is least costly to the taxpayer is regulatory measures, which have no direct cost to taxpayers other than the cost of enforcing and administering the regulations.

38.

Tariffs and quotas generally accompany price support systems in order to discourage lower priced foreign produce from competing in the domestic market.

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39.

The elasticity of supply affects the cost of price supports in the four options illustrated in Figure 8W-3. When the supply is elastic, a small change in price causes a large change in quantity, and the cost to the group that is hurt is larger.

40.

Grandfathering is an attractive option because by forbidding new farmers to enter the market, it is an easily enforceable way to limit the quantity supplied when implementing a price support system.

41.

False. This is too broad a statement to be true. All government regulation has benefits and costs, and in some cases one can assess the net impact. It seems highly unlikely that all government intervention would make society worse off.

Whether society is worse off must be based on judgments about historical experience, not on theory.

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42.

In non-recourse loan programs the government ―buys‖ goods in the form of collateral on defaulting loans. It is an example of buying up and storing, giving away, or destroying enough so that the total demand increases enough to eliminate downward pressure on price. In the land bank program, government gives farmers economic incentives to reduce supply.

43. a. Mr. A would be willing to spend up to $100,000 to stop passage of the law.

10. Mr. B would be willing to spend up to $100,000 to get the law passed.

11. The implications for social policy is that individuals are willing to spend lots of money to pass laws that benefit them as individuals. A reduction in such rent seeking would benefit society if the ability of individuals to affect laws is curtailed.

Questions from Alternative Perspectives 6.

Austrian 10. American agricultural policy keeps poor nations poor because U.S. agricultural subsidies allow U.S. companies to sell farm goods for a lower price. That makes it difficult for farmers in poor countries to compete, and thus they don’t develop and expand.

11. Foreign countries will have a hard time convincing the United States to abandon its agricultural subsidies. They have argued that the subsidies give an unfair advantage to U.S. producers and should not be acceptable under WTO regulations. Trade negotiations to reduce tariffs in the Doha Round of trade negotiations failed in large part because the United States and Europe were unwilling to accept this argument and lower their farm subsidies.

7.

Religious This is a moral question, but the shared DNA can be used as an argument that we have a moral responsibility not to kill, or at least treat organisms with which we share a common ancestry humanely.

8.

Post-Keynesian 12. The reason for this change is a change in the composition of food products consumed from direct farm goods to prepared foods provided for convenience.

Agriculture has become much more productive, which lowers the price consumers pay for agricultural products. Since food has an inelastic demand, the percentage of one’s income spent on food has decreased. This has given individuals much 9

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more money to spend, which they have spent on convenience. Instead of buying grain from a farmer, they buy baked goods, prepackaged and precooked meals and can even have the food delivered to their homes using an app on their smartphone. Thus, the percentage of money spent on direct agricultural products has decreased since much of what is thought of as ―food‖ is more than just ―food,‖ it is the processing, distribution and preparation of that food.

13. It suggests that farmers, if they want to stay in business, need to take greater control of the supply chain, and not only produce food, but also build in the processing, distribution, preparation, and marketing of that food.

9.

Feminist 14. This is an example of the cultural bias in favor of males that has long existed in our society.

2. The practice is symptomatic of the second class treatment that daughters often get in families. For example, it used to be that only sons were sent to college. Today that unfairness is decreasing in the United States but there are still significant vestiges of it remaining in our society. In developing countries gender unfairness is much stronger.

3. A likely reason is that they are the ones that are doing the work. In order to survive small farms need to do much more than farm; they need to become involved in the upper level value chain. Women have often led the way in the evolution of small farming, and as they lead the way, they have become more likely to own the farm.

10.

Radical 4. Agribusiness has definitely hurt small farmers and farm communities. It has made it impossible for them to stay in business unless they significantly were able to change their business model.

5. Agribusiness has hurt small farmers in a number of ways. First, it has hurt them by undercutting their prices, making it impossible to compete on price. But agribusiness has also taken over large aspects of the supply chain, thereby making it harder for small farms to adjust to the new market realities where much of the profit is made by the processor and marketer, rather than the producer, of food.

6. Small farmers are more likely to invest their profits into organic and specialty food production and distribution, whereas agribusiness is more likely to invest in food processing and growing techniques that rely on fertilizer and chemicals.

Issues to Ponder 10

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44.

In the first panel below, an increase in demand sufficient to raise the market price to Ps is shown. The market quantity is also increased to Qs. The cost to the government is the bolded rectangle, the price difference (Ps − Pe) times the quantity difference (Qs − Qe). If instead supply is restricted, the government must pay the farmers (Ps − P1) for every unit not grown at price Ps, resulting in a cost equal to the area of the bolded rectangle in the second panel. Therefore, the first policy would be recommended as it achieves the same result at a much lower cost to the government.

S1

S

S

Price

Price

S1

Ps Pe D1

Ps Pe P1

D Qe Qs

(a)

(b)

Quantity

Q1 Qe Quantity

The Federal government subsidizes corn sales thereby lowering the price of corn, which lowers the price of corn syrup, a major ingredient in sweetened products such as soft-drinks. Cheaper corn syrup prices lead to lower soft-drink prices and higher quantity demanded. Americans, therefore, consume more sweetened products that they would otherwise, which contributes to obesity.

Price

45.

D

S

Ps

B

Pe

D E D

0

Qs

Qe

Quantity

46. a. Consumers of peanuts pay more in higher prices-estimated between $190 and $369 million a year-and suffer from reduced consumption.

12. See the graph on the right. Area B represents additional costs to consumers while 11

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areas D and E represent deadweight loss of the program.

13. The land with peanut quotas is a government license to sell millions of pounds of peanuts and thus is priced higher to include the present value of the future returns to that license.

14. The governmental costs would likely rise enormously in its attempt to keep supply constrained to maintain the 50% above competitive equilibrium price.

15. If the U.S. limited the guaranteed high price only to U.S. producers, administrative procedures would have to be set up to see that imported peanuts are not passed off as U.S. produced peanuts.

47. a. The reasons the difference exists are mostly political. A small group of ranchers benefit greatly from the reduced fee and are a strong lobby for the cause.

16. The advantage could be that the U.S. government could require more from ranchers in their care of the land.

17. One would expect excess demand because at the price below equilibrium, the quantity of land owners are willing to supply at $1.85 is lower than the quantity demanded.

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48. a. If sugar prices fall below 23 cents a pound, a sugar producer would default on the loan so that the government purchased sufficient sugar to keep the price of sugar at 23 cents a pound. This is shown in the accompanying graph. The supply of sugar shifts from S0 to S1 raising the price to 23 cents a pound. Consumers buy Q 0 and the government essentially buys Q0  Q1 at a total cost represented by area A. 18. The government can give the corn away, burn the surplus or store it indefinitely.

19. The sugar lobby would spend more to keep the price subsidies.

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20. Consumer lobby groups would fight against the price support program.

CHAPTER 16: REAL-WORLD COMPETITION AND TECHNOLOGY Questions and Exercises 26.

False. While profits are important to businesses, because of internal monitoring problems, managers do not necessarily maximize profit. They may waste profit potential on high-priced benefits for themselves and in general inefficiency. The market, however, provides a limit on inefficiency, and firms that exceed the limit and have losses go out of business.

27.

The monitoring problem is that employees face different incentives than owners face, and therefore may act in their own interests to the detriment of the firm.

Monitoring is required because employees’ incentives differ from the owner’s incentives, and it’s costly to see that the employee does the owner’s bidding.

Incentive-compatible contracts make the incentives that employees face correspond as closely as possible to those of the owners.

28.

X-inefficiency results when firms do not operate at their maximum potential technical efficiency. The economic forces of a market would knock a perfectly competitive firm out of business if it operated less efficiently than the rest of the market. Only a monopolist can produce inefficiently and remain in the game.

29.

Firms that are X-inefficient and remain in business have to have monopoly power.

They make less profits than a firm that isn't X-inefficient because the inefficiency raises their costs. Competition generally pushes prices down and puts downward pressure on profits. If firms respond by trying to cut costs, then competition will have the effect of reducing (if not eliminating) X-inefficiency. If, however, entry of new firms is impeded, as it is in the real world, all existing firms could remain inefficient forever.

30.

True. If it were easier for consumers to collude than for producers to collude, the result would be lower prices. If prices fell below the equilibrium level, this could result in shortages because suppliers would be reluctant to provide their goods at a low price. The final collusive equilibrium would depend on the rationing mechanism for the goods firms are willing to supply.

1

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31.

If suppliers were able to restrict their output to Qr , price would rise to Pr .

Suppliers kept out of the market lose areas E in producer surplus. The consumers, on the other hand, lose both areas B and D. Area B is transferred to suppliers as additional revenue. D and E are deadweight loss.

32.

The monopolist would be willing to spend any of its profit to protect its monopoly. This is depicted as the shaded rectangle in the accompanying graph.

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33.

Economic theory tells us that many issues depend on specific information about alternatives and that there is often no clear-cut policy that follows, without lots of specific knowledge about particulars. So strong statements about theory saying we should or should not follow a policy are generally best avoided.

34.

False. Neither patents nor monopolies are necessarily bad. Patents encourage the research and development of new products by offering some limited monopoly profits. Without patents, many new products might not be developed. Patents are one way to incentivize research and development, not the only way

35.

The competitive process might lead to an inefficient outcome because of the first mover's advantage. This advantage is where the standard used by the first firm to obtain a significant share of the market becomes the industry's standard even if that standard is not the most efficient as technology changes. The QWERTY keyboard is often given as an example of an inefficiency standard that is a left over from standards needed for manual typewriters. But even when typewriters and computer keyboards improved the QWERTY keyboard set up was so common that it is hard for keyboard designers to move away from using it.

36.

Network externalities lower costs as more people use a product. As network externalities broaden the use of a product, the need for a single standard becomes more important. Eventually, one standard wins out. The firm with the standard is the big winner and will dominate the market. Once a technology is adopted as the standard, even superior technology will have a hard time competing with the standard.

37.

False. Success depends on much more than technical ability. Luck, legal fights, marketing ability, and a non-collusive industrial environment all play a role in making a firm successful.

Questions from Alternative Perspectives Austrian k. For Austrian economists, the behavior and incentive-problems faced by managers and politicians are similar. They both reflect monitoring problems. Managers have more information than shareholders, and politicians have more information than citizens. Managers and politicians could take advantage of this asymmetric information to fulfill their goals instead of the goals of their constituents. l. A key difference between managers and politicians is that it is much more difficult to vote out a politician than it is to fire a manager.

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m. This difference suggests that politicians are more valuable to society because we are willing to let them extract more personal benefits from their positions.

38.

Religious Heads of religious organizations tend to receive less than CEOs in profit-making institutions. n. There are many possible explanations. One is that money is less important to heads of religious organizations. Another is that they are less productive. It's also possible that there is a greater supply of knowledgeable religious leaders, while it is much harder to find an excellent CEO. o. This is a normative question, but most religious economists would accept some difference. Although, from their normative view, they see the compensation of some CEOs as too high.

39.

Feminist 13. As of 2020 none of the top 10 paid CEOs were women (In fact, you have to go all the way to the 39th top paid CEO to find the first woman). There are many reasons for this. One might be discrimination against women as executives – the ―glass ceiling.‖ Another may be that at the time that men are building their careers, women are having children and that women tend to be left with a greater proportion of the household responsibilities. Some may argue that another reason is that women have broader goals, such as caring for their employees by providing more generous benefit packages that may conflict with the goal of earning the highest salary.

40.

Institutionalist 14. If the rate at which a renewable resource is extracted is determined by financial markets, then at, say, a 10 percent rate of return, only biological resources growing faster than 10 percent can be retained. Financial optimality requires all others with a financial value (a positive price) to be harvested to extinction. This is the logic of the free market when applied to natural resources. This suggests that free markets often pursue unsustainable strategies in the search of the highest possible profits.

41.

Post-Keynesian In a world where consumers and firms face uncertainty and incomplete information, ―rules of thumb‖ make a lot of sense and allow one to make decisions in a complex world. p. Using rules of thumb in the face of uncertainty allows the firm to come up with a satisfactory, although perhaps not the optimal, outcome. For example, by 2

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following rules of thumb that represent the behavior of the majority, though not optimizing for the firm, the rule provides less uncertainty about the future. q. One implication is that when reality is too complex, individuals and firms rely on the opinions of others. This creates social norms and conventions accepted by the majority such as financial ratios where outcome is not based on individual optimizing but group behavior and making economic decisions based on conventions.

42.

Radical If a group can control the marketplace of ideas, they can control what people believe and what government does. Having such control is powerful, and in our economy, we have institutions, such as a free press, and a university system, which are designed to prevent, or at least minimize, such control. Whether they work is debatable. r. This is a difficult question that has no one answer. Most economists would support maintaining constant vigilance and protecting the free marketplace of ideas. That is why this book includes an alternative perspectives section.

Issues to Ponder 49. a. Here are four reasons: (1) Frequent visitor programs are promotional tools that stimulate consumer excitement for the product by appearing to give out free merchandise. (2) They are a way to create a third-party payer system whereby the individuals making the decision which airline to fly or which hotel to stay at are not the ones who endure the direct cost of the purchase. (3) It encourages brand loyalty. (4) People often do not cash in on their earned rewards.

21. Another example of such a program is a credit card that provides rebates for high use. A person who uses the credit card for business will enjoy the benefits of the program, but the firm pays for it.

22. Although this does represent a cost to the firm, the cost of monitoring these programs probably exceeds the benefits of eliminating their misuse. The cost of monitoring may include disgruntled employees who lose the benefits. (Note: large companies have begun negotiating with airlines for cheaper fares but no mileage benefits on business flights.)

23. Whether the benefits should be taxed is a normative question. Here's one opinion: Since these benefits are income to the individual, they should be taxed as such.

However, the cost of measuring this income and enforcing the taxes makes it too costly to implement relative to additional revenues.

3

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Economists recognize that there is a monitoring problem: employees' incentives differ from the owner's incentives and it's costly to see that the employee does the owner's bidding. When appropriate monitoring doesn't take place, high-level managers can pay themselves very well. To get a sense of whether they are really "worth it" one could compare the salaries to those earned where closer monitoring does take place. (The text suggests comparing U.S. salaries to those earned in similar industries in Japan).

43.

False. Even if existing colleges are inefficient, competition from for-profit colleges would not necessarily force them out of business. Political and social forces can keep such colleges from developing. Moreover, some colleges receive state assistance or have endowments that allow them to hold their costs down even if they are inefficient.

44. a. This technology would likely decrease, but not eliminate, the importance of art museums that exist to show ―originals.‖ 24. It would reduce the rents to the museums and museum curators that exist to show current art. Also, there is large social resistance to types of innovation that would make museums irrelevant.

25. These are allowed but are owned by either the symphony or music label that sells them. Listeners are almost always barred from recording concerts.

26. It would likely increase the demand for live performances because there would be no alternative ways to listen to the music.

27. The most likely explanation is historical circumstance.

45. a. The answers will vary based on the drug.

28. The answers will vary depending on the drug.

29. The online price will likely be lower. Purchasers don’t buy drugs online because the potential dangers of poorly produced drugs significantly reduces the high level of trust needed between vendor and purchaser for drugs. Convenience and tradition also play a role.

30. The answer will vary. Some people are distrustful of online purchases.

31. The drug market is less-than-perfectly competitive.

4

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46. a. I would expect fluoxetine to sell for about $10 to $15 dollars per hundred if it were a reasonably competitive market.

32. I would conclude that the market must not be competitive in the standard way that economists talk about competition.

33. This suggests that the imperfections result from imperfect information on the demand side, rather than the supply side. Most people could get their drugs from pharmnet.com, but instead choose not to. Because many drugs have third party payers, the customer is not always concerned with finding the lowest price drug but is rather concerned with convenience and the trustworthiness of the supplier.

47.

Firms are interested in more than just short-term profit; they also look to longterm profit. The company believes that establishing a market position in the short run will increase long-run profits.

48. a. These differences do not undermine economists' analysis of pricing, although they do not directly fit into it. The high prices of these goods are based on social preferences (i.e., status/conspicuous consumption) as well as the differences in advertising brand names. Basic pricing models do not take these distinctions into account.

34. These are all examples of high fixed costs and low variable costs.

35. What is being sold is more than the good; the image is part of the product and much of the cost is in the production of that image. This suggests that the cost of producing is lower than the cost of selling.

36. Each of these markets would be characterized as a luxury market as opposed to a necessities market where economists' pricing analysis holds better. In luxury markets, buyers can afford to be irrational (or whimsically rational) and be led to believe that the products do in fact differ. These are all monopolistically competitive markets, with many sellers selling differentiated products.

49. a. Pepsi is essentially buying a monopoly on the campus.

37. There would be more competition and lower prices for soda.

38. It depends. It is a transfer of consumer surplus from students to the college; whether it is a gain to students depends on what the college does with the money that it receives. If colleges didn’t get money from Pepsi, they might simply charge a higher fee to students. Assuming that there would be more competition, and lower prices, students who drink Pepsi will be hurt relative to those who do not.

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50.

In the short run, while they had a patent, Monsanto likely employed a monopolistic strategy. In doing so they restricted supply and were able to make a profit. In the long run, Monsanto will be most concerned with developing such strong brand name recognition that few competitors will challenge their position despite the patent expiration. The large number of commercials for Roundup in the past few years is evidence of such a strategy.

51. a. An advantage of a prize is that it does not limit future use of the idea, and thus will provide more efficiency.

39. The disadvantage is that in order for a prize to promise the same level of economic reward as a patent, the prize will have to be significant. It would have to be funded by taxes, which would have negative incentive effects on the part of workers if the tax were an income tax. Also, directing prizes at specific invention goals may discourage the development of technologies whose discovery has not yet been foreseen; many of the most important technologies today have been invented in that way.

CHAPTER 17: WORK AND THE LABOR MARKET Questions and Exercises 1.

Social and political forces are more active in the labor market than in most other markets because of the key role labor markets play in determining people's income and the central role jobs play in a person's life. People often define themselves in terms of their jobs.

2.

Increases in marginal tax rates for large changes in income were significantly higher in the 1970s than in the early 2000s. Therefore, in the early 2000s, families could take home a larger percentage of their increase in wages than in the 1970s.

The negative incentive effect of income taxes was particularly high in 1970s.

France has very high tax rates. In fact, Edward Prescott estimates that for every 100 euros worth of goods produced, Europeans as a whole are taxed 60 euros.

3.

What people have to offer are their skills and hours. So, the choice to work is a choice about how to spend one’s hours, that is, the choice between market and nonmarket activities. The opportunity cost of devoting one hour to market activities to earn wages is one hour devoted to nonmarket activities.

4.

An increase in the wage rate increases the opportunity cost of nonmarket activities. As the cost of the activities goes up, people will buy less of them, 6

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meaning that they will work more. Using the economic decision rule, if the person was at a point where MB = MC, an increase in the marginal benefit of working (and increase in wage) would mean MB > MC; to bring MB and MC into equilibrium, the workers would increase number of hours worked.

5.

An increase in the marginal income tax rate reduces the after-tax wage rate.

Because of the incentive effect, the number of hours a worker is willing to work at every pre-tax wage will fall. That is, the after-tax supply for labor shifts to the left.

6.

Because benefits received from programs such as welfare depend on income, the opportunity cost of not working rises with such programs. That is, the marginal benefit of not working rises giving people an incentive to choose to work fewer hours or not work at all.

7.

The elasticity of the labor supply is measured by the percent change in the quantity supplied divided by the percent change in the wage (5 ∕ 20 = 0.25). In this case, supply is inelastic because it is less than 1.

8.

Four factors that contribute to the elasticity of labor demand include: (1) The elasticity of demand for the firm’s good.

(2) The relative importance of the labor in the production process.

(3) The possibility, and cost, of substitution in production.

(4) The degree to which marginal productivity falls with an increase in labor.

9.

Four shift factors of demand and their effect on demand include: (1) The cost of competing factors of production. A rise in the cost of competing factors shifts demand for labor to the right.

(2) The development of new technology. The effect is ambiguous. If other things remained equal, the demand for workers who do not know the technology would shift to the left. Other things are often not equal. To the extent that the new technology requires building new machinery or leads to great consumer demand, labor demand might increase.

(3) Market structure. The more the market is monopolistic, the lower the demand for labor.

(4) Shifts in demand for the good. An increase in the demand for the good shifts the demand for labor to the right.

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10. a. Assuming that both markets are perfectly competitive (and we know how competitive campaigns are), we can say that, at the margin, some top-performing baseball players are paid more than the president, they must contribute more to society. gg. First of all, neither market is perfectly competitive. Neither top baseball players nor the U.S. presidents are easily replaceable. In addition, institutional factors enter into the decision about what to pay. Being a U.S. president is considered to be a service to one’s country and presidents get many nonwage perks, such as Air Force One and the White House. And after leaving office, past presidents can sell their biographies for many millions of dollars. The adjustments suggest that calculating marginal productivity is difficult and perhaps ultimately impossible, and that the results of the model do not carry over well to the real world.

11. a. It would be expected that economists' salaries will decline or at least to rise less than average salaries.

Since economists are bright, dynamic individuals, it is likely that they will leave the traditional market for economists and either start their own business or accept jobs in other markets or in other countries. This would mitigate the decline in their wages. hh. In most markets, prices do not adjust downward quickly for institutional reasons.

In the meantime, the supply curve may shift inward as unemployed economists leave the market altogether. Currently employed economists have an incentive to see that their salaries do not fall and will work toward keeping their salaries high by limiting the number of new Ph.D.'s or by using social influences to keep their wages from falling.

12.

As you can see in the accompanying graph, the minimum wage causes excess supply of workers (shown by the difference between the quantity supplied and the quantity demanded).

Economic theory does not tell us that such a law would be a bad idea. That depends on what one's goals are and how one judges the re-distributional consequences of the minimum wage.

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13.

As argued by University of Chicago economist, Sherwin Rosen, assuming that individuals want to see the best performers, the new technology would give a greater premium for the best performers of each genre, and thus would increase income inequality. A few top performers will earn much more than before, while most performers will be out of a job completely.

14.

It is unclear what the effect on demand will be. To the extent that it reduces the cost of hiring workers, companies may be willing to take on more projects, which increases demand. To the extent that it widens the geographic area of potential workers, it will reduce demand for some workers who face great competition by more qualified workers. The effect on wages is unclear. To the extent that it increases the demand for labor, wages will rise. To the extent that the supply of labor increases, wages will decline.

15.

To the extent that the hospital is a monopsonist (nurses living in Oberlin are unwilling to work at neighboring hospitals and do not want to work in nonhospital nursing jobs), the hospital takes into account that hiring an additional worker will raise market wages. Thus, it will likely hire fewer nurses and pay them less. This is shown in the graph below. The monopsonist hires Q M workers pays WM . If it were a perfect competitor, it would hire WC and page wages of WC .

16. a. No. If Walmart’s suppliers were operating in a perfectly competitive market, the price at which they sell their product is set by the market. No one firm sets the price.

Yes, if the market were monopsonistic, the purchaser (in this case Walmart) would be able to set the price at which it buys goods.

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ii. The limit on the price Walmart could name is equal to the lowest price a firm would be willing to supply the good at the quantity Walmart is willing to purchase. In the long run, firms will not be willing to sell their goods at a price that is lower than the marginal cost of producing the good.

17.

A minimum wage in a monopsonistic labor market can simultaneously raise wages and employment. In this market, the pay is less than the competitive wage, the minimum wage could change the effective supply facing the monopsonist and could raise the wage and increase employment simultaneously, as in the accompanying graph. In the graph, the monopsonist would hire Q m workers, paying Wm . With a minimum wage Wf , higher than Wm , the monopsonist would hire Q f workers, higher than Q m , and pay them Wf , a wage higher than Wm .

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18. a. Firms pay "above market wages" because they want to establish close personal ties with their workers. Doing so can lead employees to work at maximum efficiency, and the gain in efficiency may exceed the additional cost. If so, it is known as an ―efficiency wage.‖ This is an example of social forces modifying the invisible hand result.

Firms do not change wage rates much when unemployment rises, both to keep good social relations with workers, and also, in some instances, to avoid violating contracts that determine wages. This is an example of social and political/legal forces modifying the invisible hand result. jj. Colleges keep wages of various disciplines roughly equal to keep good social relations with the workers. Pay will vary somewhat because of market conditions in the disciplines, but generally social issues predominate. So, again this is an example of social forces modifying the invisible hand result.

19. a. Firms hire children because children’s marginal productivity relative to their wage is higher than it is for alternative workers.

For the same reasons that others work—they and their families need money and work is what is expected of them. kk. In deciding whether there should be an international ban on child labor, from the standard economic standpoint, one must look at the effects of that ban. If the ban will lead to children starving, the ban does them no good; if it allows them to go to school while the firm hires their parents instead, the ban may help the children.

20. a. Three types of demand discrimination include: (1) Discrimination based on individual characteristics that affect job performance.

(2) Discrimination based on correctly perceived statistical characteristics of the group.

(3) Discrimination based on individual characteristics that don’t affect job performance or are incorrectly perceived.

Discrimination based on individual characteristics that affect job performance is most difficult to eliminate because this kind of discrimination lowers cost of production and makes a firm more competitive. ll. Discrimination based on individual characteristics that don’t affect job performance or are incorrectly perceived is the easiest to eliminate because this kind of discrimination has no economic motivation. Limiting the pool of potential workers will raise costs to the firm, making it less competitive.

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21.

Demand side discrimination is likely easier to address to the extent that firm behavior is easier to monitor. Social mores and behavior—such as the family’s choice of where to move based on a spouse’s job—are difficult to monitor and control. In addition, socially, people tend to see individual’s right to choose to be more protected than a firm’s right to choose, and therefore are more likely to favor laws regulating businesses than those regulating individuals.

22.

According to studies, tall men (up to a point) are perceived to be more handsome than short men. They are also perceived as being more powerful. To the extent that tall CEOs can negotiate better contracts and are better able to motivate workers, height will affect a firm’s performance. If this is true, a firm that does not take this into account in its hiring decisions will not be able to compete as well against firms who do.

23. a. The likely impact is that there are fewer women in high-level management positions since these are often highly competitive.

Whether this is discrimination is debatable. The impact certainly leads to differences in employment. If women are socialized to prefer less competition, then I would characterize it as institutional discrimination based on social mores. If women are genetically predisposed to less competition, you would be less likely to characterize it as discrimination because it isn’t the result of human institutions. If management jobs could be developed to be less competitive, and they currently aren’t structured that way, then you would characterize it as institutional discrimination based on the structure of the job.

24.

Comparable worth laws would likely politicize the labor market much more than it is currently politicized. It would involve an enormous increase in government involvement and regulation of pay.

25. a. Based on standard economic theory, one would expect the number of teens employed to rise and the employment of non-teens to decline as the relative wage of teens declines. This assumes that the minimum wage is above the marketclearing wage. Further, one would expect that a large number of employees would lose their jobs at the end of their training period (six months) for ―just‖ reasons, such as not learning the job adequately.

It is likely that the administrative costs of participating in the program were higher than the benefits of hiring teens at the lower training wage. Also, social forces would have kept many firms from firing older workers to replace them with cheaper teen labor. It could also be that market clearing wage in teen labor market was already higher than the subminimum wage. A third possibility is the focal 2

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point phenomenon: teens may focus on the mandated minimum wage as their reservation wage and refuse to accept a job at the subminimum training wage.

26.

To the extent that more women than men take time off because of the FMLA (for childbirth), female employees will cost firms more, which decreases the demand for female employees.

Questions from Alternative Perspectives 52.

Austrian Once the ability to compete by a willingness to work for less is removed (a seller is forbidden to sell a good for a lower price), rationing moves to a non-monetary realm. This reduces the cost of exhibiting prejudice since all workers at the minimum wage level will be priced the same.

53.

Religious s. Most Christians would see moral problems with discrimination, but as economists, there is a need to see the pressures toward discrimination to carefully consider the ramifications of any law. t. Christian economists are committed to a Christian ethical position that requires them to take ethical views into account. Other economists may be so committed, but do not need to be.

54.

Feminist This statement reflects the fact that society has increasingly accepted women in the paid labor market, but still holds on to the notion that they are also ultimately responsible for work within the home as well. This is what Arlie Hochschild and Anne Machung have referred to as the ―second shift.‖ It results in increased stress on married couples as these duties are negotiated and may affect employers’ views about women as employees. u. If women who are relatively more capable than men in market jobs are not working in market jobs, there will likely be less output than there otherwise would be.

55.

Institutionalist People work for far more than pay. They work for job satisfaction and being an economist might provide more job satisfaction than being in business.

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56.

Radical Radical economists emphasize non-market forces much more than do mainstream economists. v. This is a judgment question and judgments differ. Radical economists believe that they are unfair. w. This is a judgment question and judgments differ. Radical economists believe they do.

57.

Institutionalist It is assumed that the shareholders will hold down the pay of managers since they are just workers. But in recent years, they have not been especially effective in achieving that end. There seems to be a monitoring problem in which the boards of directors are largely chosen by management, and do not provide an effective monitor of managers’ salaries.

Issues to Ponder This chapter opens with a quotation from Voltaire: ―Work banishes those three great evils: boredom, vice, and poverty.‖ Welfare laws, to the degree that they discourage work, can be said to harm the people they are meant to help. While they help people in the short run, they establish a dependency relationship, which can hurt people in the long run.

58.

As noted in the text, the choice for many people depends on their views of the real costs of being arrested, etc. The student is asked to assess whether the benefit of the large amount of compensation is worth the cost of the risk.

59. a. Since they will have to pay 20 percent of what they save in added tuition in addition to the 20 percent income tax rate, the implicit marginal tax rate they face on income they save will be 36 percent. The tax on assets is a tax on savings after income taxes have been subtracted, so the tuition tax has to be adjusted to make it a tax on pre-income-tax income. So, the relevant tax on tuition as a percent of pretax income is 1 - t i  × t t = 1 - 0.2  × 0.2 = 0.16  where t i is income tax and

t t is the tuition tax. Add this to the 20 percent income tax to get 36 percent.

The second child will raise it to 48.8% = 1 - 0.36   0.2  0.36  100 . The third child will raise it to 59.04%  1 - 0.488   0.2  0.488   100 . mm.

This is a complicated question, but one could argue that divorced parents share in the obligation to pay for college equally and therefore the relative incomes and asset shares of combined incomes and assets should be used to 4

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determine contributions. In reality, one parent might alone bear the burden of the cost, having to shoulder contributions by both. The second part to this question is for the student to research. nn. An ability-based scholarship program would attract students of significantly higher caliber if their elasticity of demand were high, but it would most likely compromise the diversity of the student body with respect to income. It would also promote retaliation by other schools, and the long-run benefit of having brighter students might be very small.

60. a. No, one would expect that drivers would work more on busy days when their effective wage rate is higher, and less on slow days, because their marginal return is higher on busy days.

It can do so because failing to achieve the daily income target feels like incurring a loss, so drivers put in longer hours to avoid it. Beating their target feels like a win, so once they have achieved it, there is less incentive to keep working.

61. a. I would expect the program raised test scores.

The program would have to assign the students either zeros or failing grades.

Otherwise, the teachers would have an incentive to have only good students take the test. oo. It would make them much more likely to teach to the test and conduct more test preparation sessions.

62.

Supply/demand analysis is partial equilibrium analysis. Immigration policy often affects the general economy and thus requires an analysis of spillover effects and changes that partial equilibrium analysis cannot capture.

63.

The fact that unemployment among black Americans is nearly twice as high as it is among white Americans can be explained by many factors, including discrimination. There are also differences in existing income levels, with the result that many black Americans reside in poorer neighborhoods and thus do not have equal access to education and other services that would lead to higher employment. Opportunities among blacks and whites may differ, leading some young black people to choose nonmarket activities over participation in the labor force. Possible solutions will vary, but could include stronger antidiscrimination enforcement, better educational programs and law enforcement to decrease the payoffs to illegal, non-market activities.

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64.

On average, women receive about 85 percent of the pay that men receive to do the same kind of job. Somewhat more than half of that difference can be explained by factors like length of time on the job, but there is still a relatively large difference that can be attributed to discrimination. There is demand-side discrimination, which occurs when an employer hires a man rather than an equally qualified woman or pays a woman less for doing the same job as an equally qualified man.

There is also sociological supply-side discrimination, which includes examples like women changing jobs to move with her partner (thus lowering her average pay), women staying home for a time to raise children during the time when people are generally climbing the corporate ladder, or women taking a larger role in childcare (and therefore perhaps missing work or meetings), again resulting in lower pay and reduced opportunities for promotion and advancement. The reasons that are most responsible for the difference vary from situation to situation.

65. a. At the school we looked at, among college professors, the share of household work done in dual earner families was more equal than expected, but females still had slightly more responsibility for child rearing. This suggests that some institutional discrimination is built into the culture and exists within these dual earning college professor families.

Salaries at most colleges, on average, are equal for equal rank and years of service up until the highest salaries, where information is often confidential, and there are few women. Discrimination from somewhere, however, is suggested by the relatively high proportion of untenured and non-tenure track women compared to men, as well as the small relative number of full and chaired female professors. pp. These findings in (a and b) suggest that institutional discrimination may affect a woman's ability to devote the time and mobility necessary to get a tenure track position and attain tenure at the peak of her child-bearing years.

66. a. The possible conclusions are that obese women earn less because they are less productive, because employers discriminate against obese women, or because obese women tend to pursue lower-paid jobs.

The findings do not necessarily mean that there is ―beauty‖ discrimination. The difference could be due to differences in productivity between obese and healthyweight women. Since the comparison is family income, the difference could also be attributed to differences in other sources of family income such as spouse’s pay. The authors found that 80 percent of the differential is due to marriagemarket differences. qq. The larger income penalty for women could be due to a more stringent beauty standard for women or it could simply be because obese women are significantly less productive than obese men. Source: Journal of Human Resources, 1996.

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67.

Who is right depends upon what happens to the wages of those jobs. At current wages, few of those jobs will be filled by U.S. citizens because they are hard, and low paying, and below their reservation wage for that type of job. If the wages rose sufficiently, U.S. citizens would likely take them, but that would increase the cost of the agricultural goods, and possibly put the producers out of business.

APPENDIX: DERIVED DEMAND a. At a wage of $7.00 they would hire 33 workers. Since the marginal revenue product is 8 when the firm has 32 workers, the firm can increase its profit by hiring the 33rd worker. However, since the marginal revenue product is only 6 when the firm has 33 workers, it will decrease profit if it hires a 34th worker. Therefore 33 workers will maximize profit.

If the price of the good fell to $1.00, the marginal revenue product would be cut in half at each level and the firm would reduce the workers they hire to 29.

68.

They would likely hire fewer workers since they would take into account the fall in the marginal physical product that hiring more workers would cause. Since a fall in marginal physical product usually leads to lower wages, a firm controlled by workers would hire fewer workers in order to keep wages high.

69.

A likely reason for the switch is technological advances that lowered the cost of machines or a rise in the relative pay students demanded. In other words, the ratio of the marginal product to the price for machines was higher than the ratio for student-workers, so farmers increased their use of machines until the ratios became equal.

70.

Yes. Widespread introduction of such programs would likely reduce the demand for teachers and lower their pay.

71.

It can pay up to the marginal revenue product, or up to $9.00. (MRP = P × MPP = 3 × 3).

72.

If the firm was a monopolist, the marginal revenue would be less than $3.00, and thus the amount it would be willing to pay would fall.

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73.

Num. of workers 1 2 3 4 5

TP

MPP

AP

MRP

10 19 27 34 40

9 8 7 6

10 9.5 9 8.5 8

18 16 14 12

74. a. The proposal that should be adopted is the one that equalizes the ratio of marginal product to the price for each of the three inputs. Using the cost minimization condition, proposal A is the best choice for the firm  30 / 5  42 / 7  36 / 6  .

If the price of labor rises to $14, none of the proposals meets the cost minimization condition. The firm should search for some other combination that would meet the cost minimization condition.

CHAPTER 17W: NONWAGE AND ASSET INCOME: RENTS, PROFITS, AND INTEREST Questions and Exercises 75.

The four traditional categories of income are wages, rent, profits, and interest. The traditional theory of the distribution of income is marginal productivity theory, which states that factors are paid their marginal revenue product. Modern economists are in the process of extending this functional theory to different categories since the class structure upon which the traditional categories are based is no longer as prevalent in our society.

Price

S P0

P1 D D + tax Q*

76.

Quantity

The graph on the right shows that the price of land is determined by the intersection of demand with a perfectly inelastic supply.

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rr. A tax on land shifts the demand for land down, as shown in the graph on the right.

The after-tax price that the demander pays is constant, at P0, but the after-tax price that the supplier receives is reduced by the amount of the tax to P1. ss. The tax does not cause the price of land to rise because the supply is perfectly inelastic, meaning that suppliers will supply the same amount of land regardless of the price they receive. tt. If you support the position of Henry George, you would argue that other taxes should be replaced with a tax on land. The answer to this question depends on determining the goals of taxation, and may be better answered at the local than the national level.

77. a. The law would have raised the price of reindeer meat and increased the profits of those licensed to own reindeer.

Whether the law was fair depends on value judgments and, depending on those judgments, various answers are possible. (See ―In Alaska, Reindeer are the Sole Province of Native Peoples‖ in The Wall Street Journal, 12/14/65, for details.)

78. a. The value of desert land near the ocean will rise and it will become a scarce resource.

If this actually reduced the cost of generating electricity to two cents per hour, the demand for oil will most likely decline as consumers substitute electricity for oil.

This will depress the price of oil. uu. If you were a major oil producing country, you would be hesitant to encourage development of a technology that would reduce the revenues for the major production in my country, unless you had relatively more desert land near the ocean compared to other countries. In that case, you would encourage the technology as long as the expected revenue gain exceeded the revenue loss from the decreased demand for oil. Even if that were not the case, you might realize that there is little you could do to block this new technology and therefore might encourage it for political reasons.

79.

Normal profits equal the opportunity cost of making an investment. Economic profits are returns above and beyond normal profits.

80.

To find the present value of a perpetuity of $100 per year, use the annuity rule, which says that the present value is equal to the amount of the cash flow divided by the interest rate. Thus, the present value will be $100/0.09 = $1,111.

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81.

If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 30 years can be calculated using the present value factor table. The present value factor is 0.08 for an interest rate of 9 percent in 30 years. You should be willing to pay about $20,000 × 0.08 = $1,600 for this offer.

82.

To find the present value of a perpetuity of $200 per year, use the annuity rule, which says that the present value is equal to the amount of the cash flow divided by the interest rate. Thus the preset value will be:

The future values of $200 today in one year and two years: Future value = Present value × 1 i  where i = interest rate and n = number of years. n

vv. Years to double your money: (72/interest rate)

83.

Modern economists often don't talk about labor income as wage income. Instead they use the term human capital to emphasize the profit and rent components of wages. This makes the functional distribution of income analysis less useful because the various categories are intertwined.

84.

Marginal productivity theory essentially says that supply and demand determine who gets what. If the initial allocation of property rights were unfair, then the market results would also be unfair.

Questions from Alternative Perspectives 10

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Radical Pierre Joseph Proudhon meant that most property is initially held in common, but then those with control take over the property and exclude others, essentially stealing the property from everyone. A fair society would figure out alternative mechanisms to distribute property that would prevent such stealing.

Feminist When women cannot hold property, they have no power in a relationship since they have no alternative but to remain in the relationship or starve. When they have independent property, they have more power so one would expect domestic violence to decrease.

Austrian When a person has property, he or she has the right to do what they want with it.

Zoning takes away that right, so essentially it is the appropriation of property by the government. The Austrian view is that it should not be legal.

Religious The purpose of the Jubilee year tradition of freeing slaves, returning land to its original owners and canceling debt, is to extend God’s beneficence from the rich to the poor by breaking oppressive forces of slavery and debt. It was designed keep the distribution of power and resources in society more equal than it otherwise would and to establish good will among peoples. Our society is so commercialized that it would be difficult to establish such a tradition today, but if some variation of it could be developed, many religious people believe that it would serve a useful purpose, just as it did in earlier times.

Institutionalist Intellectual property rights help make the distribution of income far less equal than it otherwise would be. Many economists believe that the economy would be much better off with much weaker intellectual property rights since people would still write songs, write books, and develop new ideas. Most people have an incentive to create and find better methods of doing things independently of the profit motive. Alternative methods of funding such activities could be developed if the inherent incentive to be creative is not strong enough to create as much music, knowledge, and art as we would like.

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Issues to Ponder Zoning laws are laws that set limits on the use of one's property. Some people argue that they are immoral because they modify property rights, which they see as natural and inviolate.

85. a. Marital property can be defined to include any jointly owned asset. An advanced degree is an asset whose present value is determined by the future stream of income the holder can earn. It is jointly owned to the extent that the spouse contributed to the purchase of that asset either directly by sharing in tuition costs or indirectly by providing other home services that reduced the cost of the degree.

Thus broadly defined, an advanced degree is an asset.

A future stream of income is determined by many factors besides the degree such as good looks and good health. These aren't considered marital assets, so why should a degree which is just as personal be considered one? Second, in many people's view a spouse's right to that present value depends upon his/her contribution to the purchase of that asset. If the marriage took place long after the degree was obtained, it should not be viewed as a joint asset. Finally, property is what the law defines as property. Even though to an economist an advanced degree might be property, if the law doesn't define it as such, it is not property.

86.

In perfect competition economic profits are pushed all the way down to zero; thus no one would get rich quick. But to the extent that this also discourages innovation and change, the economy would stagnate.

87.

Property rights underlie markets; they allow markets to develop and encourage individuals who have the property rights to take care of the resources they control.

Without property rights markets couldn't function so to the degree that markets benefit society, they also benefit the poor. Of course the poor would be better off if they, not other people, controlled the property rights. Consider a squatter who lives somewhere but does not have rights to the property. He cannot sell the property, or borrow on it, which prevents him from options that he would otherwise have had and which could have made him and society better off.

CHAPTER 18: WHO GETS WHAT? THE DISTRIBUTION OF INCOME Questions and Exercises 88.

The top 20 percent of individuals in Bangladesh earn 41.3 percent (= 100 – 58.7) of the income.

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89.

A Lorenz curve is a geometric representation of the size distribution of income among families in a given country at a given time. To do this just for lawyers, you would be showing how income is distributed just among members of that profession. (It might surprise people to find out that the distribution is not as even as they might think.)

90.

Research has shown that income differs substantially between men and women, and between white and Black people. Some of these variations are the result of sociological and cultural differences, but a substantial fraction is the result of discrimination. There is little evidence to indicate discrimination exists on the basis of hair color, although there might be some.

91. a. See the accompanying graph.

ww.

A perfectly equal distribution of income would be shown by a diagonal line; thus, the country with the most equal distribution of income among the three is the Czech Republic.

xx. The country with the least equal distribution of income among these three is Mexico. yy. One could not tell which country has the most progressive tax system without looking at the curves over time and examining other factors that determine the curves’ shapes.

92.

Arguments could be made for both approaches. Poverty could be defined relatively since one of our concerns is the distribution of income and the gap 13

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between the rich and poor. Poverty could also be defined absolutely since another of our concerns is that people have enough to eat, which is an absolute concept.

93.

As the text describes, people face less social mobility in the United States than in Great Britain. It is difficult to say why this is true. Perhaps there is greater discrimination in the United States, which is keeping people from moving up the income ladder. Perhaps the growing number of illegal immigrants, by holding down growth in wages in the middle-to-lower end of the pay scale, is also limiting social mobility. The growing number of illegal immigrants would tend to depress wages of lower-paid workers, keeping them in lower-income brackets. It is also possible that the tax structure is more progressive in Great Britain than in the United States.

94.

The Lorenz curve for the world would likely be more bowed out than the United States since income is very widely disparate among countries.

95.

As a fraction of men’s income, women’s income has risen (from 60 percent in 1960 to about 85 percent in 2021). There are likely a variety of reasons including lower discrimination against women, higher education levels among women, and more women entering the workforce.

96.

The class system in the United States today looks more like a pentagon than a diamond or pyramid because there is a very large middle class, a somewhat smaller lower class, and a very small upper class. The reason for this is that upward mobility in the United States is limited as well as the effect of globalization on the labor market—reducing jobs and income for low-skilled labor in the tradable sector, which expanded the lower class. Those in the middle class and who worked in the tradable sector remained in the middle class.

97.

Bertrand de Juvenal believed that a high level of income inequality was necessary to sustain the arts, beauty, education, and civilization.

98.

John Rawls believed that some inequality may be necessary as long as it makes the least well-off better in absolute terms.

99. a. You will pay no tax on the first $10,000; $5,000 on the next $20,000; $6,000 on the next $20,000; and $10,550 on the remaining $30,000, for a total tax payment of $21,500.

Dividing $212,500 by your income of $80,000 gives an average tax rate of 26.87 14

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percent.

The marginal tax rate will be the tax on one more dollar of income, which in your case will be 35 percent.

100.

a.

This would increase the incentive to work since working longer hours will not push one up into the higher tax bracket.

Questions of fairness are normative and have no right answer. To the extent that people believe that hard workers shouldn't be highly taxed for their extra effort, this tax structure would be considered fairer. zz. Making the tax system regressive in hours worked would further increase the incentive to work longer hours, likely increasing the average number of hours worked.

Questions from Alternative Perspectives Institutionalist The costs of transfers for the upper quintile is a loss of 1.5 percent of their total share of income.

Because most of their income is discretionary (not needed for food and rent), they are more likely to have financial resources available to change the transfer structure.

While transfers over the long run might nearly double their income, they have little to no discretionary income to ―invest‖ into changing the situation since much of their income is spent on necessities such as food and rent.

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101. Religious Following the Old Testament, it suggests that Americans are righteous people.

Following the New Testament, it suggests that it is going to be very difficult for many Americans to enter the kingdom of heaven.

This is a judgment question; judgments differ. Religious economists would likely suggest creating government institutions that support religious beliefs. The Bible encourages people to be generous with what they have and to help others. aaa.

This question is somewhat subjective, but the Old Testament seems to imply that private individuals should work hard and be faithful in order to become wealthy, while the New Testament seems to encourage a high level of private charity.

102. Radical It leaves about $5.29 a day per person for food.

It leaves about $1,289 per month for other things.

103. Austrian I would probably not like it.

It would likely reduce my incentive to work.

It would likely reduce his incentive to work and increase his incentive to maximize transfers from government.

If I voluntarily gave the money, it would not reduce the incentive to work; it might increase it.

104. Feminist This is a judgment question; judgments differ. From many feminist economists’ perspectives, more government programs to directly achieve a more equal distribution of income would be desirable. Examples might include a much higher minimum wage, universal free childcare, and mandatory paid sick leave.

This is a judgment question; judgments differ. Many feminist economists would argue that daycare could be subsidized, and flex time could be encouraged by public policy.

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Issues to Ponder Nowadays in the United States, classification is based on characteristics that transcend one’s source of income, education, reading material, and job or career. Using these factors, one could argue for a class distinction between managerial decision makers and other workers. Whether it makes sense to do so depends upon the light it sheds on social and economic problems.

105.

The observed difference may be due to supply and demand factors. If many people wish to be English teachers and few wish to be garbage collectors, then market factors will result in a higher wage for the garbage collectors—and if one believes in the market mechanism, this is right. This question raises other, more complicated questions about fairness of compensation and the social value of different occupations; there are no obvious right answers.

106.

Four conditions that you might list before you would favor equality of income are (1) that individuals have essentially the same needs, (2) that they work the same amount, (3) that they have essentially the same health, and (4) that they have put in the same effort up to this point.

Depending on what conditions you listed, it could change your views on welfare in a number of different ways. bbb.

Again, it depends on what conditions you chose. If the condition does not include differences in ability, then you would likely favor a progressive income tax. ccc.

If the tax were progressive in wage rates, rather than income, hard work would be encouraged and raw ability (if represented by wage level) would be taxed more. If you did not list ability, then you should say that the conditions would be better met.

107.

This question raises issues of fairness and equality and requires value judgments.

As the author notes, considering the circumstances that have led to someone starving or being homeless, or that are involved in someone's consumption of chocolate, will affect some people's judgments about the appropriateness of society's response.

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108.

If people's desire for equality is so great that any sense of initiative is undermined, economic growth based on individual initiative is impossible, and all people will be brought down to the lowest level of income.

109.

The answer to this question will depend in part on the individual student’s circumstances. In general, the incentive effects of a tax may result in a switch from labor to leisure.

110.

a.

Taking into account in-kind benefits and unreported income would reduce the number of people seen as in poverty. Taking account of the fact that food makes up only a seventh of the family’s budget would increase the number of people in poverty. Taking account of home ownership and cost-of-living differences would involve distributional consequences. It would raise the level of poverty for some groups and lower it for others.

What is fair involves normative judgments. Even if the adjustments were made, one could still argue that the current definition of poverty is too low and that benefits should be increased.

111.

a.

To the extent that redistributing income to the poor makes others feel that the society is more just and therefore increases their utility, income redistribution may be a public good. This is likely to occur when the poor are seen as innocent victims of their circumstances.

To the extent that people in a society believe redistribution is unjust and therefore decreases their utility, income redistribution may be a public bad. This is more likely to occur when the poor are viewed as being responsible for their circumstances. ddd.

When real wages increase, people may volunteer less because the opportunity cost of working also rises. As a result, they have less information about the poor and are more likely to view income redistribution as a public bad.

112.

On the surface, the democratic system of one person/one vote would seem to suggest that the politics of redistribution would favor the poor, but it doesn’t. One would expect that the poor would use their power to make sure that income was redistributed to them from the rich, but they don’t. The reasons for this include the fact that many of the poor don’t vote, and so consequently they are not seen as a voting bloc by politicians. Another reason is that when poor people do vote, they vote with other issues in mind. Also, campaigns require financing, which is often supplied by the rich, and so their interests may be more represented than those of the poor. In other words, not enough poor people vote based on purely economic reasons for a paradigm shift, and in turn large distribution, to occur. This does not 18

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necessarily mean the poor view the current distribution of income as fair, it simply means other factors eclipse redistribution for the poor.

CHAPTER 19: THE LOGIC OF INDIVIDUAL CHOICE: THE FOUNDATION OF SUPPLY AND DEMAND Questions and Exercises 1.

Marginal utility is the satisfaction you get from consuming an additional unit of a good over and above what you’ve already consumed while total utility is the satisfaction you’ve gotten from consuming all the goods you’ve consumed so far.

2.

According to the principle of diminishing marginal utility, marginal utility falls as one consumes more of a good. Marginal utility of the last unit consumed rises as one consumes less of the good.

3.

The table looks like this (interpret marginal as between the two numbers).

Cans of Soda 0 1 2 3 4 5 6 7

Total Utility 0 10 22 32 40 44 44 42

Marginal Utility 0 10 12 10 8 4 0 -2

eee. Marginal utility begins to fall at the third soda. fff. Scout will not consume the 7th soda because it reduces total utility. It provides negative marginal utility. ggg. We don’t know whether Scout is following the utility maximizing rule without more information. If this were her only choice and the soda were free, she’d drink 6 cans of soda—maximizing total utility. Drinking 2 cans would maximize marginal utility.

4.

There are many psychological explanations for people’s actions, but economists use a simple underlying psychological foundation, rational self-interest.

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5.

From the information in the table, the marginal utility per dollar is: Number 1 2 3 4 5 6 7 8

(MU/P) for A 20 18 15 10 5 2 -7 -20

(MU/P) for B 10 7 6 5 4 4 3 2

(MU/P) for C 8.33 1.67 1.67 1.67 1.67 1.67 -1.67 -1.67

(Note that marginal utility should be interpreted between units of consumption.)

We start by buying that good with the highest units of utility per dollar. With $20 to spend we would buy 1 of A, for 20 units of utility per dollar, leaving us with $10 to spend. We would then buy 1 more of A, getting 18 units of utility to the dollar. This would exhaust our money.

6.

From the information in the table, the marginal utility per dollar is: Number

(MU/P) for (MU/P) for (MU/P) A B for C 1 10 25 15 2 9 20 10 3 8 15 8 4 7 10 6 5 6 8 5 6 5 6 4 (Note that marginal utility should be interpreted between units of consumption) With $12 to spend, the consumer should buy 1 of A, 4 of B, and 2 of C. hhh. If the price of B rises to $2 its (MU/P) would be cut in half. The consumer should now buy 1 of A, 2 of B, and 2 of C. iii. If the price of C is 50 cents but the other prices are the same as in part a, the (MU/P) for C would increase, and the consumer would buy 2 of A, 5 of B, and all 6 of C.

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7.

You should continue your present pattern of consumption. One more widget will give you 2 more units of utility for $2, and one more wadget will give you 3 more units of utility for $3. Because (MU widget / Pwidget )  (MU wadget / Pwadget ) , your present consumption pattern gives you as much total utility as any variation, considering your income and prices.

8.

What explains this paradox is the difference between total utility and marginal utility. Although our total utility for the consumption of water (a necessity) is much higher than that of diamonds (a luxury), the marginal utility of a gallon of water is much lower than the marginal utility of another diamond because of the principle of diminishing marginal utility. It is the marginal utility that determines willingness to pay, and thus defines the demand curve.

9.

The law of demand states that quantity demanded falls as price rises and quantity demanded rises as price falls. If you are already in equilibrium and the price of a good rises, you will no longer be in equilibrium. The marginal utility per dollar of the good whose price has risen will be lower than for some possible substitute. To raise the marginal utility per dollar of the good whose price has risen, you must reduce your consumption of that good. Therefore, as the price of the good rises, you consume less of it—the law of demand.

10. a. You would buy 2 pizzas at $10 each, and 4 calzone at $5 each.

When the price of a calzone rises to $10, you would buy 3 pizzas and 1 calzone.

This demonstrates the law of demand because as the price rises, you would buy a smaller quantity of the good whose price has risen.

11.

Your study partner is wrong because relative prices have changed, which means that even though you have been compensated for the effect of the price increase on your income, you will still substitute goods whose prices did not rise for those goods whose prices did rise. The substitution effect is the reduction in quantity demanded that is the result of a rise in the relative price.

12.

The law of supply states that as price increases quantity supplied increases. The opportunity cost to the supplier is the value of the next best alternative they had when they supplied that good. If we are talking about labor, then it is the next best alternative value of the person's time. The opportunity cost of that forgone pleasure tends to increase as you supply more, which is why opportunity costs underlie the law of supply.

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13.

If the supply curve is perfectly inelastic, the supplier has no alternative; thus, the opportunity cost is zero.

14.

As usual, the answer is: it depends. Specifically, it depends on their utility function. If they value the uses of their time spent in "voluntary simplicity," it would definitely be rational. If most people had this type of utility function, then a decrease in measured production could well be associated with an increase in total utility.

15.

The purpose of conspicuous consumption, according to Thorstein Veblen, is to demonstrate to others that one can afford the goods consumed. Utility is derived not from consuming the good or its functionality, but from how much one spent for the good, or its price. An example of such a good today is a Rolex watch.

People don’t buy Rolex watches just to keep the time, but to show to others that they can afford to buy a $10,000 watch.

16. a. Since the ―rational‖ move now suggests that the first person should keep all the money, one would expect that the offers would be smaller, which is what economists have found. See: R. Forsythe, J. Horowitz, N. E. Savin and M. Sefton, ―Fairness in Simple Bargaining Experiments,‖ Games and Economic Behavior, 1994.

Since the second person can impose no penalty on the first for making less than a 5050 offer, he should accept any amount that he gets. That is what economics researchers have found.

Questions from Alternative Perspectives 1.

Religious This is a judgment question; most people will answer that no, not all decisions are economic decisions. Some decisions are based on one’s values, or what the Divine has called one to do. jjj. The decision of tithing is normally thought of as a duty to God, not as an economic decision. To place tithing into an economic framework, the process of tithing would have to be seen as an individual paying for a good. Within such a framework, following God’s commands would be seen as providing utility the same way that purchasing goods or services would.

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2.

Austrian Austrians believe that only the market can reveal people’s true demand, and without the market there is no way of knowing people’s true demands.

3.

Feminist Households differ in how they make decisions, but in large parts of the world, men have a predominant voice in household decision making. kkk. Yes, bargaining generally takes place, but the degree of bargaining depends on social mores. lll. Social mores, taught psychology, legal structure, and ability to withdraw from the relationship, tend to give individuals power. mmm.

People tend to act somewhat competitively and somewhat cooperatively in most walks of life.

4.

Post-Keynesian This statement reflects the views of Thorstein Veblen, who believed that people engage in what he called conspicuous consumption, which is contrary to the views of neoclassical economics. He argued in essence that consumers’ preferences are endogenous and depend on prices whereas neoclassical economics argues that preferences are exogenous and independent of prices. The implication is that you do not have consumer sovereignty but consumer dependency. nnn. It might be difficult to distinguish between goods that are bought because people want them or have been influenced by advertisement and conspicuous consumption.

5.

Radical Given the assumptions of the question to impose equal burden in lost utility, the tax rate on the higher income would be higher than the tax rate on the lower income. ooo. This would reduce the argument to tax different incomes at different rates.

There would be less of a presumption that, if utility were comparable, that having higher tax rates for higher incomes would be welfare improving. ppp. Assuming that utility was comparable among individuals, and one wanted to equalize levels of marginal utility, it would be likely that high-income earners would face higher tax rates than low-income earners.

Issues to Ponder 23

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The principle of diminishing marginal utility means that as individuals increase their consumption of a good, at some point consuming another unit of that good will not yield as much additional pleasure as did consuming the preceding unit or units. This is important because the marginal utility you get from a good plays a central role in determining how much you're willing to pay for it and how much of it you will demand. If the principle of diminishing marginal utility seldom held, the patterns of consumption and demand would be radically different; individuals' consumption would focus on a single good.

Economists’ theory of value depends on the underlying assumptions. Given those assumptions, price and value are closely related. If those assumptions (such as assumed rationality and freedom of choice) don’t hold, the statement is true; if they do hold, the statement is false.

This question asks students to put a utility value on their study pattern and consider it in terms of rational choice. It is likely that their study patterns are rational.

This question asks students to explain the motivations for four choices they have made in the past year. The student will explain in each case that the opportunity cost of not undertaking the activity was greater than the opportunity cost of undertaking that activity. In other words, the marginal utility per dollar of the activity undertaken exceeded the marginal utility per dollar of all other choices at that time.

I would expect that Wicksteed would equate the marginal utility of fresh eggs divided by their cost (including walking time to fetch them) and the marginal utility of visits from friends divided by the cost to induce them to visit.

For Americans, a large part of utility (happiness) is how much they consume relative to others. As everyone gets more, relative happiness does not increase.

Most people buy goods without a lot of thinking. An example of ours is when we buy meat at the store. We have a general idea of what the price should be, and if the price is lower than that (and a sign or sticker that says sale) we buy it. It follows the principle of rational choice only if that principle takes into account the costs of deciding.

People have a sense of fairness that includes equality of outcomes and are willing to forgo income to enforce that sense of fairness. It is unclear whether these experiments transfer to the real world where people could rationalize that the 24

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increase in income is the result of their superior abilities and efforts. In the experiment described in the text, payment is clearly not related to ability or effort, just bargaining power. a. If he or she is not a 100 percent rational economist, it is likely that you will lose your spouse or significant other—or they will at least be upset that you didn't buy them a real diamond. (Assuming that he or she discovers that the diamond is not real.)

The utility gained from a diamond is not just its brilliance or perfection but also the knowledge that it is real (and thus expensive) and that some sacrifice (driven by affection) was made for its purchase. A fake diamond suggests that there was little sacrifice and thus the giver’s love was cheap as well. qqq. Who is to say that the utility from the consumption of a product is not just? It may, however, be unjust to conclude that someone loves you less because they bought the fake diamond.

113.

a. It tells us that people interpret price as an indication of quality.

This is the case with other goods that cannot be easily sampled without purchasing it, such as hotels and dinners at a restaurant. These are called ―experience‖ goods. rrr. This suggests that pricing affects preferences. Higher prices can be perceived as an indicator of higher quality and people’s preferences can be impacted by what they perceive others believe to be high quality wine.

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APPENDIX: INDIFFERENCE CURVE ANALYSIS 1.

Zachary’s budget constraint for a, b, and c are shown in the accompanying graph.

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2.

With a budget constraint of a, Zachary will be on utility curve II. With budget constraint in b, Zachary will be on utility curve III. With budget constraint in c, Zachary will be on a utility curve that is to the right of III. Zachary prefers the budget constraint that is the furthest to the right, III. Zachary would least prefer the budget constraint that is farthest to the left. sss. The marginal rate of substitution for a is 2, for b is 1 and for c is 1. The marginal rate of substitution equals the absolute value of the slope of the budget constraint at the optimal combination of goods. Even though we do not know the optimal combination with budget constraint c, we can still figure out the marginal rate of substitution for that combination.

3.

If the marginal rate of substitution were zero, the indifference curve would be a horizontal line. If the marginal rate of substitution were constant, the indifference curve would be a straight line with negative slope.

4.

If there were increasing marginal utility, it would be bowed away from the origin (bowed out).

CHAPTER 20: GAME THEORY, STRATEGIC DECISION MAKING, AND BEHAVIORAL ECONOMICS Questions and Exercises 1.

The prisoner's dilemma game is a well-known, two-person game that demonstrates the difficulty of cooperative behavior in certain circumstances. ttt. The assumptions are that each player acts in his self-interest, the two players do not communicate with one another, nor do they enter into binding agreements. uuu. A binding agreement, or even just trust, as well as one person taking into account the results of the outcome of the other creates the possibility of escaping the prisoner's dilemma. vvv.

The standard model says that people are self-interested and therefore will do what's in their self-interest, they will not trust one another, and (if the game is played once) will cheat on any agreements. Experimental economics says people do take into account the effect on others when making decisions.

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2. a. It isn’t expected to change the outcome because there is nothing keeping Player A from going against her word; A is using cheap talk. www.

Verbal promises are cheap talk and do not affect the outcome.

xxx. Player A could make her pronouncement more believable if she pays Player B some amount that will be returned if she makes good on her promise. She could still defect.

3.

A Nash equilibrium is the predicted outcome of a noncooperative game if each player follows his or her best strategy and assumes that the other players are following their best strategies. The solution to the prisoner’s dilemma game is a Nash equilibrium because no player can improve his payoff by changing strategy unilaterally.

4.

Yes. There is no need for a dominant strategy to exist in order to have a Nash equilibrium. The outcome is a Nash equilibrium because each player has made his or her optimal choice based on the optimal choice of the other player; there is no incentive to unilaterally change their strategies.

5. a. The dominant strategy for Firm A is to cheat. The dominant strategy for B is also to cheat. yyy. Both cheat.

6. a. Neither prisoner has a dominant strategy. zzz. There are two Nash equilibria: both accuse, and both remain silent.

7. a. Choice X is the dominant strategy for both A and B. aaaa. Player A: no dominant strategy; Player B: Y is the dominant strategy. bbbb.Player A: no dominant strategy; Player B: Y is the dominant strategy.

8.

The prisoner’s dilemma would no longer be a dilemma if it were a sequential game because one player’s choice would be revealed. The first player would reveal his or her choice and then the second player would choose the best strategy, potentially making both better off.

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9. a. Sequential. cccc.

Sequential.

dddd.Some decisions were sequential, others simultaneous. eeee.

Sequential.

10.

Yes, rollback strategies exist for both simultaneous and sequential games. In a sequential game, this use of backward induction will give you the best strategy for your first move. In a simultaneous game, a rollback strategy is much more difficult because it is based on the expected choices of other players made simultaneously.

11.

False. People don’t always act in the way that a Nash equilibrium suggests.

People don’t always make the necessary calculations, and they take the well-being of others into account when making their choice. For example, the 2/3 game is an example of a real-world observation that differs from the Nash equilibrium.

12.

The multiple-play ultimatum game allows for players to send signals. Therefore, the receiver can punish a player who doesn’t share enough so that in the next round the player offers a fairer payment. This means that repeated games increase the possibility for cooperation compared to single-play ultimatum games.

13.

Sellers prefer a Vickrey auction because the second highest bid in a Vickrey auction is generally higher than the highest bid in a regular sealed bid auction. In a Vickrey auction bidders have an incentive to bid their true valuation for the good since by bidding his or her true value, a bidder will win the auction without paying the higher amount.

14. a. You would be willing to bid a little more than $100 because it is just enough to win the auction as the expected next highest bid is $100, and it does not exceed its worth to you of $250. ffff.

You would bid your true value because if you bid more and the second highest bid is between your true value and your offer, you would win the item, but you would make a loss (winner’s curse). If you bid more and the second highest bid is less than your true value, you win but it does not help to bid over. Bidding less than your true value does not help either because you will pay the second highest bid, and it might even hurt if the second highest bid is between your offer 3

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and your true value. You would lose the item you would have won if you had offered your true value.

15.

They preferred the package of ground beef that was labeled 75% lean even though the two were identical because consumers are much more likely to choose the alternative framed as the positive option. They see 25% fat as a loss of health (negative) and 75% lean as a gain to health (positive). This is an example of a framing effect. Framing effects are the tendency of people to base their choices on how the choice is presented.

16.

It takes just a few people to act rationally because if ―money is left on the table,‖ the few people who act rationally will take advantage of the irrationality of others, and they will take that money off the table.

Questions from Alternative Perspectives 1.

Religious The Golden Rule (love your neighbor as yourself) is an idea common to all major religions. Therefore, one could expect that people with religious training will make those choices that make the other players as well off as they themselves would like to be. This would affect the outcome of strategic games. Whether this interaction is preferable is up for debate.

2.

Austrian Game theory, I would argue, better fits Ludwig von Mises’ definition of economics because it focuses on the very basic component of economics—human action. Supply/demand analysis also studies human action, but in a narrower way with very specific assumptions.

3.

Feminist If women are more likely to collaborate and trust others, as empirical evidence suggests they are, women may be more likely to avoid the prisoner’s dilemma problem, since they will not be as willing to believe that the other prisoner will follow their self-interest. Which is preferable is up to debate.

4.

Institutionalist Game theory uncovers how social constructs (accepted ways of doing and being such as trust and rules of thumb) affect economic outcomes. Because social constructs are institutions, game theory demonstrates the importance of institutions.

4

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5.

Feminist What is disturbing about the scene from the movie, A Beautiful Mind, is that women are portrayed as objects to be acquired in a game that depends solely on the choices made by men. Economic sensibility has many meanings and can encompass the idea that some things are beyond value. So, I would say that although Nash violates feminist ideals, both he and feminists can represent economic sensibility.

6.

Radical The assumptions of the standard model are that individuals are selfish and rational. Behavioral economics is showing us that individuals are more nuanced; they are purposeful rather than fully rational; they demonstrate enlightened selfinterest, rather than greed, and that they are boundedly rational rather than fully ―Nash-style‖ rational.

Issues to Ponder 1.

Potential employers will use challenging courses as a screening tool. It is easy for an applicant to state that she works hard. Taking a difficult course is a way to demonstrate that statements by the applicant such as claiming to work hard are true; therefore, this is a screening device.

2.

To the extent that stock market prices are the result of strategic interaction— buying stocks that you guess other people will value—stock market pricing has similarities to the two-thirds game. If the market is falling in value and there doesn’t seem to be an underlying model to the fall in stock prices, stockbrokers might try to guess the average of how low they think the stock market will go before buying again. In that case this averaging will end up with lower and lower prices, just like the two-thirds game. The difference is that the stock market has some underlying fundamental value that affects the expectation and directs people to not attempt to estimate a number that is two-thirds of the average, but that is the average. In that case, the tendency for the price estimates to become unstable is removed. The stock market might have bubbles and those bubbles may burst, but fundamentals place some limits on those bubbles.

3. a. The Nash equilibrium is for both players to defect.

5

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gggg.The payoff is not symmetric. B has the advantage. In the Nash equilibrium, Player B gains 0.5 while A gains nothing. B gains more when player A cooperates. This might have made Player A more likely to defect than cooperate.

That is, indeed, what happened. Player A cooperated 68 times while Player B cooperated 78 times. They jointly cooperated 60 times. hhhh.They cooperated to try to maximize their joint payoff. Such cooperation was made possible by trust that built up over successive games. iiii. Each chose to defect because he no longer had the opportunity to either reward or punish the other player with subsequent plays.

4. a. There is a strong tendency for the dollar to be auctioned off for more than a dollar because if the highest bid was 99 cents and the second highest bid was 98 cents, the 2nd highest bidder could do better by bidding $1 because he would not only pay the $1, but also win the dollar. Staying as the second highest bidder leaves him at a loss of 98 cents. But then the person at 99 cents would be better off by bidding $1.01. This goes on. No matter what the stage of the bidding, the secondhighest bidder can improve his position by almost a dollar by barely topping the current high bid. jjjj. A rational person who does not value his or her time playing will never lose the auction because he or she will always bid more. Of course, if she is rational she will realize her time is valuable and finally stop at the point where the value of her second-highest bid is just less than the value of her time of continuing. kkkk.Because playing will lead to a position in which she will lose money, a rational person would never enter this auction, unless she received enjoyment in participating or unless she thought the other players were irrational.

5.

a. The Nash equilibrium will be 50. Notice that the winner isn't guessing 1/2 of the average, but just the average. llll. Yes. I'd expect the class to get it fairly quickly once they realized that this is different than the two-thirds game in which one must guess 2/3 of the average of the guesses. mmmm. The difference is that some people will have difficulty with the computation.

6. a. I would expect the people who are rational to become wealthier.

6

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nnnn.

The traditional model doesn’t take into account the endowment effect and therefore would predict that wealth distribution wouldn’t change. oooo.I might run some experiments starting with a low number of people who are subject to the endowment effect and continue increasing that number until there is some impact on wealth distribution. All you need is a rational person with sufficient resources to take advantage of an ―irrational‖ person.

7.

In a Vickrey auction a seller who has someone at the auction submitting a bid for seller would bid an amount just less than what the seller thought would be the highest bid, thus forcing the winning bidder to pay nearly the highest amount he would be willing to pay. The person wouldn’t change his bidding strategy. He would just accept the likelihood that what he pays would be close to his bid than otherwise.

APPENDIX: GAME THEORY AND OLIGOPOLY 1. a. The dollar values in the payoff matrix show the change in net profit (change in profit based on the Superbowl adless the cost of the Superbowl advertisement) for each firm. In the case that neither or both advertise, we assume profit remains unchanged at $100,000.

For example, if Netflix advertises and Hulu does not (the shaded box), Netflix anticipates its revenue will rise by $130,000 ($230,000 - 100,000). Since Netflix spent $80,000 on the ad, its expected change in net profit is 50,000. Hulu’s expected profit falls by $50,000.

Hulu

Advertise N: -$80,000 H: -$80,000 N: $50,000, H: -$50,000

Advertise Not Advertise

Netflix Not Advertise N: -$50,000, H: $50,000 N: 0 H: 0

pppp.There is no dominant strategy. qqqq.However, there are two Nash equilibria: upper right and lower left corners.

2.

a.

TwiddleDum

Cheat

Cheat Dum: $1.5, Dee: $1.5 7

TwiddleDee Not Cheat Dum: $3, Dee: $1

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Not Cheat Dum: $1, Dee: $3

Dum: $2, Dee: $2

rrrr. You would advise TwiddleDee (Mr. Notsonice) to cheat since he can probably expect TwiddleDum to cheat. ssss. If the game is played many times, you’d recommend that TwiddleDee figure out an agreement with Twiddledum so that their combined profit increases. If either firm cheats in the first cycle of the game, then their agreement will likely fall apart.

CHAPTER 21: THINKING LIKE A MODERN ECONOMIST Questions and Exercises 1.

A model is an abstraction from reality and therefore does not show all the details of reality. Instead, it highlights the features that are important to the model.

Examples include a road map, globe, plastic model of the human heart, scale model of a bridge, etc. (A number of examples are possible.)

2.

An inductive approach is an approach to understanding a problem or question in which understanding is developed empirically from statistically analyzing what is observed in the data. A deductive approach is an approach that begins with certain self-evident principles from which implications are deduced (logically determined). Modern economists tend to approach models inductively, while traditional economists approach models deductively.

3.

Traditional economists are economists who study the logical implications of rationality and self-interest in relatively simple algebraic or graphical models such as the supply and demand model. Behavioral economists use a broader set of building blocks—enlightened self-interest and purposeful behavior. They argue that rationality should be broadened to purposeful behavior and self-interest to enlightened self-interest.

4.

Enlightened self-interest means that a person takes into account the well-being of others, as well as themselves, when making decisions. Self-interest means that a person takes into account only his own interest when making decisions.

5.

The assumption of rationality is that one would eat until the marginal benefit of eating another spoonful equals the marginal cost. Assuming that all the food on the plate is paid for, there is still a marginal cost—gaining weight or feeling uncomfortably full. So, eating until your plate is clean might not be rational if the 8

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pleasure from eating that extra spoonful does not exceed the disappointment of gaining weight or if it makes you feel too full.

6.

Two advantages are that the traditional model is simple and its conclusions can be tested. Two disadvantages are that the assumptions are too simple to reflect reality and relying on the tools of analysis to determine what is studied may cause researchers to overlook important data.

7.

Two advantages of the behavioral model are that it better matches observed behavior and broader building blocks free researchers to look for more patterns in the data. Two disadvantages are that each model depends on a specific context and they are not easily generalized to other contexts and irrational behavior results in complicated models that are often difficult to solve.

8. a. The endowment effect. tttt. In the traditional sense it is not rational because how two goods are presented to you should not affect your choice. Endowment effects fit the broader building block of ―behaving purposefully;" they do not fit the narrower ―rationality‖ building block.

9.

A heuristic model is an informal model expressed in words that conveys the essence of the model. Heuristic models can have either traditional or behavioral building blocks. Heuristic just describes how a model is expressed, not its underlying assumptions.

10.

In a path-dependent model, there are multiple equilibria where one equilibrium may be indisputably better than another. In this case, there may be a role for government to nudge the market toward the better equilibrium. This same reason for government intervention does not exist in the supply/demand model because in the supply/demand model there is only one equilibrium, and the market is expected to reach that equilibrium without government intervention.

11.

According to Robert Frank, people are more likely to return the $20 because they believe that the cashier would be penalized for the $20 (the register wouldn’t balance) but would not be penalized for the unscanned lampshade. The cost of the lampshade would be paid by the store, not the individual, and people care more about other people than institutions such as stores.

9

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If people only cared about themselves, they wouldn’t report either of the mistakes.

That people report the $20 suggests that people do care about others. They follow enlightened self-interest. It suggests that traditional building blocks do not always match reality.

12.

Economists rely more on empirical evidence today because computers have become much more powerful in storing and analyzing data. The strong reliance on empirical work is true of all modern economists—both those who use traditional building blocks and those who use behavioral building blocks.

13.

―Letting the data speak‖ means taking relationships found in the heuristic model and seeing if these relationships can be generalized to other data sets. In other words, to let the data speak, you collect data and analyze them with statistical and econometric tools.

14.

A regression is a statistical tool to test the relationship among variables. It produces a ―best-fit‖ estimate of those relationships. It is a primary tool of empirical economists.

15.

Natural experiments, events created by nature that can serve as an experiment, may help to shed light on various economic issues. For a natural experiment, you would look for data that most closely mimics a controlled study—one group with a particular set of characteristics compared to a group that is very similar, but with the difference that you would like to study.

16.

An agent-based economic model is a model in which one specifies agents with particular characteristics and allows them to interact in a simulated environment.

For example, ACE researchers try to create virtual computer models that capture the essence of interrelationships among agents and then observe the results.

Economists then study how the behavior of the agents evolves in the system.

17.

Models that are generated from a specific set of data cannot be tested against the data out of which they were formed. That is circular reasoning. Instead, economists must use other data, called ―out of sample data‖ to test the validity of the model. ―Out of sample data‖ provides an independent assessment of the model.

18.

False. Models provide theorems but not precepts. Theorems are logical conclusions based on a model. Precepts are policy rules that a particular path of action is preferable. While a model will suggest precepts, precepts are also based 10

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on history and the limitations of the model, which are judgments by the economist.

19.

An example of a traditional economist’s precept is that more is preferred to less, and that more output is generally good; thus, policies directed at achieving more growth make society better off. The behavioral economic precept is that growth should be questioned.

Another traditional economist’s precept is that people make rational decisions about consumption by comparing marginal benefits and marginal costs. The behavioral economics precept is that how much people save depends on the institutional structure, and with so much of the institutional structure designed to get people to spend, people likely save far too little. uuuu.Traditional vvvv.Modern wwww.

Traditional

xxxx.Modern

Questions from Alternative Perspectives 1.

Feminist Economists’ models see all people as equally situated and do not allow for social and political limitations on people. Thus, they interpret a person’s actions as expressing their desires, which means the models leave out all types of institutional discrimination and social injustices that a different frame could focus on.

2.

Religious It depends on how one interprets rational. In one sense all people are rational; it is just that different things make people happy. Thus Mother Teresa could have been rational if her happiness was based on serving others and God. Economists usually interpret rationality within a very limited type of self-seeking happiness, and thus would not see her as rational. Most religious people would see that type of model as highly limiting.

3.

Radical The economic approach requires researchers to quantify and statistically study the problem. This requires researchers to focus their study on issues that can be 11

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quantified and observed, which often involves small questions. Sociologists focus less on formal statistical studies and thus can focus on large questions that may be important, but which often do not have quantitative answers.

4.

Austrian Behavioral economists make different assumptions than traditional economists about what motivates behavior, but they still accept the large picture that traditional economists have and force all analysis into formal models. This approach tends to miss larger issues such as unintended consequences of actions and the large degree of uncertainty that characterizes many decisions.

5.

Institutionalist Yes. That the modern focus on issues that can be quantitatively studied tends to shortchange those aspects of life that cannot be studied quantitatively. Moreover, it leads us to see ourselves as a reflection of those quantitative measures. This is sometimes called a quantitative bias. For example, our society’s focus on GDP and output rather than people’s broader satisfaction may be a result of economists’ tendency to measure GDP.

Issues to Ponder 1.

Purposeful behavior means that people behave in ways that reflect a purpose that doesn’t necessarily have to be rational. This assumption reflects economists’ observation that sometimes people behave in ways that do not maximize their self-interest. Economists call this behavior ―predictable irrationality.‖

2.

The assumption is that test performance reflects innate ability. This study shows that how a test is framed (―I am a woman taking a math test‖ compared to ―I am an Asian taking a math test‖) can affect behavior, a result of irrational behavior.

3.

The supply/demand model is not a path-dependent model because the equilibrium does not depend upon how the market arrives at that equilibrium. A pathdependent model can have more than one equilibrium while a supply/demand model has only one equilibrium. (One exception is a kinked-demand model, which can have multiple equilibria.)

4.

Whether an economist is modern or not does not depend on the building blocks she uses. Modern economists rely heavily on data, use a number of models and allow complex relationships among variables. These models can be based on the assumption of rationality and self-interest (traditional assumptions) or purposeful behavior and enhanced self-interest (behavioral assumptions).

12

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5.

An economist who cannot solve a model analytically might use a computer to simulate the model and look at the data generated by the computer to determine the implications of the model. He would then compare these implications against real-world data.

6. a. It gives the student the greatest flexibility in scheduling their workload throughout the semester. yyyy.The student knows that they will procrastinate and not start the papers until the week they are due. zzzz.

The first option is the most rational choice, because it gives the student the most flexibility. The first option allows the student to follow the schedule of the second option if the student chooses.

CHAPTER 22: BEHAVIORAL ECONOMICS AND MODERN ECONOMIC POLICY Questions and Exercises 114.

A coordination mechanism is a method of coordinating people’s wants with other people’s desires. All markets are a type of coordination mechanism. Another coordination mechanism includes the algorithm that matches courses students request and the courses they are assigned. (Other examples are possible.)

115.

False. Some markets don’t have explicit prices. They have what are called ―shadow prices.‖ Economists have developed ways to convert opportunity costs into shadow prices regardless of whether money is exchanged.

116.

False. Both money prices and shadow prices affect incentives. While a money price is not paid in a market with shadow prices, an opportunity cost is paid. The shadow prices measure the opportunity cost.

117.

The incentive compatibility problem is a problem in which the incentive facing the decision maker does not match the incentive needed for the mechanism to achieve its desired end. An example is the salary of managers. While it is in the interest of the corporation to keep costs down (keep salary as low as possible) it is in the interest of the manager to boost his own salary. (Other examples are possible.)

13

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118.

The primary task of a mechanism design economist is to identify a goal and design a mechanism to achieve that goal.

119.

Mechanism design economists realized that many of the current models of individual behavior did not fit institutional realities. These economists needed to understand people’s predictable irrationalities so that they could take them into account in designing real-world mechanisms.

120.

A model that includes just price might fail to take into account shadow prices that reflect social and moral incentives faced by decision makers. An example is the late pick-up at childcare example in the text. By replacing the moral incentive (a shadow price) to pick up one’s child on time with a market price, late pick-ups unexpectedly rose. Once a social infraction, the late pick-ups now became a service parents could buy.

121.

Choice architecture is the context in which decisions are made. Behavioral economists have discovered that contrary to the assumptions of traditional economics, choice architecture will affect people’s choices. Mechanism design economists take this into account when designing mechanisms to achieve particular goals.

122.

Nudges are not new. Firms have been presenting choices to people in intentional ways to affect their choices for many years. Any type of advertising can be considered a nudge.

123.

A nudge policy is a policy in which government structures choices people face so that they are free to make the choice they want but are more likely to choose in a way that meets predetermined goals of policy makers. An example of a nudge policy from the book is presenting healthy foods at eye level. (Other examples are possible.)

124.

A nudge can be defined as libertarian because the government is not forcing people to make any particular choices nor is it changing the incentives facing people for making any particular choices. Government is merely placing the questions in a particular context.

125.

Nudge policies are paternalistic because the government frames choices in ways that people make the choice that policy makers believe is ―best.‖ 14

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126.

Person B is more likely to participate because studies have shown that people are more likely to choose the default option. The default option for Person A is not saving (the box to save is not checked); the default option for Person B is saving (the box to save is already checked).

127.

Nudges are useful for choices in which benefits, and costs are separated by time, complicated with many dimensions, and infrequent choices.

128.

People tend to place more weight on costs and benefits that are immediate compared to costs and benefits that occur in the future. This may result in choices that upon reflection are viewed as suboptimal. Presenting choices in a way that makes future costs and benefits more salient will offset this tendency.

129.

In the traditional model, people can make vastly complicated decisions instantaneously, so they don’t need nudges to make good decisions. In the behavioral model, there is a limit to the amount of data people can process, so nudges can help them make better choices.

130.

The first type of nudge is advantageous default option policy. When faced with a choice, people are predisposed to select the default option. By taking advantage of that tendency, economic policy makers can direct people to do what they think is better for them, while still leaving people free to make their own choice. The second type of nudge policy can be classified as information and encouragement policy. With these policies, the government encourages people to make certain choices that the government has decided are good for them.

aaaaa.

Potentially advantageous default nudge.

bbbbb.

Information or encouragement nudge.

ccccc.

Not a nudge.

ddddd.

Information or encouragement nudge.

131.

This nudge can be defined as libertarian paternalistic because the government is not forcing people to make any particular choice nor is it changing the incentives facing people for making any particular choice. Government is merely framing the filing options in a way that people will tend to choose the ―best‖ option as determined by policy makers.

15

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132.

If government can institute the behavioral economic policy directly, or if a private firm chooses to implement a policy on its own, it’s a nudge. However, if government has to develop a regulation and requires firms to implement a particular nudge, the nudge no longer meets the criteria of libertarian paternalism; the nudge is not a nudge, but a push.

133.

Any action by the government that requires firms to take a particular action is a push. Push policies restrict free choice by someone or some institutions in society by enacting taxes or regulations.

134.

Any action by the government that requires firms to take a particular action is a push. Push policies restrict free choice by someone or some institutions in society by enacting taxes or regulations. A nudge policy is a policy in which government structures choices people face so that they are free to make the choice they want but are more likely to choose in a way that meets predetermined goals of policy makers.

eeeee.

Nudge.

fffff. Neither. ggggg.

Push.

hhhhh.

Push.

iiiii. Nudge.

135.

Conspicuous consumption is buying a good for the purpose of showing it off.

Although one might get pleasure from the good itself, most of the pleasure comes from showing others that you have relatively more than them.

136.

To the extent that conspicuous consumption crowds out consumption of other goods that would provide longer-lasting pleasure, it can lower total happiness. An example is going out to dinner at the restaurant where socialites go just to be seen and giving up a quiet evening at home having a personal conversation with your spouse that benefits your relationship long-term.

137.

Four reasons are: (1) Very few policies meet the criterion of libertarian paternalism. (2) Designing helpful policies is complicated. (3) It isn’t clear if the government knows better. (4) Government policy may make the situation worse.

16

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138.

The possibility for true nudge policy that meets the libertarian paternalism criterion is very small because all nudges require some kind of government intervention. If the government passes a law that requires firms to present a particular choice as the default option, the policy does not meet the libertarian criterion, and thus is more than a nudge because the government is telling the firm what to do.

139.

For this to be a true nudge, one must assume that people prefer to save more than they are currently saving. Whether this is reasonable or not is debatable. A traditional economist would say that it is not reasonable. If it were, people would already be saving as much as they prefer. Behavioral economists would say that it might be reasonable because every choice is framed.

Questions from Alternative Perspectives 140.

Austrian We don’t; there are implicit value judgments in the behavioralist approach to policy. From an Austrian perspective, the libertarian policy is acceptable; the paternalistic policy is not.

141.

Radical No, a policy that meets the libertarian paternalistic goal is not necessarily a good policy. Consumer sovereignty is an assumption of economics; it is not something that morally should necessarily exist. The fact that economics does not discuss the importance of that assumption suggests a hidden ideological bias in economics.

142.

Institutionalist Behavioral economics takes away the basic rationality building block that underlies all the policy results that follow from the supply/demand model. If one cannot say that the demand curve reflects people’s preferences, then you cannot claim that a supply/demand equilibrium maximizes total welfare.

143.

Feminist While behavioral economists might recognize that cultural norms impact behavior, this still leaves open the question about which cultural norms ought to be encouraged. Recognizing the possibility of nudges increases the risk that those in power (men) will design nudge policies that benefit themselves (men) at the detriment of those with less power in society (women). It is essential that issues of gender-equality be addressed before entertaining a broad support of nudge policy.

Issues to Ponder 17

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144.

Government could develop ―veil of ignorance nudge courts‖ in which juries are asked to determine whether a nudge should be implemented or not. Advocates for both sides could be allowed to argue their case, as would happen in a court. The decision could be addressed by, say 10 courts, with an x percent majority required in at least y percent of the courts to implement the nudge. The costs of such a large bureaucratic system may well outweigh the benefits of any nudge policies put in place.

145.

Beginning in 1973, the American League instituted the designated batter. This meant that the shadow price of beanballs (throws that hit the batter) fell because pitchers no longer faced the possibility of being hit by a pitch themselves. Since they faced a lower shadow price, American League pitchers had less of an incentive to throw fewer beanballs.

146.

The league might raise the actual price of beanballs by instituting a fine for beanballs.

147.

a.

Yes. It is a complicated and infrequent decision.

jjjjj. Yes. The costs and benefits are separated by time. kkkkk.

No. It is a simple decision; the costs and benefits are close in time and it is a decision that is made often. lllll. Yes. It is an infrequent decision (in most cases).

148.

Whether we as a society focus too much on consumption is a matter of debate.

There are a number of ways to change that focus. One is to institute a consumption tax, making consumer goods more expensive. Another is for the government to advertise the benefits of simplifying one's life or the harmful effects of accumulating too many goods.

149.

The list will differ by student. The following are five possibilities: (1) grocery stores place items needed to make a dinner in one location making it easier for shoppers to imagine the need for those ingredients, (2) department stores place high profit-margin goods in the front of the store where product turnover is higher, (3) butchers label meat according to leanness (75% lean) instead of fat (25%) to make the product appear more healthy than it is, (4) internet providers give "early-payment discounts" instead of late-payment penalties making customers feel better about paying on time, (5) pharmaceutical companies will 18

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feature a doctor reading the benefits of a drug rather than a regular person to add credibility.

CHAPTER 23: MICROECONOMIC POLICY, ECONOMIC REASONING, AND BEYOND Questions and Exercises 150.

A Pareto optimal policy is one that benefits some people and hurts no one. It's hard to object to such a policy, although one could if one saw certain social values as inviolate. Such issues are, for the most part, academic, since, in reality, no such policy can exist. All real-world policies make some people better off and some people worse off.

151.

The problem with proposing only Pareto optimal policies would lie in developing them. As the text points out, there are no examples of real-world policies that benefit some people without hurting anyone. If economists seek to propose only Pareto optimal policies, they may end up proposing no policies. Focusing only on Pareto optimality would condemn economists to irrelevancy in real-world affairs.

152.

All economists are not likely to oppose any policy, price controls included.

Economists will support or oppose policies based on an analysis of marginal costs and benefits, but also in part on value judgments and in part on their reading of the political and social institutions within which economic policies are instituted.

Differences over these lead to differences in policy recommendations. Most, but not all, economists, based on their readings of history, oppose the vast majority of price controls.

153.

a.

Since the supply of teenage babysitters shifted to the left just as the demand for them shifted to the right, the equilibrium price probably rose dramatically. The impact on the number of times parents go out without their children depends on the relative size of the shifts.

mmmmm.

The price of babysitters probably rose as described in part a.

nnnnn.

The average age of babysitters probably fell as parents loosened their requirements of babysitters in an attempt to find substitutes for the reduced number of 14- to 17-year-olds. ooooo.

Whether the government should require a minimum wage and age for babysitters is normative and opinions will differ. While instituting a minimum wage would raise the wages of some, it would also reduce the quantity of 19

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babysitters demanded, leaving some potential babysitters without opportunities to babysit. Instituting a minimum age might be supported on the grounds that parents would hire children who are just too young to take care of other children.

Another argument against such a policy is that most of these jobs are paid in cash and the cost of implementing them would be huge.

154.

The usual arguments against the buying and selling of body organs include the concern that people might seek to make such sales for the money involved and exploit the poor, and that those with the ability to pay would get needed organs sooner than those without means, again favoring the wealthy over the poor. Some may believe that it is immoral to sell body parts. Arguments for selling body parts include that both parties freely enter the transaction, and that both sellers (since they decided they preferred the money to the body part) and buyers benefit.

Economic theory provides no answers to such questions.

155.

There seems to be no reason why people today would value their lives more than in the 1970s. There is usually an inertia that makes any change difficult. People need to be educated about issues such as safety belts before they can make informed decisions. This can explain the difference in attitudes. The introduction of airbags also involved informational issues. People needed to be convinced that airbags save lives. In the 2000s there was still some debate about the negative consequences for children with passenger side airbags. The inertia in the 1970s could also be related to the strength with which car companies lobbied against legislation.

156.

Any decision about prisons involves complicated ethical and moral as well as economic considerations. In reference to the economic issues alone, it would seem that it does make sense to build more prisons since the marginal benefits of doing so exceeds the marginal cost, unless successful education programs turn out to be a cheaper way to reduce future crime. Assuming that prisons are currently full, the marginal benefits of additional prisons are greater than the marginal costs.

157.

a.

According to standard economic reasoning, the value of an additional dollar spent in preventing death is (assuming the journal’s figures are correct) more valuable in the United States than in Sweden and in Portugal, and thus more money should go to saving lives in the United States. However, there are moral issues that complicate matters and make the answer unclear.

ppppp.

This is a complicated question. First, many Americans fly in Portugal and, second, it would be bad publicity for an airline to value lives of people differently by national origin or to even acknowledge making such a marginal 20

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cost/marginal benefit analysis with regard to safety precautions at all. Moreover, there are those sticky moral issues, which lead one to value all life equally.

158.

a.

The study is based on the cost/benefit analysis that states that a consumer will purchase a helmet if the value of the reduced risk of head injury is greater than the cost of the helmet. So, the value of life is greater than or equal to the annualized cost of a helmet divided by the change in the probability of death due to the purchase of the helmet.

qqqqq.

At least $1.6 million (= $6.51 ∕ 0.0000041 = $1,587,805). (The parents might have been willing to pay more for a helmet; we can't know from the information provided.) rrrrr. Because the helmet will be less effective in saving life, the probability of reducing the risk of death falls, so the value of life increases.

159.

A well-functioning market (one with perfect information and no externalities) might still result in undesirable outcomes such as (1) a distribution of wealth that is perceived to be unfair, (2) choices by individuals who are irrational, or (3) violations of inalienable or at least partially inalienable rights of individuals.

160.

Assuming who pays for dates reflects supply and demand considerations, and assuming that the majority of the Chinese are heterosexual, this suggests there will be a shortage of women, and thus men will be paying a higher percentage of the cost of dates in the future. Each woman will be able to choose between several men for each date, forcing them to compete and lower their ―price.‖

161.

a.

The price of pigs will most probably rise slightly, as a new demand for pig organs develops, shifting the demand for pigs to the right.

sssss. It is doubtful that it is Pareto optimal. Some people will be made better off, but individuals who feel that such use of pigs is immoral will be hurt. The rise in the price of pigs will also hurt some people who demand pigs for other purposes. ttttt. If this program were successful, it would significantly reduce the black-market price of human organs. The black market would be replaced by an open market for organs, which would cause black market demand to fall.

162.

Public choice economists study the subject of government failure. These economists argue that most politicians say that they are out to do the public good, but in practice they often pursue economic policies that just sound good in their quest to be reelected.

21

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163.

The likely effect of that proposal was a flood of criticism. Certain human rights such as the sanctity of the human body are held in high regard regardless of societal status. A proposal that, on its face, seems economically sound is not acceptable if it does not include issues of human rights. That was the effect because the economic model did not account for all issues. Morality issues provoke strong political reactions.

164.

The basis for the opinions of public choice economists about the government's ability to correct for market failure is that politicians are subject to the laws of supply and demand. The costs and benefits of a decision will depend on politics and will determine the policies they undertake, rather than what an outside observer would likely say is the best policy. The incentives facing politicians are keeping their constituencies happy, not arriving at the best solution to difficult problems.

Questions from Alternative Perspectives 165. Austrian uuuuu.

Often, policy goals do not match outcomes. For economists this is a serious problem that goes under the name government failure. vvvvv.

Politicians often have a short-run policy horizon, which means the goals matter much more than outcomes, especially if the politician will be out of office by the time of the outcome.

166. Institutionalist wwwww.

An example of a market failure is in the music provision market, where there is an almost zero marginal cost of providing music to another person but due to copyright laws, individuals are not allowed to play music unless they pay a price significantly above marginal costs. (Many other answers are possible.) xxxxx.

A free market advocate would likely say that nothing should be done since the business is simply following its self-interest and government intervention would likely cause more problems. But he or she might also say that the government caused the externality by instituting the copyright law in the first place. yyyyy.

An Institutionalist would argue that there are both benefits and costs of the copyright laws. He or she would take into account that the reason for this institution is the belief that the copyright laws increase individuals’ incentives to create music. Institutionalists would explore other institutional structures that would likely achieve a preferable outcome.

22

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167. Post-Keynesian zzzzz.

Social norms are created by society as a whole. It is difficult to attribute their creation to a single group. aaaaaa.

Norms hold society together. Without them there would likely be no society, which would make almost everyone worse off. However, norms can also lead to discrimination and often shift over time. bbbbbb.

Norms make policy analysis much more difficult. The right and wrong answers that follow from the markets turn into shades of gray.

168. Radical cccccc.

This is a judgment question and judgments differ. Radical economists tend to believe that cost/benefit analysis is not an especially good tool for many policy questions. dddddd.

Yes, it tends to work better when the issue being studied does not have large distributional consequences or moral dimensions.

169. Religious eeeeee.

This is a judgment question and judgments differ. Religious economists tend to believe that economists worry too much about the advice being scientific, and not enough about whether it is good advice. ffffff.The presentation of economics would likely be less focused on abstract models and more focused on the nuances of policy decisions.

Issues to Ponder 170.

Some of this analysis will depend on whether or not the course is a requirement. If it is, taking it would have more benefits than if it were optional (in which case the benefits would be the knowledge gained, and getting to know that professor, meeting other students you might not have met, etc.). The cost would be tuition expense, book(s), supplies, any added cost of transportation or food (because of the effect on your schedule), and the opportunity costs of courses not taken, professors not taken, students not met, etc. (Other costs and benefits are possible.)

171.

The textbook suggests a method for valuing one’s life. A correct answer should consider what you would pay to reduce their chance of dying by a certain amount.

The value of life is that amount times the inverse of the reduced probability of dying.

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172.

Most people can (and many unknowingly do) function with only one kidney.

Thus, it can be argued that having two kidneys means having one more than you need to live a perfectly normal life. Aside from the expense, pain, etc., of having the kidney removed, selling one for a million dollars may sound like a good deal.

However, should the remaining kidney become diseased, the seller would be left with no choice but dialysis, or obtaining a transplant himself or herself. The question is whether the million dollars is worth the risk. (There are also cultural and religious factors involved.)

173.

a.

Because the cost of using a road is now close to zero, excess demand results. In the accompanying graph, excess demand is QD – QS .

By charging a price of P1 to use the roads, excess demand could be reduced or eliminated.

gggggg.

Some will attempt to disable the readers. Others will share rides. Still others will shift to driving vehicles that don't have readers, such as motorcycles. Still others will find out where the readers are and go around them, or if prices are to rise at a certain time, go right before.

24

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hhhhhh.

This will likely result in an increase in congestion right before prices change. Pre-peak-load congestion might be avoided if the start of the peak-load price is a random lottery. In other words, if you drive between 4 and 5 o’clock you are equally likely to be charged the peak rate and the not peak rate, but there is no way to know beforehand. It could also be a price gradient, where prices rise a few cents per minute for the hour before rush hour and continue rising until it reaches its peak price.

174.

If these figures correctly value these regulations, then one should first look at other lifesaving expenditures to see if their cost is lower. As a general rule, lower marginal cost regulations (with the same marginal benefit) should be imposed first, making the seat belt standards the more attractive regulation.

175.

a.

If 70 percent of families choose male offspring, monogamous heterosexual marriages will be difficult to maintain as there will be too few women. Women might start having two husbands (as they do in a few cultures).

iiiiii. It will likely push down the female dowry since the quantity of women demanded significantly exceeds the quantity supplied (assuming the distribution of individual sexual preferences does not change). jjjjjj. On supply/demand grounds, a family would be wise to have a daughter since their relative importance would rise as their expected relative supply declines.

Having a daughter would make it more likely that they would be able to have grandchildren and continue their family line.

176.

a.

A higher percentage of births by C-section are done at for-profit hospitals, most likely because the profit margin for C-sections is higher than that for vaginal births.

kkkkkk.

The implication that can be drawn is that goodwill cannot be relied on to lead to low-cost health programs. Other mechanisms must be instituted to ensure efficiency. llllll. In the case of fixed payment, the for-profit hospital would probably do more vaginal births, which cost less than C-sections. The C-section rate would most likely rise at nonprofit institutions as necessary C-sections are limited at for-profit hospitals and shift toward nonprofit hospitals.

177.

An economist might propose a policy that has little chance of adoption because he or she might be removed from the concerns that make policies unviable (i.e., political concerns). In so doing, economists add ideas to real world possibilities 1

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and may influence the way people think. The goal behind policy proposals is not always to get them implemented.

178.

a.

The device reduces the probability of a crash by 1 ∕ 3. Multiply this by the cost of the crash ($30,000) to find the most rational person would be willing to pay for the device—$10,000. This exceeds the cost of the device, so installing them makes sense.

mmmmmm. The reason is that people do not want to be tracked or have their violations of the law recorded. The policy comes with invasion-of-privacy arguments against it. nnnnnn.

They will likely be first installed in cars where the owner of the car is different from the driver, such as in rental fleets, government-owned cars, or in teenagers’ cars. The reason is that the black boxes would provide the owners with a way of monitoring the driver’s actions. oooooo.

179.

They will likely reduce violations significantly.

a.

Because treatment costs less than criminal justice, I would recommend treatment.

pppppp. person.

I would have to know the social benefit of reducing drug use by one

qqqqqq.

No, the costs exceed the benefits.

180.

If the hourly wage is higher on welfare than in a job, rational individuals will choose welfare. If one wanted to reduce the number of people on welfare, there are many possible policy recommendations from such information. One could call for a much higher minimum. Alternatively, one could call for a reduction of welfare, or the establishment of subsidized day care as part of the support if the welfare recipient works. Since the welfare payments vary so widely by state, one could also argue for equalizing welfare payments across states. Arguments against these proposals include that the minimum wage is not actually a ―living wage,‖ that working isn’t actually a viable option for many on welfare, and that costs of living differ geographically.

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